India: Targeted Online Advertising Through ‘Adwords' Adds Massive Royalty Tax For Google

The Bangalore bench of the Income-tax Appellate Tribunal (Tribunal) in its recent ruling in the case Google India Private Limited v ACIT1 has held that payments made by the group's Indian entity, Google India Private Limited (Google India or Taxpayer) to Google Ireland Limited (Google Ireland) in the form of fees for rights of distribution and marketing of Google Ireland's 'Adwords Program' to advertisers in India were in the nature of 'royalty'. As per the Taxpayer, the arrangement merely involved sale of advertising space by Google Ireland to Google India, which the latter then re-sold to advertisers in India. The Tribunal has, after considering Google's business model and transaction flow and process in detail, looked at the arrangement as that of use of Google Ireland's intellectual property (embedded in its online web technology) by Google India instead of sale of online advertising space simpliciter and thus, held the Taxpayer as a defaulter for not having withheld tax on payments made by it to Google Ireland. The ruling deals with two additional grey areas in the international taxation space which have often been subject matter of extensive litigation viz. (a) limitation period for invoking withholding tax proceedings in relation to payments to non‑residents (on which the law is silent); and (b) taxation of royalty on a 'receipt' basis under the relevant tax treaty provisions (unlike on an accrual basis under domestic law).

Background

By way of a distribution agreement dated 12 December 2005 (Distribution Agreement), Google India was appointed as a non-exclusive authorized distributor of the 'Adword Program' to advertisers in India for the sale of Google Ireland's online advertising space. The 'Adwords Program' essentially enables an advertiser to register a search term or phrase as a "key word" which is relevant to the advertiser's website, so that when the said term or phrase is searched for by any user on the Google search engine, the relevant ad of the advertiser is displayed as a "sponsored link" on the search results page of the user.

In terms of the Distribution Agreement, extensive training had been provided to Google India in relation to the 'Adwords Program', its functionality, features, tools etc. by Google Ireland to enable it to effectively market and distribute the same to Indian advertisers. Interestingly, however, the 'Adwords Program' is marketed by Google India as a 'self‑serve' online advertising service since information relating to the program is freely available to the public on Google's website along with explanatory videos.

In terms of the process, after creating a login account, an advertiser has the option to submit a bid amount for a specific keyword that he wishes to use. The display of his ad is then dependent upon the auction price paid by the advertiser. The keyword bid at the highest rate would be shown at the top of the search results.

Separately, a services agreement dated 1 April 2004 (ITES Agreement) had also been entered into between the two Google affiliates, whereby Google India provided certain information technology enabled services to Google Ireland.

The apple of discord essentially was whether Google India was merely a reseller of online advertising space through the promotion of the 'Adwords Program', or whether it provided advertising services to advertisers in India by using the intellectual property made available to it by Google Ireland. While Google India argued that the payments made by it to Google Ireland were business profits not liable to tax in India in the absence of a permanent establishment, the revenue characterised such payments as royalty income for the access provided to Google India in the intellectual property embedded in the 'Adwords Program' on which it was liable to deduct tax at source.

Arguments Advanced by the Revenue Authorities and the Taxpayer

Set out below are some of the arguments advanced by the revenue authorities and the rebuttals offered by the Taxpayer:

REVENUE AUTHORITIES

TAXPAYER

The Distribution Agreement and the ITES Agreement cannot be separated from each other, and must be read in conjunction.

The rendition of ITES services by Google India under the ITES Agreement is independent of the distribution of advertising space under the Distribution Agreement. The ITES division of Google India is a separate business segment, which provided ITES services even prior to commencement of the distribution activity.

In terms of the Distribution Agreement, Google India is required to provide all after sales services to advertisers in accordance with the broad instructions and training standards of Google. All advertisers are instructed to contact Google India for support, and not to communicate directly with Google Ireland. Google India is required to provide such services in terms of the ITES Agreement, and therefore terms and conditions set out therein (such as access to confidential information, non‑disclosure etc.) would squarely apply to the Distribution Agreement as well.

Google India is mainly responsible for responding to all routine queries in relation to sales and billing. In the case of an advertiser facing technical issues, it is Google Ireland which would have to respond to customer queries.

ITES services are provided to ensure that the advertisements placed by advertisers globally conform to Google editorial guidelines and local Government regulations. The confidentiality clause under the ITES Agreement allows Google India to use confidential information which is largely customer data solely for the purpose of performing its obligations under the ITES Agreement and does not give it the right to use the same under the Distribution Agreement.

The confidentiality clause is a generic or standard clause included for the purposes of protecting information that may be acquired by Google India as a consequence of rendering services to Google Ireland.

The grant of distribution or marketing rights in the 'Adwords Program' itself involves the "transfer of a right in the copyright." Google India has been granted the "right to use", a valuable business asset of Google Ireland, i.e. its search engine technology and associated software, copyright of which belongs to Google Ireland. Google India has been authorized to sell the 'Adwords Program' to advertisers which is tantamount to the grant of licence to Google India, payments for which fall within the definition of "royalty".

Google India neither received any right nor access to the 'Adwords Program'. The Google search engine is used by the end-user and not by the Indian advertiser, and such end-user may not necessarily be based in India. Google India does not have access to any back‑end portion of the software, i.e. databases, software tools, algorithm etc. The consideration paid by Google India to Google Ireland for purchase of advertisement space through the 'Adwords Program' is in the nature of advertisement fees.

Google India has been granted the right to use "Google trademarks and brand features" under the Distribution Agreement for the purpose of selling ad space.

Use of "Google" trademarks and other brand features referred to in the Distribution Agreement is merely incidental to enable Google India to distribute ad space in India. There has been no specific transfer of any patent or trademark to Google India. Any reseller or distributor needs to use the brand of the product being sold to perform its obligations.

The distribution rights granted to Google India involve transfer of rights in respect of a "process". The entire search engine technology for which a license has been granted to Google India for selling advertisement space to advertisers is a "process".

For a "process" to be classified as intellectual property, it is required to be a "secret" process. The "Adwords Program" cannot be equated to a "secret process" since information relating to the program is freely available in the public domain along with explanatory videos.

The Distribution Agreement also contemplates "transfer of know-how" as Google India has been provided access to internal tools of the 'Adwords Program' through extensive training by Google Ireland.

There has been no specific information concerning technical, industrial, commercial or scientific knowledge, experience or skill which has been received by Google India from Google Ireland.

 

Tribunal's Ruling

  • The Tribunal found in favour of the revenue and held that payments made by Google India to Google Ireland were in the nature of royalty, which was chargeable to tax in India basis the following:

Grant of "right to use"

  • Google India has access to a vast repository of information, which includes users' I.P. addresses, names, sex, location, photographs, time spent by them on a web site, their mobile devices used, their eating habits, wearing preferences etc. The Google search engine also enables Google India to track user search history and behaviour.
  • Technology tools that form a part of the 'Adwords Program' such as the 'keyword planner' offer suitable keyword suggestions to an advertiser and indicate the traffic forecast for a particular keyword. This enables the advertiser to optimize his keyword selection for greater visibility and conversion, and at the same time, weed out unnecessary user traffic. The 'Adwords Program' also uses 'Google Analytics' to narrow down appropriate keywords basis user behaviour. Such keyword optimization is only possible as Google India permits the use of Google Ireland's patented software, and protected databases.

Provisioning of targeted advertising services

  • The Distribution Agreement is not an agreement for providing advertising space simipliciter such as in the case of newspaper or television advertising. The Distribution Agreement, goes a step further, by facilitating the display and publishing of an advertisement to targeted customers, which is possible only through the use of Google Ireland's patented tools through which Google India has access to user information and databases. The fact that truncated search results are displayed to a customer with only relevant advertisements demonstrates that Google India does not merely display ads but actively directs targeted traffic to advertisers, with the help of technology made available to it by Google Ireland.
  • Moreover, space on search engines / websites is readily available and any person can buy static IP addresses and upload advertisements in the endless web world. Therefore, the Distribution Agreement has been entered into not merely for providing advertisement space but for providing targeted advertising services as well.
  • Google India neither sells storage space on servers located outside India (on which ads are stored) nor does it sell designated ad space on its website or search engine. Advertisements change on a day to day basis as online bids are required to be placed by competing advertisers on a dynamic basis. The process of inter-se bidding amongst advertisers for displaying ads on a real-time basis clearly demonstrates that that it is not fixed ad space which is sold by Google India. Advertisers bid for placement of a particular advertisement to the relevant customer base at a particular time for which targeted advertising services are rendered by Google India with the help of the 'Adwords Program'.

Access to confidential information

  • Intellectual property of Google Ireland vests in its search engine technology, associated software, and confidential information, which tools and data are necessary for Google India to provide targeted advertising services to Indian advertisers, including after sale services. Customer data and user profiles are central to the successful working of the 'Adwords Program', without which Google India could not have effectively marketed the program in India.

Reading ITES Agreement and Distribution Agreement in conjunction

  • The substance of the agreements is to be given precedence over their form. The ITES Agreement provides for confidential information, access, use and non-disclosure thereof, which enables Google India to discharge its pre and post sales obligations to Indian advertisers under the Distribution Agreement. The ITES Agreement cannot be divorced from the activities undertaken by Google India under the Distribution Agreement. Both the agreements are inextricably connected and have been artificially bifurcated to avoid payment of taxes.

Grant of "right to use trademark"

  • The decisions of the Delhi High Court in Sheraton International Inc v DDIT2 and Formula One World Championship v CIT3 were inapplicable in the instant case. This is because in those cases, the use of trademark for advertising hotel bookings and promoting the F1 racing event, respectively was incidental to the main activity of providing hotel rooms and organizing a car racing event. Neither case involved granting of license to use intellectual property. However, in the instant case, the agreement in question involved the grant of license to use Google Ireland's intellectual property. It would not have been possible for Google India to undertake promotion and distribution of the 'Adwords Program' without the use of the "Google" trademark and other associated brand features.

Transfer of "right in respect of a process"

  • The secret process of targeting customers is not in the public domain and therefore Google India was granted a right in respect of a process to market and promote sale of ad space.

OECD TAG Report and Right Florists distinguished

  • Even though both the Technical Advisory Group (TAG) constituted by the Organization for Economic Co-operation and Development (OECD) and the High-Powered Committee set up by the Central Board of Direct Taxes (CBDT) concluded that payments arising from online advertisements would constitute business profits rather than royalties, their analyses was based on different facts. Likewise, the decisions of eBay International AG,4 Right Florists Private Limited,5 Pinstorm Technologies Private Limited6 and Yahoo India Private Limited7 were distinguished on facts. In the present case, Google India makes use of customer data, patented technology, process and trademark embedded in the 'Adwords Program' to render targeted advertising services. Such intellectual property is used as a tool of the trade for generation of income. It is clear from the Distribution Agreement that Google India had right, title and interest over Google Ireland's intellectual property.
  • On the issue of the period of limitation prescribed under Section 201 of the (Indian) Income-tax Act, 1961 (IT Act), the Tribunal observed that in view of conflicting judgments and in the absence of any binding judgment of the jurisdictional High Court, it was bound to rely on the decisions of CIT v Bharat Hotels Limited8 and Mahindra & Mahindra Limited v DCIT[9]albeit delivered in the context of the pre‑amended position of Section 201, where no time limit was prescribed to initiate proceedings to treat a person as an assessee-in-default. Having said this, the Tribunal noted that established principles of the Constitution of India and the scheme of the IT Act read with the applicable tax treaty necessitate treating a non‑resident no different from that as a resident. A non‑resident cannot be made worse off than a resident as the law envisages non‑discrimination and equal treatment of both residents and non‑residents. By treating both at par, the Tribunal observed that the period of imitation for initiation of proceedings for a resident as well as a non‑resident under Section 201 should be 6 years from the end of the relevant financial year. In doing so, the Tribunal neither accepted the contention of the taxpayer that the time limit should be 4 years (which would be discriminatory for a resident), nor the argument of the revenue authorities that there is no limitation to initiate proceedings against a non‑resident (which would be discriminatory for a non-resident).
  • Google India had also argued that there was no requirement for withholding of tax as the amounts remained unpaid during the years under consideration. The argument that under the provisions of the India - Ireland Tax Treaty, royalty is chargeable to tax only on receipt basis was rejected on the following grounds:
    • A tax treaty can only provide the characterization of the income, at what rate the said income is to be taxed and the country where it is to be paid. It is not within the scope of a tax treaty to provide when (i.e. year of accrual or receipt) the income is required to be charged or the method of accounting to be followed.
    • The benefit of a tax treaty is only available to a non-resident and not to the resident payer. A tax treaty applies only at the option of the non‑resident recipient. A payer cannot presume the applicability thereof. In terms of Section 195, there is an obligation on the part of the payer to deduct tax at source in case any payment is made to a non-resident. In case of a doubt on the chargeability to tax of the payment, reference must be made to the tax officer, which was not done in the instant case by Google India.
    • A payer cannot claim that the royalty is chargeable to tax in the hands of the non-resident on receipt basis as it may not have access to the accounting method followed by the non-resident payee.
    • In any case, Google Ireland itself in its Indian tax returns had disclosed that it followed the mercantile system of accounting.

Comment

While dealing with some critical international tax issues, this ruling seems to have given a new direction to how payments towards marketing of specialised software programs (underlying contractual arrangements for which would deal with rights of the parties as regards the embedded IP) shall be viewed from a tax perspective. Interestingly, other cases dealing with provisioning of online advertising services through the use of search engines (such as in Right Florists); and those that have held the use of trademark or brand name to be incidental to the main distribution or promotion activity (such as in Formula One) have been distinguished by the Tribunal. This is because the arrangement between the two Google affiliates was viewed as use of IP rights by the distributor instead of marketing and distribution of software program simpliciter. It remains to be seen if the same interpretation can be taken in the post equalisation levy regime i.e. whether the use of confidential information and other IP rights in relation to online advertising would fall within the purview of equalisation levy (which is commonly and interestingly referred to as 'Google Tax') of 6% or will there be an overlap with royalty based taxation at the general rate of 10%. While Google India has already preferred an appeal against the decision with the Karnataka High Court, one awaits how higher judicial fora shall interpret such an arrangement under extant tax laws.

Footnotes

[1](2017) 86 taxmann.com 237

[2](2009) 313 ITR 267

[3](2016) 76 taxman.com

[4]140 ITD 20

[5]ITA No 1336 / Kol / 2011

[6](2012) 24 taxmann.com 345

[7](2011) 11 taxmann.com 431

[8]384 ITR 77

[9]30 SOT 374

The content of this document do not necessarily reflect the views/position of Khaitan & Co but remain solely those of the author(s). For any further queries or follow up please contact Khaitan & Co at legalalerts@khaitanco.com

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