With increased globalization and the growth of information technology, the import of technical know-how, acquisition of software and technical services is not very uncommon in developing economies like ours. The increased focus on service oriented economy has paved the way for augmented prominence of Intellectual Property Rights transfers across borders.
I. Issues relating to categorization of Income for Taxation
Characterization of cross-border software payments or payments in relation to import of technical services, as either royalty or business profits or some other head has always been a contentious issue in India. The underlying point of question involved herein is that whether such a transaction would amount to a "transfer of a copyright" or "transfer of a copyrighted article".
To start with, there is no direct rule or basis for categorizing a transaction involving transfer of software or technical know-how under a particular head for the purpose of taxation. Taxation in India of such payments to foreign companies would depend on the nature of the transaction. The payments made by a resident to a non-resident/foreign company towards such transactions could be characterized as royalty, fees for technical services, capital gains or business profits depending on the nature of the transaction.
Indian courts have recognized in an array of judgments that the category of income would depend upon the "predominant purpose for which the consideration is paid in a transaction". Broadly, if the consideration paid by the foreign company is towards the purchase of a product itself, then the payment made should be classified as "business income". However, if the consideration is towards the "right to commercially exploit the intellectual property in the product", then the same could be equivalent to "royalty"1. Another contentious transaction from categorization perspective is full rights on the product are not transferred to the purchaser. Without prejudice to the specific nature of the transfer, in general, such payments are likely to be categorized as business income or capital gains rather than royalties.
The categorization of a payment as "Fee for technical services (FTS)2" is comparatively less debatable and it is generally recognized that any payment for the technical services, which involves the application of inter-alia technical knowledge, experience, skill, know-how, or processes, availed by a resident form a foreign company would be regarded as FTS.
II. Taxation under Income Tax Act, 1961
The applicable rate of taxation on royalty and FTS has always been a matter of debate because of high difference in rates under the DTAAs and Income Tax Act, 1961. Before 2013, as per Section 115A of the Income Tax Act, 1961, taxation on royalty and FTS was 10 per cent on gross basis. However, the rate was amended by Finance Act, 2013, to 25 per cent on gross basis.
Again, the Government of India vide Finance Act, 2015, reverted to the previous applicable rate of 10 percent in order to encourage the entrepreneurs running business ventures or initiating to start new ones and to safeguard the genuine cases of payments made by subsidiaries companies in India to their foreign holding company under the given heads. The aforesaid rates are exclusive of applicable surcharge and educational cess.
However, as per Section 206AA of the Income Tax Act, 1961 (applicable since 1st April, 2010) there is a mandatory requirement of furnishing PAN even by a non resident. In case non-residents do not posses PAN, a higher rate of withholding tax of 20 per cent against payments to non residents would be applicable. Lastly, royalties and fees for technical services accruing or arising to a foreign company (which has a permanent establishment in India) have been excluded from chargeability of Minimum Alternate Tax (MAT) if tax payable on such income is less than 18.5% (exclusive of surcharge, education cess, etc.). Hence given the applicable rate is 10%, there will be no MAT on such income.
III. Applicability and Conflict between Income Tax Act, 1961 and DTAAs
The Double Tax Avoidance Agreements (DTAAs) between India and other jurisdictions also generally contain the provision for taxation of income earned by non residents in the form of royalty or FTS. The rates provided under the DTAAs are equal or higher than the applicable rates under the Income Tax Act, 1961.
However Section 90(2) of Income Tax Act, 1961 allows a non-resident taxpayer to opt between provisions of Income Tax Act and Articles of DTAAs, whichever is beneficial to the taxpayer. The provisions of DTAAs are generally less favorable or in line with the provisions of Income Tax Act, 1961. For example, under the Indo-Mauritius DTAA prior to the amendment on May 10, 2016, Mauritian residents earning FTS from Indian sources was assessed as business income (not taxable in India in the absence of permanent establishment). But the position has been revised to include a source based tax rate of 10% on FTS. Under the Indo-Singapore DTAA: Source based rate of 10% on royalty and FTS is applicable. In many of India's DTAAs, an FTS provision is present as part of the royalties article or as a separate article. However some DTAAs do not have the FTS Article, for example Indo-UAE DTAA, Indo- Philippines DTAA, to name a few.
In term of Section 90(2) of the Income Tax Act, 1961, notwithstanding the provisions of Section206AA of the Income Tax Act, 1961 the foreign company shall be able to get the benefit of lesser rate under the DTAA. Also it should be note that in order to avail the benefits of DTAAs, PAN is not a mandatory requirement. Following documents are however required by a non-resident for availing these benefits: (i) Tax Residency Certificate (TRC) issued by home country of the non-resident (ii) Declaration in Form 10F (if required) as prescribed by Income-tax Rules and (iii) Self-declaration by non-resident in relation to permanent establishment in India in terms of the relevant DTAA. However it should be noted that, once the tax is withheld under the provisions of Section 206 AA due to absence of PAN, then such non-resident cannot be able to seek refund of excess tax withheld, on grounds of beneficial treatment of DTAA, in the assessment by filing tax returns because a non-resident is not entitled to file tax returns without having a PAN number.
1. As per Explanation 2 to Section 9(1)(vi) of the Income Tax Act, 1961, "Royalty" is defined as the consideration (including lump sum payment) for the transfer of all or any rights (including the granting of a license) in respect of a patent, invention, model, design, secret formula, process, trademark, copyright, literary, artistic or scientific work.
2. As per Explanation 2 to Section 9(1)(vii) of the Income Tax Act, 1961, FTS is defined as any consideration (including any lump sum consideration) for the rendering of any managerial, technical or consultancy services (including the provision of services of technical or other personnel. However FTS has generally broader definitions under the DTAAs.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.