The Financial Express: Supreme Court on software taxation: A torch-bearing verdict in the tax-treaty space
By Mukesh Butani & Tarun Jain
Whether the licence to use computer software is a transfer of copyright was the core issue before the Supreme Court in the case of Engineering Analysis and a batch of over 80 appeals that was decided on March 2. The question arose in view of the Karnataka High Court deciding in the affirmative, thereby obliging the licensees to deduct tax from the payment for obtaining the right to use the software, though most other High Courts, particularly the Delhi High Court, had decided the issue in favour of the taxpayer. The Supreme Court reversed the Karnataka decision and declared that such licence does not constitute a transfer of copyright, either under the copyright law or under the Income Tax law. If the decision would have stopped here, it would have been just another precedent for practitioners of tax law. However, the March 2 verdict marks a watershed moment for India’s tax policy in general, and in particular, for international customary law of treaties. Hence, this development requires a commentary to absorb the 226-page landmark judgment.
The foremost criticality of the decision is its unequivocal re-endorsement of the application and primacy of the double-tax treaties signed by India with more than 80 countries. Exhaustively delineating the scope of tax treaties, albeit in the context of ‘royalties’ under 18 treaties in this case, the SC concluded that the tax liability does not fall upon a person who is eligible to claim the treaty benefit. It further remarked that a denial would cause an absurd result, far divorced from reality. Rejecting the High Court’s lukewarm response to the claim for treaty benefit, this decision categorically declares that notwithstanding the rigours of the domestic tax law—not even a retrospectively enacted provision—the benefit under the treaties cannot be denied. The decision lends further force (referring to its earlier decision in the Ram Jethmalani case) to the primacy of the internationally-accepted Vienna Convention on Law of Treaties and its principles as the standard method of treaty interpretation, thereby clearly instituting India’s commitment and alignment to international standards. Thus, the decision restores the constitutional aspiration, enshrined as a Directive Principle in Article 51, that the Government must endeavour to “foster respect for international law and treaty obligations”.
The larger aspect is the analytical dissection of the income tax law by the SC to highlight that it is not charitable benevolence that a benefit is extended under the tax treaties; instead, the very scheme of the law is designed to give primacy to tax treaties. Even though this principle has not been stated for the first time, and it did arise in the famous Azadi Bachao Andolan case, the present ruling crucially sails beyond to declare that the treaties override even subsequent retrospective amendments to the domestic tax law. On the principle of domestic law changes to effect changes in the treaty framework, the court remarked that it is fallacious to assume that a change in domestic law to rectify a situation of mistaken interpretation can spontaneously further the tax administration’s case in a treaty situation. This affirmative declaration insulates foreign investors from unilateral changes to India’s tax policy and promises certainty in their tax treatment.
Another dimension of the decision is the invocation of the ‘doctrine of impossibility’, i.e., when there is a disability that makes it impossible to comply with the law, the alleged disobedience of the law is excused. The decision holds that amendment in the year 2012 with retrospective effect from 1976 (i.e., the date when the relevant provisions were originally enacted) cannot be invoked to hold tax-deductors responsible for failure to deduct tax by applying a provision of a statute when it was not actually and factually on the statute book. Thereby, even though it cannot restrict Parliament from enacting retrospective tax laws, the SC has effectively reined in the government’s latitude in prosecuting bonafide actions of taxpayers, which translate into infraction owing to retrospective amendments. Making critical observations on the amendment of the law retrospectively from 1976 when India legislated source-based taxation for royalty income, the Supreme Court observed, it is ‘equally ludicrous’ for the 2012 amendment to apply from 1976 when the concerned technology itself came into being decades later. Hopefully, this would discourage the pangs for retrospectivity, an instrument frequently deployed as a panacea to address gaps in tax policy and laws.
The decision addresses another thorny issue in India’s tax policy which relates to India’s position on international tax principles as expressed in the OECD Model Tax Treaty and its commentary by way of reservations. The government has been officially stating its position, which is documented by the OECD, including ‘reservations’ expressed by India. Though the tribunals and high courts have, in a catena of judgments, rejected arguments to the effect that these do not represent the position of India, the tax administration routinely refuses to align with the position it has expressed to the OECD model or its Commentaries read with the respective treaties. This has resulted in lack of standardisation and interpretation principles, even though the design of Indian tax treaties is heavily inspired by the OECD Model. This decision, by approving the approach which “accords with the OECD Commentary on which most of India’s DTAAs are based”, aligns India’s treaty policy with the international tax fraternity, thereby obviating the basis for divergence. The apex court has categorically held that India’s change in position to the OECD Commentary cannot be a fact that influences the interpretation (such as the definition of royalty, in this case) under the respective treaties. As a way forward, in the event the government chooses to depart from the internationally prevalent standards, it must do so as a formal policy document, and not surreptitiously with ground-level officers refusing to abide by international standards and thereby causing repetitive appeals before various forums.
In short, the SC decision is a welcome realignment of international customary law and India’s international tax policy; a seminal moment. One would hope that the government would respect the verdict and abide by it in letter and spirit, thereby bringing this two-decade old dispute to a closure which, as the Court at the start of judgement observed, “have a chequered history”.
Incidentally, though the decision was in the context of tax laws, there were takeaways even for IPR laws. The decision addresses vexed issues in the realm of copyright law, settling the legal position, which was so far precariously addressed by High Court decisions. The SC explained, in the context of copyright law and software transactions, the ‘doctrine of first sale’ and ‘principle of exhaustion’ by weaving through the jurisprudence under sales tax, customs laws, etc. Quoting the European Court of Justice, the Supreme Court remarked that a “copyright owner exhausts his distribution right in copies of a computer programme upon making the first sale, provided the copy is made unusable by the first acquirer”. Alas, had our taxman followed the court’s earlier rulings, the acrimony could have been avoided. Nevertheless, the verdict marks as a substantive tide of jurisprudence besides keeping lawyers productively engaged.
The authors are Partners, BMR Legal