1.These are appeals by the assessee arising out of the consolidated order dt. 29th Nov., 2001, of the CIT(A)-V, Bangalore, for the asst.
yrs. 1999-2000 and 2000-2001.
2. The assessee is a limited company and is engaged in the business of manufacture and sale of electronic switching systems required for the telecommunication industry and substantial part of its sales are to the Department of Telecommunications (DOT). During the financial years, relevant to the aforesaid assessment years, the assessee imported certain equipments from M/s Lucent Technologies Inc. USA (hereinafter referred to as "Lucent, USA"), a non-resident company. In respect of payments made, the assessee had not deducted tax at source. For failure to deduct tax at source, the assessee has been treated as assessee-in-default under Section 201(1) of the IT Act, 1961 (hereinafter referred to as "the Act") and the Department has also demanded interest under Section 201(1A) of the Act.
(i) No tax was deducted on the amounts paid, for the reason that acquisition of software is inextricably linked to the acquisition of hardware inasmuch as neither of them can function without the other.
(ii) As the transfer of software had taken place outside India, no profit accrued or arisen or could be deemed to have accrued or arisen in India.
(iii) In any event, by virtue of the provisions of the Double Taxation Avoidance Agreement (DTAA), the gains, if any, arising from the transfer of the software was not chargeable to tax as the supplier has no permanent establishment in India.
4. The ITO (TDS) did not accept these contentions and held that the provisions of Section 195 did apply to these transactions and the assessee was required to deduct tax at source on the payments made to non-resident. The arguments that weighed with the ITO (TDS) in reaching these conclusions may be found in the following paragraphs: (i) Software and hardware have been imported separately. In fact, software has come from Lucent, USA, whereas hardware has come from Lucent, Taiwan.
(ii) Proviso to Section 9(1)(vi) of the Act dealing with royalty gives exemption in respect of computer software supplied by a non-resident manufacturer along with a computer or computer based equipment under any scheme approved under the Policy on Computer Software Export, Software Development and Training 1986 of the Govt.
of India. The assessee cannot claim the benefit of this provision on two accounts: (a) As mentioned earlier, computer hardware and software have been supplied separately.
5. It was contended that the assessee is a manufacturer and supplier of electronic switching systems required in the telecommunication industry and the switching system manufactured and supplied to the customers is based on customer specific requirement and depending upon such requirement of each customer's order, switch has to be configured and the software is integrated with the switch. The assessee, for this purpose, imports software as well as parts and components of the switching system. The assessee integrates software into hardware and sells switch to the DOT and it was claimed that as it was integrated transaction, there was no obligation to deduct tax at source. The contention of the assessee was rejected by the ITO (TDS) on the ground that import of software may be regarded as patent or invention or as a scientific work or a secret formula or process and accordingly the payments made for acquisition of the same would be a royalty as defined in the Explanation to Section 9(1)(vi) of the Act. He has also taken the view that the amount paid could be regarded as royalty within the meaning of the expression in Article 12(3)(a) of the DTAA entered into between India and the United States as the definition of royalty in the DTAA is similar to the definition in the Explanation to Section 9(1)(vi) of the Act. According to him, the software is not sold outright as the intellectual property rights continue to belong to Lucent. However, as the software is an integral part of the equipment supplied, the consideration paid would also be regarded as consideration for the use of or the right to use industrial, commercial or scientific equipment and would accordingly be royalty within the meaning of Article 12(3)(b). In corning to this conclusion, the AO has also relied upon the decision of the Authority for Advance Ruling in ABC, In re (1999) 238 ITR 296 (AAR). The relevant findings of the AO recorded in para. 2 of his order are extracted for the purpose of completion : "Software is an Intellectual property right (IPR) which can be licensed to a user. The same software can be given to any number of users. On an outright sale of an article like hardware, property in its entirety is transferred to the purchaser to the exclusion of others, whereas, in software there is no such outright sale, what is transferred is only the right to use, which may be available to many such users but the IPR still remains in tact with Lucent (USA). Thus effectively, consideration paid is only for license to use. Thus payment made by the Indian company for import of software is on a totally different footing when compared to the payments made for purchase of hardware. When such is the case, it has to be examined whether such payment (for import of software) is chargeable to tax in the hands of recipient in terms of the IT Act r/w the provisions of the DTAA signed, between India and the USA. As per the provisions of Section 9(1)(vi) of the Indian IT Act, any payment on account of royalty made by the resident of India to any person outside India is deemed to be income of the recipient in India. Hence, such payments, if are royalty in nature, would be deemed to be the income chargeable to income-tax in India. One has now to examine whether such payments partake the character of "Royalty" as defined in the Section 9(1)(vi) itself. As per the definition given in Expln. 2 to Section 9(1)(vi). "Royalty includes consideration for the use of any patent, invention, model, design, secret formula or process or trademark or similar property. It is quite possible that such software is patented by the company since patenting of technical softwares like these, is quite common nowadays. Even if it is not patented, a software program of this kind used in telecom switching is a high technology work, and is essentially an 'invention' (to 'invent' means create by thought, devise, originate a new method, an instrument, etc. and 'invention' means the process of inventing, a thing invented). These telecom softwares are not routine, run-of-the-mill kind of programs but are highly sophisticated and complex, which require investments in millions of dollars and, hundreds of man-hours for development. It is partly because of such softwares that modern telecom has been adding new features and facilities on regular basis.
Furthermore, these softwares can also be considered as 'scientific work' (the word 'scientific' means systematic, accurate, assisted by expert knowledge) because software is essentially a systematic array of logical instructions which is developed by persons who are experts in that field. Consideration for scientific work has also been covered in the definition of royalty. Accordingly, I treat this payment as consideration for the use of any patent or invention or scientific work, which falls in the ambit of "Royalty" as per the IT Act.
Even further these softwares can also be classified as secret formula or process. The software program as mentioned above is an array/sequence of instructions, which are used by the computer, or computer aided equipment to do a certain thing by carrying out procedures in a systematic manner. This is what a formula is supposed to do, the source code of this software program is not made public, even otherwise that does not really matter much since such programs are part of now universally recognized IPRs. Similarly the software can also be termed as a "process". The word "process" has been defined in the Oxford Dictionary as "course of action or a procedure especially a series of stages in manufacture of some other operation". This is how a software works.
Without prejudice to the above DTAA (between India and USA), Royalty is discussed in Article 12 of the DTAA. Sub-article 3(a) of the DTAA defines the royalty as "payment of any kind received as consideration for the use of, or the right to use,......any patent, trademark, design or model, plan, secret formula or process.......Hence to this extent it is similar to the definition of royalty given in the IT Act, and which is applicable to the facts of the instant case.
Royalty has been defined further inter alia, in Sub-article (3)(b) "as payments of any kind received as consideration; for the use of, or the right to use any industrial, commercial or scientific equipment......." (meaning of 'equipment' as per Oxford Dictionary is "the necessary articles, etc., for a purpose the process of being equipped and the meaning of 'equip' is to 'supply with what is needed'). As discussed at length in the earlier paras, since the software in question being an integral part of the telecom equipment is an equipment by itself, and since this equipment (namely, the software) is not sold outright (as the IPR still "belongs to Lucent, USA) the consideration paid is for the use or right to use a commercial/industrial/scientific equipment and thus such consideration also will fall within the ambit of 'Royalty' as defined in the DTAA. The definition of royalty in the IT Act does not contain such a clause makes no difference since the consideration for the said software falls within the ambit of royalty as defined in the IT Act under other clauses.
As per the Sub-article 2 of Article 12 of the DTAA "Royalty" is taxable in the State in which they arise and according to the laws of the State, which, as has been mentioned in earlier paras, is deemed to accrue and arise in India if payment is made by an Indian resident. I may also mention here with regard to software falling within the definition of royalty in DTAA and IT Act that all these arguments have found favour with the Hon'ble AAR in a case P.No. 30/1999 reported in (1999) 238 ITR 296 (AAR)" 6. In the light of the above discussions, the ITO (TDS) held that consideration paid by the assessee-company to a non-resident company for importing software is held to be a payment in the nature of royalty and, therefore constitutes income chargeable under the Act in the hands of the recipient viz., Lucent, USA, as it was obligatory on the part of the assessee to have deducted tax at source in terms of Section 195 on the remittance made outside India. Rate of tax on royalty as per Section 115A of the Act is 20 per cent whereas as per the DTAA it is 15 per cent for royalty payments of category 12(3)(a) and 10 per cent for royalty payments category 12(3)(b). Giving maximum benefit of the DTAA to the assessee by accepting that the said software constitutes equipment as well, the ITO (TDS) adopted the rate of 10 per cent and treated the assessee as assessee-in-default to the extent of tax and further demanded interest under Section 201(1A) of the Act. The assessee was unsuccessful before the CIT(A) and is now in appeal before us.
7. The learned counsel for the assessee reiterated the facts and contentions that were taken before the two authorities. The learned counsel pointed out that the DOT places purchase order for supply of a digital local telephone exchange on the assessee. The price for the equipment to be supplied is a lump sum price and the equipment to be supplied consists of various modules as well as the software that runs the equipment. The learned counsel drew our attention to purchase order, which is placed at pp. 1 to 13 of the compilation. The learned counsel elaborately dealt with the facts relating to equipment to be supplied for Vanasthalipuram exchange. On the basis of the order it received from the DOT, it places its own order on Lucent, USA, for supply of the parts and components of the switching system. The said purchase order is placed at pp. 14 to 16 of the paper book. The learned counsel stressed that the perusal thereof would reveal that a single purchase order for lumpsum consideration of USD 1,29,804.56 is placed on Lucent, USA. The annexure to the orders sets out the various items that are to be supplied by Lucent, USA. It is clear from the aforesaid that Lucent, USA, has also to supply the applicant software required to make the equipment operational. Lucent, USA, in turn, raises two invoices for the supply of the various items of hardware as well as the software. It is clear from the respective invoices, which are placed at pp. 17 and 18A of the paper book, that such supplies are made pursuant to a single purchase order. It was explained that upto July 1998, customs duty was payable on the software supplied as can be seen from p. 19 of the paper book. It is only thereafter that owing to exemption notification, excise duty was not paid for the software supplied. The assessee, thereafter integrates the software into hardware and sells the switch to the DOT. Copy of the invoice raised by the assessee on the DOT is placed at p. 20 of the paper book.
7(i) The learned counsel pointed out that acquisition of software component is, therefore, inextricably linked to the acquisition of hardware. None of its units can function independently. The learned counsel pointed out that considering, these facts, there was absolutely no obligation on the part of the assessee to deduct tax at source. The learned counsel explained that so far as the supply of hardware component is concerned, there could be no question of any royalty embedded therein and the provisions of Section 9(1)(vi) do not apply to the facts of the case. It was pointed out that the assessee is not supposed to use software item, which the assessee is required to integrate into the hardware, in any other transaction of activity. The learned counsel pointed out that the entire software is customer-made i.e., to the requirement of a particular buyer. The question of its being used in any other equipment is simply out of place. Even the equipment that is imported for one particular exchange cannot be used in any other exchange. The learned counsel further pointed out that the assessee cannot even duplicate the software for any subsequent use. The ITO (TDS), the learned counsel pointed out, is not justified in treating the acquisition of software that is supplied as patent or invention or a scientific work or a secret formula or process and also erred in treating the payment made for acquisition of the same as in the nature of royalty within the meaning of Section 9(1)(vi) of the Act. The learned counsel pointed out that the software that is supplied in the facts of the case is an integral part of the equipment supplied and the consideration paid for such acquisition is not consideration for the use of or the right to use any industrial, commercial or scientific equipment within the meaning of Article 12(3)(b) of the DTAA entered into between India and US. The learned counsel pointed out that the transaction between the assessee and Lucent, USA, is a transaction for purchase of switching system including parts and components thereof. The software that is purchased is an integral part of the switching system and there is no dispute that the payment made by the assessee for purchase of hardware is not exigible to tax in India inasmuch as the transfer of hardware took place outside India. On a parity of reasoning, as the transfer of the software has also taken place outside India there can be no accrual in respect of the same in India. The learned counsel went on to make a distinction between 'copyrighted article' and 'copyright' rights. The learned counsel illustrated it in the form of purchase of book or a music cassette. In a transaction like this, what is purchased is a copyrighted article, the copyright belonging to the author or the singer as the case may be.
The purchaser has no right whatsoever to duplicate or make copies of the work that is purchased. This distinction was again demonstrated with an example viz., if an Indian publisher imports several copies of a book for the purpose of sale in India it would amount to the purchase of a copyrighted article. But if publisher acquires a right to publish in the book in India and thereafter makes copies for the purpose of sale the payment made for acquiring the right would be regarded as a royalty. In the present case, the learned counsel pointed out, all that the assessee has acquired is certain software, which is to be integrated into the hardware that is purchased and thereafter to sell the equipment as a whole. The assessee has no right to duplicate or utilize the software purchased in any other switch that it may sell. It is not disputed that for each switching system sold by the assessee, a corresponding acquisition both of the hardware as well as the software is made from Lucent, USA. The learned counsel pointed out that a certificate issued by the Lucent, USA, wherein it has been clarified that the assessee had no legal authority to duplicate or the software either for the purpose of distribution or resale. A copy of the certificate is kept in the paper book. The distinction between the purchase of a copyrighted article and copyright rights is borne out by the preamble. The learned counsel went on to impress that the distinction between 'copyrighted article' and 'copyright rights' is borne out by the preamble and final regulations and classification of transaction involving computer programs published by the Internal Revenue Service of the Government of the United States. The said document is also placed in the paper book. It was pointed out that a transaction involving the transfer of computer program is treated as either being a transfer of a copyright article in the computer program or a transfer of a copy of the computer program (copyrighted article).
It is therefore, clarified that a transfer of a computer program is classified as a transfer of a copyright if, as a result of the transaction, a person acquires either a right to make copies of the computer program for purpose of distribution to public, or the right to prepare a derivative computer program based on the copyrighted computer program or the right to publicly display the computer program. If, on the other hand, a person acquires a copy of the computer program but does not acquire any of the rights referred to hereinbefore, then, the transaction has to be classified as a transfer of a copyrighted article. It was submitted that on the basis of the distinction drawn, it would be clear that what the assessee has acquired is a copyrighted article and accordingly the consideration that is paid thereof has to be regarded as a purchase price and not a payment by way of royalty.
7(ii). The learned counsel further submitted that without prejudice to what has been claimed earlier, having regard to the provisions of the DTAA, amount that is paid by the assessee to Lucent, USA, would not be chargeable to tax in India. It is also an admitted position that Lucent, USA, is in the business of selling software program and the price that is paid to it is to be regarded as a business profit embedded in the purchase and sale transaction. Therefore, in accordance with the provisions of Article 7 of the DTAA, profit arising from such a sale would be chargeable to tax only in the US. It is further submitted that the provisions of Article 12 would have no application inasmuch as the payment that is made by the assessee would not be royalty as defined therein. Para (3) of Article 12 defines the term 'royalty' to mean : (a) Payments of any kind received as a consideration for the use of or the right to use any copyright of a literary, artistic or scientific work including cinematography films or work on film, tape or other means of reproduction for use in connection with radio or television broadcasting, any patent, trademark design or model, plan, secret formula or process or for information concerning industrial, commercial or scientific experience, including gains derived from the alienation of any such right or property, which are contingent on the productivity, use or disposition thereof; and (b) payments of any kind received as a consideration for the use of or the right to use any industrial, commercial or scientific equipment other than payments derived by an enterprise described in para (1) of Article 8 from the activities described in paras (2)(c) or (3) of Article 8.
7(iii). The learned counsel submitted that what is covered within its ambit is payment for grant of a license to use a copyright, patent, trademark, etc. If a payment is made for acquisition of such right, then the same would not fall within the definition of royalty unless such payment is contingent on the productivity, use or disposition thereof. The learned counsel tried to distinguish between payment made for use of software and payment being made for the purchase of software from the decision of the Calcutta High Court in the case of CIT v. Davy Ashmore (I) Ltd. (1991) 190 ITR 626 (Cal).
7(iv). The learned counsel further submitted that the commentary on Article 12 concerning software payments issued by the OECD, a copy whereof is to be found at pp. 54 to 59 of the compilation, also supports the contention of the assessee that the payment made by the assessee cannot be regarded as royalty.
8. The learned counsel then placed reliance upon the decision of the Andhra Pradesh High Court in the case of CIT v. Klayman Porcelains Ltd. (1998) 229 ITR 735 (AP) and decision of the Madras High Court in the case of CIT v. Neyveli Lignite Corporation Ltd (2000) 243 ITR 459 (Mad) in support of the proposition that if the payment is made for acquiring the drawings, designs, etc., then the same would not represent royalty but would be assessable as business profits.
8(i). The learned counsel further pointed out that the ruling of the Authority for Advance Ruling in P.No. 30 of 1999, reported in (1999) 238 ITR 296 (AAR) relied upon by the ITO (TDS) is not relevant for deciding the issue that has arisen in the present case. The Authority, according to the learned counsel, in that case was required to consider whether payment received by US Corporation for permitting Indian company to access and use its central processing unit and data network situated in the United States could be assessed to tax in India. The Authority held that the software was used in central processing belonged to the applicant who had allowed the Indian company to use the software and the payment made by the Indian company would be regarded as a payment by way of royalty within the meaning of Article 12(3) of the DTAA.8(ii). The learned counsel pointed out that in coming to that conclusion, the Authority has relied upon the revised commentary on the model convention, which was referred by them. The commentary, in fact, supports the contention of the assessee that amounts cannot be brought to tax by way of royalty as on the facts prevailing in the present case, it is a case of transfer of a copyrighted article and not a case of a grant of a permission to use a copyright. With the support of the above contention, the learned counsel vehemently argued that there was absolutely no obligation on the part of the assessee to deduct tax at source in respect of payments made to Lucent, USA for acquiring software and the ITO (TDS) was, therefore, not justified in treating the assessee in default and consequently levying interest under Section 201(1A) of the Act.
9. The learned Departmental Representative, on the other hand, vehemently supported the findings of the ITO (TDS) as well as the order of the CIT(A). Our attention was drawn to the memorandum explaining the provisions in the Finance (No.2) Bill, 1991, reported in (1991) 190 ITR (St.) 281, decision of the Gujarat High Court in the case of CIT v.Ahmedabad Mfg. & Calico Printing Co. (1995) 215 ITR 735 (Guj), Calcutta High Court decision in the case of N.V. Philips v. CIT (1988) 172 ITR 521 (Cal) and the decision of the Authority for Advance Ruling reported in (1999) 238 ITR 296 (AAR) (supra).
10. We have carefully considered the rival submissions and gone through the records in the light of the paper book filed by the parties as also the principles laid down by the judicial authorities to which our attention was drawn, at the time of hearing by both the parties, The facts of the case clearly reveal that the assessee is engaged in the manufacture and sale of electronic switching systems required for the telecommunication industry and a substantial part of its sales are to the DOT. As the facts reveal, initially DOT places a purchase order for supply of digital local telephone exchange equipment on the assessee.
The price for the equipment to be supplied, is a lump sum price and the equipment to be supplied consists of various modules as well as the software that runs the equipment. The price of the equipment to be supplied for the Vanasthalipuram Exchange is Rs. 6,84,94,690. The cost of the switching equipment is Rs. 5,04,49,736. The break up of this sum is to be found at pp. 5 to 7 of the paper book. The cost of the software component embedded therein is Rs. 50,78,876 as is clear from p. 8 of the compilation. On the basis of the order so received from the DOT, assessee placed an order on Lucent, USA for supply of parts and components of the switching system. Purchase order placed for Vanasthalipuram Exchange is at pp. 14 to 16 of the paper book. A perusal thereof would clearly reveal that a single purchase order for a lump sum consideration of USD 1,29,804.56 is placed on Lucent, USA. The annexure to the orders sets out the various items that are to be supplied by Lucent, USA and it is clear therefrom that the application software has also to be supplied by Lucent, USA. Lucent, USA, in turn, raised two invoices, one for supply of various items of hardware and the other for supply of software. However, as is clear from pp. 17 and 18A, which are respective invoices that such supplies are .made pursuant to a single purchase order. The transaction, viewed from this angle, clearly shows that what the assessee has purchased is an integrated equipment both of hardware and software from Lucent, USA. In other words, the acquisition of software was inextricably linked to the acquisition of hardware and one cannot function without the other. It is impracticable to have such value addition without the help of the other. In our view, the assessee's transaction with Lucent, USA is a purchase of an integrated equipment, which consists of both hardware as well as software. One cannot function without the help of the other. As pointed out by the learned counsel, what the assessee has purchased is a copyrighted article and not copyright of the rights. Therefore, it is wrong on the part of the Department to have separated the transaction of purchase of software and viewing the purchase of software as an independent transaction. The assessee had not acquired any rights in the software. The assessee cannot be seen to be duplicating the software in making use of the same. The software that is so supplied by Lucent, USA is customer-specific and cannot be even reused or duplicated in any other exchange where identical orders are placed by the DOT. In other words, software that is supplied by Lucent, USA is customer-specific and is required only to be integrated into hardware that is supplied for specific unit. The Department, therefore, in our view is not justified in bifurcating the transactions as one of supply of hardware and the other of software and treating software as a part of royalty. It must be appreciated that the assessee, in this case, has not acquired rights in the copyright program so that it can be exploited commercially. It is a customer-specific supply and it is a case of clear business transaction of purchase of equipment along with software to make the hardware functional. In our view, therefore, Department is not justified in treating the impugned payments as royalty simpliciter and thereby holding that the assessee is an assessee-in-default for failure to deduct tax at source, In our considered view, the facts of the case as already explained in earlier paragraphs and discussions herein, the payment for impugned transactions does not partake the character of royalty and, therefore, there is no question of any obligation on the part of the assessee to deduct tax at source in respect of these disputed payments. The assessee is under no obligation to deduct tax at source under Section 195 of the Act in respect of the sums paid for acquiring software.
Therefore, the orders of the ITO (TDS) under Sections 201 and 201(1A) of the Act are therefore vacated.