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No ‘business connection’ constituted in India for sale of GSM systems; payment for embedded software held as not in the nature of ‘royalty’ – Delhi High Court affirms decision of Income-tax Appellate Tribunal (Special Bench) in case of Ericsson AB, Sweden
In brief
In a recent decision, in the case of Ericsson Radio Systems A.B. Sweden1 (EAB), the Delhi High Court (HC) has upheld the Income-tax Appellate Tribunal (the Tribunal) Special Bench Ruling in case of Motorola Inc. v. DCIT2 by holding that EAB did not have a ‘business connection’ in India and that consideration/payment for supply of software (embedded in the telecommunication GSM system) is not
1 DIT v. Ericsson Radio System AB [TS-769-HC-2011 (DEL)]
2 Motorola Inc. v. DCIT [2005] 95 ITD 269 (Del)
taxable as ‘royalty’, either under the provisions of the Income-tax Act, 1961 (the Act) or under the India-Sweden Double Taxation Avoidance Agreement (the tax treaty).
Facts
• EAB is a company incorporated in Sweden. For the financial years (FYs) 1996- 97 and 1997-98 (relevant years), it was engaged in the business of manufacture
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2 and sale of telecommunication GSM systems (comprising equipment and
software) to various cellular operators the world over, including in India.
• During the year under consideration, EAB entered into contracts with various Indian cellular operators (ICOs) for supply of GSM systems. Under these contracts, the property in the equipment was transferred to ICOs outside India. The contracts also provided that the equipment sold was to undergo an
‘acceptance test’ in India. Insofar as software is concerned, a non-exclusive license was granted to ICOs, whereas ownership in the software remained with EAB. The software was loaded onto the equipment and was used for functioning of the equipment.
• Installation of GSM systems in India was carried out by EAB’s group entities (Ericsson Telephone Corporation India AB, India Branch office (EFC) for three months in the FY 1996-97 and Ericsson Communications Ltd (ECL) for nine months in the FY 1996-97) under separate contracts with ICOs. Apart from the installation activities, EFC and ECL also carried out acceptance tests of the GSM systems. The income earned from installation activities was offered to tax by these entities in India.
• Apart from supply contracts, there was an overall agreement between ICOs and EAB. Further, in the event the installation contractors (EFC/ECL) terminated their contract, EAB would identify a new contractor for installation of the systems.
• The assessment of EAB was made by the Revenue, where it was held that EAB had a business connection (BC) as well as permanent establishment (PE) in India. Therefore, income from supply of hardware/equipment was held to be taxable in India. The Revenue Authorities further held that since EAB has provided software to ICOs under a license, consideration for supply of software was taxable as ‘royalty’ both under the Act as well as under the tax treaty.
• On appeal, the Commissioner of Income-tax (Appeals) (CIT(A)) granted partial relief to EAB. Against the order of the CIT (A), the Revenue and EAB preferred an appeal to the Tribunal. These appeals and cross- appeals, along with appeals of other tax payers, namely Nokia and Motorola, were referred to the Special Bench of the Tribunal. The Special Bench adjudicated the matter in favour of EAB by holding that:
- EAB had no BC in India, and therefore, no part of income from sale of equipment was taxable under the Act;
- EAB does not have a PE in India;
- The consideration for supply of software cannot be assessed as royalty either under the Act or under the tax treaty since the software is an integral part of the GSM systems and cannot be taxed on a stand-alone basis as royalty. It was also held that the software is a copyrighted article and supply of it does not allow the ICOs to use any of the copyright rights in the software;
- Interest under section 234B of the Act is not leviable as EAB is a non- resident company whose entire income is subject to tax deduction at source in India.
Appeal to the Delhi HC
Aggrieved by the order of the Special Bench of the Tribunal, the Revenue appealed before the Delhi HC, where the following questions were raised:
• Was the Tribunal justified in holding that EAB did not have a BC/PE in India?
• Was the Tribunal justified in holding that payment for software is not taxable as ‘royalty’ under the Act/tax treaty?
• Was the Tribunal justified in holding that interest under section 234B of the Act is not leviable?
3 Revenue’s contentions
• The terms and conditions of three agreements, viz. supply agreement, installation agreement and overall agreement (all entered on the same day), were interlinked, intertwined and inseparable. Accordingly, these agreements together form a turnkey/ integrated business arrangement.
• EAB’s obligations did not end with the passing of the title to the cellular operators, but, in addition, the EAB was required to set up the GSM systems, which also obligated it to supervise the installation contractor and other services necessary to set up and maintain GSM systems. Hence, this was not a case of mere sale of goods transaction but a works contract.
• The acceptance test conducted to confirm the successful installation was carried out in India and the overall responsibility to ensure successful installation in India vested with EAB.
• Consideration for software supply should be considered as ‘royalty’ as the copyright of the software still vests with/is owned by EAB. The provisions of the Copyright Act essentially envisage use of copyright by the licensee in respect of a software program, which would qualify as ‘royalty’ under the Act as well as under the tax treaty.
EAB’s contentions
• The income from the sale of equipment accrued outside India as the equipment was manufactured outside India and the title to it, along with associated risk, was transferred outside India. The place of signing/execution
of the contracts was not relevant. Reliance was placed on the Supreme Court (SC) decision in the case of Ishikawajima-Harima Heavy Industries Ltd3.
• The intention of the parties, as manifested in the supply contract, was to transfer title to the equipment as well as associated risks to the buyers in Sweden. With reference to the Sale of Goods Act, 1930 (SOGA), it was contended that property in goods passes where the parties intend it to pass and the acceptance test in India did not negate such intention.
• The ICOs cannot be regarded as EAB’s business connection since it is a settled law that for a business connection to come into existence there must be something more than a mere transaction of sale and purchase on a principal to principal basis.
• The installation contractor, i.e. EFC/ECL, also cannot be regarded as a business connection for EAB in India since there is no contract between EAB and installation contractors and no income had arisen to EAB from the installation contracts. Merely the group relationship between EAB and EFC/ECL would not, by itself, give rise to any business connection for EAB in India.
• A without prejudice argument was taken that even if a BC is deemed to exist, no part of income from supply of equipment can be deemed to accrue or arise in India as material operations in connection with such supply, viz.
manufacture, transfer of title, etc, were performed outside India.
• The judgement of the SC in the case of Ishikawajima-Harima Heavy Industries Ltd. (above), insofar as it deals with the taxability of the offshore supplies, is in no manner affected by the amendment made to section 9 of the Act by the
3 Ishikawajima-Harima Heavy Industries Ltd v. DIT [2007] 288 ITR 408 (SC)
4 Finance Act, 2010 as it only impacts the issue as to when income by way of fees
for technical services or royalties can be deemed to accrue or arise in India.
• The software was integrated with the hardware at the customer’s site.
Breakdown of the consideration for the supply of hardware and software was necessary because of the different customs duty payable.
• A distinction has to be made between the acquisition of a ‘copyright right’ and a ‘copyrighted article’. At best, this was a sale of copyrighted article since the ICOs did not acquire or use any copyright in the software.
HC ruling
Business connection / permanent establishment
• The taxable event in connection with supply of equipment took place outside India with the passing of title along with associated risks to the buyer outside India.
• The place of negotiation of contracts, signing of the contracts, formal acceptance and overall responsibility of the assessee were not relevant considerations.
• In terms of SOGA, property in the goods passes where the parties intend it to pass. The intention of the parties, as manifested in the supply contract, was to transfer title to the equipment as well as associated risks associated to the buyers in Sweden. Though the supply of equipment was subject to the acceptance test performed in India, this was not material as the contract made it clear that the acceptance test was not a material event for passing of the title and risk in the equipment supplied. This was due to the reason that if the result of the acceptance test showed that the systems did not conform to the parameters, the only consequence would be repair/replacement of the defective part, with or without damages. Thus, once sale is concluded outside India, the acceptance test in India did not impact this conclusion.
• In the present case, there was a clear finding that property had passed to ICOs outside India. Once this fact is established, even in composite contracts (though not found to be so in EAB’s case), supply has to be segregated from installation for apportionment of profits as per Explanation 1 to section 9(1)(i) of the Act.
• The Explanation below section 9 and the addition of clause (ii) in the Explanation by the Finance Act, 2010 has no relevance, as it is not the case that EAB has rendered technical services which can be deemed to accrue or arise in India when it supplies the equipment or the software.
• There is no BC in India in the form of ICOs, since these are independent contracting parties. Furthermore, there is no BC in India in form of installation contractors (ECL/EFC) since there was no contract between EAB and the installation contractors. Accordingly, EAB was not deriving any profit out of the installation contract. Moreover, a BC would not arise merely because installation contractors (ECL/EFC) were subsidiaries of EAB’s holding company.
• Since there is no BC, the question of existence of a PE does not need to be examined.
Payment for embedded software – whether ‘royalty’
• Software merely facilitates functioning of equipment and was an integral part of the GSM systems. Accordingly, it was not permissible to assess hardware and software separately4.
• Even in a situation where software is supplied on a CD, it would be tangible property5 and payment made by cellular operators for acquiring such property cannot be regarded as royalty.
4 Reliance placed on the decision of SC in the case of CIT v. Sundwiger EMFG Co [2003] 262 ITR 110 (SC)
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• The fact that ICOs did not acquire any of the rights referred to in section 14(b) of the Copyright Act, 1957 was not disputed by the Revenue. Since none of the rights as contemplated under section 14 of the Copyright Act, 1957 vested with the ICOs, the payment made was for acquisition of a ‘copyrighted article’ and not for a ‘copyright right’. This distinction between ‘copyright right’ and a
‘copyrighted article’ was also accepted by the Authority of Advance Rulings in the case of Dassault Systems KK6.
• Even assuming payment for software qualifies as ‘royalty’ under Act, by virtue of narrow definition of royalties under the tax treaty, it cannot be regarded as
‘royalty’ under tax treaty.
• In summary, it was held that payment received by EAB was towards GSM systems of which software was an inseparable part and was incapable of independent use. Accordingly, payment was made for supply of goods and no part of payment could be classified as royalty.
Levy of interest under section 234B
• Levy of this interest under section 234B of the Act was not justified since EAB had no obligation to pay advance tax, as being a non-resident, its income was liable for tax withholding in India.
Conclusion
• The ruling reiterates the settled position that supply of goods is not taxable in India where property in the goods is transferred outside India. Though the Court did not make any reference of its earlier decision in the case of LG Cable Ltd. 7, it appropriately discussed the relevance of the acceptance test with respect to the taxability of the offshore supply.
5 Reliance placed on the decision of SC in the case of Tata Consultancy Services v. State of Andhra Pradesh [2004] 271 ITR 401 (SC)
6Dassault Systems KK .,In re [2010] 229 CTR 105 (AAR)
7 LG Cable Ltd v. DDIT [2008] 314 ITR 301 (Del)
• The taxability of the computer software has been an issue of considerable litigation especially after the Delhi Tribunal’s decision in Gracemac Corporation8 and Karnataka HC’s decisions in the cases of Samsung Electronics and Lucent Technologies9.
The Delhi HC in this judgement had not considered the decisions in the case of Samsung Electronics Ltd. (above) and Lucent Technologies (above) since these decisions were rendered after the hearings in the case of EAB were concluded and the order was reserved. Yet the Delhi HC, while examining the taxability of the software, has relied on the SC judgement in the case of Tata Consultancy Services (which was distinguished by the Karnataka HC in the above decisions). Also, though the nature of software in EAB’s case was found to be different (as it was an integral part of the GSM systems and not off–the-shelf software that does not come as part of hardware), the Delhi HC duly considered the arguments of the Revenue’s Counsel on the interpretation of the provisions of the Copyright Act, 1957 which were considered and were made the basis of the Karnataka HC’s decision in the Samsung case. Besides, the Delhi HC impliedly approved the Dassault Ruling and the argument of
‘copyrighted article’ versus ‘copyright’. Thus, this decision appears to give a ray of hope to the software suppliers.
Given the divergent views of the judiciary, it seems likely that issue of taxability of software will only be put to rest by the SC.
8 Gracemac Corporation v. ADIT [2010] 42 SOT 550 (Del.)
9 CIT v. Samsung Electronics Ltd. [TS-699-HC-2011 (Kar.)], CIT v. Lucent Technologies [TS-737-HC- 2011 (Kar.)]
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