News Alert 4 January, 2012

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4 January, 2012

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 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 In a recent decision, in the case of Ericsson Radio Systems A.B. Sweden 1 (EAB), the treaty). Delhi High Court (HC) has upheld the Income-tax Appellate Tribunal (the Tribunal) Special Bench Ruling in case of Motorola Inc. v. DCIT 2 by holding that Facts 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 • 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

1 DIT v. Ericsson Radio System AB [TS-769-HC-2011 (DEL)] 2 Motorola Inc. v. DCIT [2005] 95 ITD 269 (Del)

PwC News Alert January 2012

and sale of telecommunication GSM systems (comprising equipment and • On appeal, the Commissioner of Income-tax (Appeals) (CIT(A)) granted partial software) to various cellular operators the world over, including in India. 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 • During the year under consideration, EAB entered into contracts with various appeals of other tax payers, namely Nokia and Motorola, were referred to the Indian cellular operators (ICOs) for supply of GSM systems. Under these Special Bench of the Tribunal. The Special Bench adjudicated the matter in contracts, the property in the equipment was transferred to ICOs outside favour of EAB by holding that: 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 - EAB had no BC in India, and therefore, no part of income from sale of license was granted to ICOs, whereas ownership in the software remained with equipment was taxable under the Act; EAB. The software was loaded onto the equipment and was used for - EAB does not have a PE in India; functioning of the equipment. - 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 • Installation of GSM systems in India was carried out by EAB’s group entities integral part of the GSM systems and cannot be taxed on a stand-alone (Ericsson Telephone Corporation India AB, India Branch office (EFC) for three basis as royalty. It was also held that the software is a copyrighted article months in the FY 1996-97 and Ericsson Communications Ltd (ECL) for nine and supply of it does not allow the ICOs to use any of the copyright rights months in the FY 1996-97) under separate contracts with ICOs. Apart from the in the software ; installation activities, EFC and ECL also carried out acceptance tests of the - Interest under section 234B of the Act is not leviable as EAB is a non- GSM systems. The income earned from installation activities was offered to tax resident company whose entire income is subject to tax deduction at by these entities in India. source in India.

• Apart from supply contracts, there was an overall agreement between ICOs Appeal to the Delhi HC and EAB. Further, in the event the installation contractors (EFC/ECL) terminated their contract, EAB would identify a new contractor for installation Aggrieved by the order of the Special Bench of the Tribunal, the Revenue appealed of the systems. 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? • 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 • Was the Tribunal justified in holding that payment for software is not taxable India. Therefore, income from supply of hardware/equipment was held to be as ‘royalty’ under the Act/tax treaty? 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 the Tribunal justified in holding that interest under section 234B of the was taxable as ‘royalty’ both under the Act as well as under the tax treaty. Act is not leviable?

PwC News Alert January 2012

Revenue’s contentions of the contracts was not relevant. Reliance was placed on the Supreme Court (SC) decision in the case of Ishikawajima-Harima Heavy Industries Ltd 3. • The terms and conditions of three agreements , viz. supply agreement, installation agreement and overall agreement (all entered on the same day) , • The intention of the parties, as manifested in the supply contract, was to were interlinked, intertwined and inseparable. Accordingly, these agreements transfer title to the equipment as well as associated risks to the buyers in together form a turnkey/ integrated business arrangement. 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 • EAB’s obligations did not end with the passing of the title to the cellular the acceptance test in India did not negate such intention. 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 • The ICOs cannot be regarded as EAB’s business connection since it is a settled services necessary to set up and maintain GSM systems. Hence, this was not a law that for a business connection to come into existence there must be case of mere sale of goods transaction but a works contract. something more than a mere transaction of sale and purchase on a principal to principal basis. • The acceptance test conducted to confirm the successful installation was carried out in India and the overall responsibility to ensure successful installation in • The installation contractor , i.e. EFC/ECL , also cannot be regarded as a India vested with EAB. 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 • Consideration for software supply should be considered as ‘royalty’ as the installation contracts. Merely the group relationship between EAB and copyright of the software still vests with/is owned by EAB. The provisions of the EFC/ECL would not, by itself, give rise to any business connection for EAB in Copyright Act essentially envisage use of copyright by the licensee in respect of India. a software program, which would qualify as ‘royalty’ under the Act as well as under the tax treaty. • 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. EAB’s contentions manufacture, transfer of title , etc, were performed outside India.

• The income from the sale of equipment accrued outside India as the • The judgement of the SC in the case of Ishikawajima-Harima Heavy Industries equipment was manufactured outside India and the title to it, along with Ltd. (above), insofar as it deals with the taxability of the offshore supplies, is in associated risk , was transferred outside India. The place of signing/execution 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)

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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. • 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 • The software was integrated with the hardware at the customer’s site. (though not found to be so in EAB’s case), supply has to be segregated from Breakdown of the consideration for the supply of hardware and software was installation for apportionment of profits as per Explanation 1 to section 9(1)(i) necessary because of the different customs duty payable. of the Act.

• A distinction has to be made between the acquisition of a ‘copyright right’ and • The Explanation below section 9 and the addition of clause (ii) in the a ‘copyrighted article’. At best, this was a sale of copyrighted article since the Explanation by the Finance Act, 2010 has no relevance, as it is not the case ICOs did not acquire or use any copyright in the software. that EAB has rendered technical services which can be deemed to accrue or arise in India when it supplies the equipment or the software. HC ruling • There is no BC in India in the form of ICOs, since these are independent Business connection / permanent establishment 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 • The taxable event in connection with supply of equipment took place outside installation contractors. Accordingly, EAB was not deriving any profit out of India with the passing of title along with associated risks to the buyer outside the installation contract. Moreover, a BC would not arise merely because India. installation contractors (ECL/EFC) were subsidiaries of EAB’s holding company. • The place of negotiation of contracts, signing of the contracts, formal acceptance and overall responsibility of the assessee were not relevant • Since there is no BC, the question of existence of a PE does not need to be considerations. examined.

• In terms of SOGA, property in the goods passes where the parties intend it to Payment for embedded software – whether ‘royalty’ 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 • Software merely facilitates functioning of equipment and was an integral part buyers in Sweden. Though the supply of equipment was subject to the of the GSM systems. Accordingly, it was not permissible to assess hardware acceptance test performed in India, this was not material as the contract made and software separately 4. 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 • Even in a situation where software is supplied on a CD, it would be tangible result of the acceptance test showed that the systems did not conform to the property 5 and payment made by cellular operators for acquiring such property parameters, the only consequence would be repair/replacement of the cannot be regarded as royalty. defective part , with or without damages. Thus, once sale is concluded outside India, the acceptance test in India did not impact this conclusion. 4 Reliance placed on the decision of SC in the case of CIT v. Sundwiger EMFG Co [2003] 262 ITR 110 (SC)

PwC News Alert January 2012

• The fact that ICOs did not acquire any of the rights referred to in section 14(b) • The taxability of the computer software has been an issue of considerable of the Copyright Act, 1957 was not disputed by the Revenue. Since none of the litigation especially after the Delhi Tribunal’s decision in Gracemac rights as contemplated under section 14 of the Copyright Act, 1957 vested with Corporation 8 and Karnataka HC’s decisions in the cases of Samsung the ICOs, the payment made was for acquisition of a ‘copyrighted article’ and Electronics and Lucent Technologies 9. 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 Delhi HC in this judgement had not considered the decisions in the case of the case of Dassault Systems KK 6. Samsung Electronics Ltd. (above) and Lucent Technologies (above) since these decisions were rendered after the hearings in the case of EAB were concluded • Even assuming payment for software qualifies as ‘royalty’ under Act, by virtue and the order was reserved. Yet the Delhi HC, while examining the taxability of of narrow definition of royalties under the tax treaty, it cannot be regarded as the software, has relied on the SC judgement in the case of Tata Consultancy ‘royalty’ under tax treaty. 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 • In summary, it was held that payment received by EAB was towards GSM different (as it was an integral part of the GSM systems and not off–the-shelf systems of which software was an inseparable part and was incapable of software that does not come as part of hardware), the Delhi HC duly independent use. Accordingly, payment was made for supply of goods and no considered the arguments of the Revenue’s Counsel on the interpretation of part of payment could be classified as royalty. 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, Levy of interest under section 234B the Delhi HC impliedly approved the Dassault Ruling and the argument of ‘copyrighted article’ versus ‘copyright’. Thus, this decision appears to give a ray • Levy of this interest under section 234B of the Act was not justified since EAB of hope to the software suppliers. had no obligation to pay advance tax, as being a non-resident, its income was liable for tax withholding in India. 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. 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 8 Gracemac Corporation v. ADIT [2010] 42 SOT 550 (Del.) Pradesh [2004] 271 ITR 401 (SC) 9 CIT v. Samsung Electronics Ltd. [TS-699-HC-2011 (Kar.)], CIT v. Lucent Technologies [TS-737-HC- 6Dassault Systems KK .,In re [2010] 229 CTR 105 (AAR) 2011 (Kar.)] 7 LG Cable Ltd v. DDIT [2008] 314 ITR 301 (Del)

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