India: Income Earned Through Rendition Of Cloud Hosting Services Not Taxable As ‘Royalty' In India

Background

The Income Tax Appellate Tribunal (ITAT) ruled that income earned by Rackspace, US Inc. (assessee) did not qualify as Royalty or Fee for Technical Services (FTS) but business income, not taxable in India in the absence of Permanent Establishment (PE) of assessee in India, under the provisions of the Income Tax Act, 1961 and India- USA tax treaty (tax treaty) since the payment was for rendition of cloud hosting services being in the nature of standard services, performed in view of the terms of a service agreement. Further, the provisions of tax treaty, being more beneficial to the assessee would prevail, thereby keeping it outside the ambit of taxation in India.

Brief facts and contentions

The assessee, a tax resident of USA, earned income from rendition of public cloud hosting and dedicated/managed hosting of services to Indian customers and claimed the said income as being in the nature of business income, not liable to tax in India in the absence of PE of assessee in India

The Assessing Officer (AO) opined that the aforementioned income would be taxable in India as royalty and FTS. Aggrieved, the assessee filed an appeal to the DRP but his plea was quashed.

Resented by the order of DRP, the assessee filed an appeal before the ITAT

ITAT'S Judgement

The ITAT held that income earned by assessee through rendition of cloud hosting services to Indian customers did not constitute Royalty or FTS under Article 12 of the tax treaty. Key observations of the ITAT are as follows:

The assessee had merely provided hosting services to the Indian customers being in the nature of standard services, rendered in pursuance of a service level agreement. Moreover, the possession and control of equipment used for rendition of concerned services vested with the assessee and no control or possession of any such equipment was granted to the customers. Further, there was no agreement to hire or lease out any equipment but only a service level agreement.

According to the amended provisions of section 9(1)(vi) of the Act and explanations thereto, the ITAT noted that the payment made by the Indian customers to the assessee in respect of cloud hosting services would qualify as 'Royalty' irrespective of whether or not the customers had possession or control over the equipment or whether or not the equipment was located in India.

However, as per the provisions of Section 90(2) of the Act, the assessee can opt to be governed by the provisions of the tax treaty to the extent they are more beneficial than the provisions of the Act.

As per the provisions of article 12(3) of the tax treaty, the ITAT observed that definition of 'royalty' is exhaustive and not inclusive and hence and must be given the meaning as contained in the Article itself

Referring to the plain text of the tax treaty provisions, it opined that the definition of 'royalty' did not encompass within its ambit, the payment for the services involved in the present case as Rackspace USA is providing hosting services to the Indian customers and does not give any equipment or control over the equipment.

It further noted that as per the definition, the term "use" or "right to use" for the purpose of the tax treaty, it entails that the payer has possession/control over the property and/or the said property is at its disposal.

Consequently, the income earned by the assessee through rendition of cloud hosting services would not be taxable in India as 'royalty' but as business income and same shall not be taxable in India, in the absence of PE of assessee in India.

Nangia's Take

This ruling demonstrates that taxation of an income can vary depending upon the span of 'royalty' in the Act as well as the tax treaty. Moreover, the amendment in the Act cannot be linked with the pre-specified tax treaty provisions to decide the taxability of income. Maximization of benefit to the assessee has been given precedence over the concern of swelling the revenue kitty of the government, thereby instilling the faith of the taxpayers in the judiciary

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