The Delhi High Court has ruled that income from sale of software embedded in hardware was not taxable as royalty despite the retrospective amendment to the Income Tax Act, as the changes cannot override a tax treaty. Deciding on a case between the Income Tax Department and Nokia Networks of Finland, the court said the amendment cannot be read into the India-Finland Double Taxation Avoidance Agreement. It said payment for supply of software was not in the nature of royalty because it was for a copyrighted article and “not for a copyright”. Software was held to be an integral part of GSM equipment, it said.

Finance Act, 2012, retrospectively categorised income accruing to a non-resident from sale of software as royalty, subjecting the transaction to withholding tax, levied at 20 per cent of the gross purchase amount. 

Though the amendment did not specifically mention about software embedded in hardware, revenue authorities were insisting on collecting royalty on income from integrated supply of equipment and software in the light of the changes in the Act.

Experts said this was the first ruling by a High Court after introduction of retrospective amendments, affirming the position that the tax treaty would not be affected by the change in the domestic law. This would be a relief to software vendors and connectivity service providers protected by tax treaties. “The High Court ruling has provided clarity that the retrospective amendment cannot be applied in case of embedded software,” said Rahul Garg, Executive Director, PwC.

“However, similar cases are pending in the Supreme Court. In my view, the High Court decision is laying down the correct proposition of law and as such it is likely that the Supreme Court would confirm the same.”

Nokia Networks, which manufactures equipment used in phone network, opened a liaison office in India in March 1994. In May 1995, it incorporated a subsidiary, Nokia India Pvt Ltd. While the liaison office was carrying out advertising and other auxiliary activities, Nokia India was involved in installing the equipment supplied by Nokia Networks under independent contracts with Indian telecom operators.

The I-T department had argued that the liaison office constituted Nokia’s permanent establishment (PE) in India. The tax department argued that the “look at” approach should be applied as pronounced by Vodafone International ruling, but it was not permitted by the court.

The court ruled that the liaison office was not a PE as it did not carry out any business activity for Nokia in India. If a company does not have a permanent establishment in India, the income accruing to it from sale of software as goods is treated as business income and taxed in its home country. By categorising it as royalty, the income tax department can stake a tax claim on the income from sale of software.

The court rejected the revenue department’s claim that retrospective amendment to the Income Tax Act was clarificatory in nature and always intended to include software payments. (Business Stnandard)