Saturday, November 26, 2011

Law Street in The Economic Times (November 2011)

Dear Readers,
Technology! What would life be without a fast internet connection. Sadly, even as technology moves forward rapidly, the tax-men are left grappling with how to deal with new emerging issues. Take the issue of withholding tax on import of software, it hasn't been resolved till date. Now comes cloud computing. It is a mystery how this will be dealt with.
For the first time ever, The Economic Times, cut the few last sentences to fit the copy (owing to a change in format), hence perhaps you may want to scroll below for the entire column, instead of reading the online version.
Have a nice weekend.

The grey tax clouds

• Tax laws must rapidly evolve to meet technology advancements
• Tax on software continues to be litigative
• Tax on cloud computing needs an answer

Will tax be able to keep pace with changing technology issues? Going by recent trends, at least in India, Zenobia Aunty thinks the pace of keeping up is sluggish, much slow than the slowest internet connection.

A recent news item took her by surprise. The Karnataka High Court has recently held that import of computer software would result in transfer of a copyright and the payment made to the foreign supplier would be in the nature of a royalty payment. Thus, the Indian buyer would have to withhold tax on the same, both as per the Indian Income tax Act and the relevant tax treaty.

Transfer of a copyrighted article, such as shrink wrapped software ought not to result in a royalty payment. It is similar to buying a book off the shelf. However, Zenobia Aunty is given to understand that the High Court in the given case, observed that the right to make a copy of the imported software and use it for internal business, store it in the hard disk of the designated computers and take a back up would amount to copyright under the Indian CopyRight Act. It was actual transfer of part of a copyright, rather than an outright sale of a copyrighted product. Hence, the need to classify it as royalty, which both you and I know suffers a withholding tax in India.

In the past there have been several rulings of tax tribunals and Authority of Advance Rulings which have appreciated that a distinction needs to be made between a copyright right and a copyrighted article for the purpose of characterization of computer software transactions. In case, the transaction is held to be a sale of a copyright right, then unless and until the foreign supplier has a permanent establishment in India, India cannot tax the payment as it constitutes a business income of the foreign supplier and is not a royalty payment.

The issue of withholding tax on import of computer software is a hot bed of litigation globally. Tax experts state that a few countries, such as Singapore, US, UK have taken a clear stand and do not advocate imposition of withholding tax at source, either owing to the existence of clear cut guidelines or practice adopted by the tax authorities and the judiciary. On the other hand, countries such as China and India seem to have adopted an ambiguous stand with divergent views.

Ambiguity doesn’t help. Now we need to wait till the Supreme Court addresses the issue. Perhaps clarity in the Direct Tax Code would help. A final decisive answer is needed. While a foreign tax credit can be availed of in the home country (foreign supplier’s country) if tax has been legitimately with-held at source in the other country, it can be cumbersome to get a foreign tax credit if tax has been presumed to be wrongly withheld. No wonder then that this issue continues to be in the forefront of tax litigation in India.

Zenobia Aunty saves some of her data in cyberspace on the cloud. Thus, she has begun to have nightmares of the possible tax consequences that will arise if payment is made for such cloud services. Cloud computing is having access to software and/or infrastructure facilities in cyber space. Users do not have to spend on upgrading software or hardware. It is cheap and many a self employed professional and SMEs or even banks are opting for cloud usage. Many high profile technology companies are providing cloud services.

Based largely on ownership of data and access, clouds can be private, public or hybrid. Further, based on what is provided to the cloud user, cloud models are classified as software as a service (SaaS), platform as a service (PaaS) or Infrastructure as a service (IaaS).

With the ambiguity that exists even in the realm of import of shrink-wrapped software, Zenobia Aunty shudders to think of the magnitude of tax litigation that may crop up in instances where cross border cloud services are used.

Going by the recent Karnataka High Court decision, would the tax authorities view that what was used under the cloud computing service agreement was a part of the software (copyright), which was hosted on the vendor’s cloud server and thus it was royalty subject to withholding in India? Or would they interpret that the payment was for use of scientific equipment - applications hosted in the cloud and thus were in the nature of Fees for Technical service (FTS)? Both payments towards royalty or fees for technical service would typically be subject to a tax withholding in India.
Further, in some treaties entered into by India, such as those with US, a ‘narrow approach’ with respect to taxation of FTS is followed and only if the technical service ‘makes available’ technical know-how, skill etc to the recipient of the services (in our case, the Indian user of the cloud service) is it regarded as FTS subject to withholding at source. However, interpretation of this term – make available - is not free from litigation either.

While technology may be making our lives easier, the ambiguities in tax laws do cast a grey cloud overhead.

Source of the photograph

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