For nearly two decades, one of the most debated issues in Indian international taxation was whether payments to non-residents for the purchase or licensing of software should be treated as taxable “royalty” in India. The controversy intensified after the retrospective amendment to the domestic tax law in 2012, which specifically included the right to use computer software (including licensing) within the definition of “royalty.”
However, the taxation of such payments was never solely determined by domestic law. Tax treaties between India and other countries often provided more favourable terms for non-residents, and in the absence of a specific provision taxing software payments as royalty in these treaties, many non-resident companies claimed exemption. This led to repeated disputes with the Indian tax authorities, resulting in conflicting rulings from various High Courts and the Authority for Advance Rulings (AAR).
On 2 March 2021, the Supreme Court delivered a landmark decision in Engineering Analysis Centre of Excellence Pvt. Ltd. vs. CIT (Civil Appeal Nos. 8733–8734 of 2018), settling the issue in favour of taxpayers. This blog summarises the key aspects of the judgment, the principles laid down, and the implications for businesses.
1. Background
The dispute centred around whether payments made to non-residents for software — whether purchased outright or licensed — could be classified as “royalty” and taxed in India.
The 2012 retrospective amendment to the Income-tax Act expanded the domestic definition of royalty to cover the right to use computer software. However, tax treaties did not always contain such a definition. Under Indian law, non-residents can choose the more beneficial provisions between domestic tax law and applicable tax treaties, provided they meet eligibility requirements (such as furnishing a Tax Residency Certificate).
In practice, this meant that while domestic law could tax software payments as royalty, many tax treaties did not. Non-resident suppliers would rely on treaty provisions to claim that such income was not taxable in India. The revenue authorities challenged this, leading to litigation across multiple judicial forums. With conflicting rulings emerging, the matter eventually reached the Supreme Court.
2. Key highlights of the judgement
2.1 Issues covered
The Supreme Court examined multiple scenarios:
- Purchase of software by Indian end-users directly from foreign suppliers or manufacturers.
- Purchase of software by Indian distributors/resellers from foreign suppliers or manufacturers.
- Purchase of software by Indian distributors/resellers from foreign distributors/resellers.
- Purchase of integrated hardware/equipment along with software by Indian distributors or end-users from foreign suppliers.
2.2 Key facts noted by the Court
- Distribution agreements: These granted non-exclusive, non-transferable rights to resell software. Copyright ownership remained with the original owner, and distributors were prohibited from sublicensing, transferring, reverse-engineering, modifying, or reproducing the software. Distributors could only resell and profit from the sale; they had no right to use the software themselves.
- End-User Licence Agreements (EULA): These allowed installation and use of the software but prohibited reproduction or transfer of any copyright. No interest in the copyright itself was transferred.
2.3 Principles upheld in relation to “royalty”
- Copyright is an intangible right, distinct from the physical medium containing it.
- Ownership of a physical copy of software does not equate to ownership of the copyright.
- The right to reproduce a program (a copyright right) differs from the right to use it (which is not a transfer of copyright).
- A licence allowing use without transferring copyright is not “royalty” under the Copyright Act or applicable treaties.
- The nature of the transaction — sale of goods versus transfer of copyright — must be determined based on the agreement’s terms and surrounding circumstances.
- Article 12 of the India–Singapore tax treaty (considered in this case) defines “royalty” narrowly, and this treaty definition prevails over the broader domestic law definition where applicable.
- The sale or licence of software through EULAs or distribution agreements does not transfer copyright rights and thus does not amount to “royalty” for tax purposes.
2.4 Other matters addressed
- Treaty definitions prevail over domestic law where more beneficial. CBDT Circular No. 333 (2 April 1982) affirms this.
- Tax treaty language must be interpreted liberally in line with the parties’ intentions, consistent with the earlier Azadi Bachao Andolan judgment.
- The obligation to deduct tax at source under section 195 arises only if the payment is chargeable to tax under the Act read with the treaty.
- Retrospective amendments (like the 2012 change) cannot be enforced for periods before their introduction, as the law does not expect compliance with impossible conditions.
- OECD Commentary is a relevant interpretative aid for tax treaties.
3. Concluding Thoughts
The Supreme Court’s decision brought much-needed clarity, ruling decisively that payments for the sale or licensing of software — under the fact patterns examined — do not constitute “royalty” and are not taxable in India when the applicable tax treaty does not define them as such.
For taxpayers, this ruling has several implications:
- Reversal of tax demands: Many Indian companies had been treated as “assessees in default” for not withholding tax on such payments. This judgment allows them to seek reversals and, in some cases, refunds, subject to conditions and timelines.
- Caution in applying treaties: Businesses must still meet all conditions for treaty benefits, including obtaining the Tax Residency Certificate and Form 10F, and considering the impact of Multilateral Instrument (MLI) provisions like the Principal Purpose Test.
- Consideration of equalisation levy: Even if software payments are not “royalty” for income-tax purposes, they may be subject to other levies, which should be evaluated.
Ultimately, this judgment reinforces the principle that the characterisation of payments in cross-border transactions must be determined by the real nature of the arrangement, the rights actually transferred, and the relevant treaty provisions — not merely by broad domestic law definitions.
