Amendment in definition of royalty does not extend to disallowance u/s 40(a) – Mum ITAT

Sonata Information Technology Ltd. v DCIT [ITA NO. 1507 (MUM.) OF 2012 dated 7.9.2012] (Mum ITAT)


The assessee is a company engaged in the business of purchase and sale of software. Assessee made a payment of Rs. 199,79,11,595/- for purchase of software from persons who are resident in India. The Assessee did not deduct tax at source while making payment towards such purchases. 

According to the AO, the payment is in the nature of Royalty because it was for a right to use software and therefore the Assessee ought to have deducted tax at source and since the Assessee had not so deducted tax at source, the sum in question was not allowed as deduction under the provisions of Section 40(a)(ia) of the Act. The CIT(A) also confirmed the addition.

Assessee’s contentions:

  • Assessee was in the business of purchase and sale of software and that it did not have a right to use the software and that it was akin to purchase and sale of goods and therefore the payment in question was not in the nature of royalty.
  • Reliance is placed on following rulings:
    – DIT vs. Ericsson A.B. New Delhi (Del HC)
    – CIT v. Dynamic Vertical Software India Pvt. Ltd. (332 ITR 222 Del.)
  • The Board has given a circular in notification No. 21/2012 dated 13/06/2012 notifying that no deduction of tax shall be made on the following specified payment under section 194J. Even though this notification has come into force w.e.f. 1.7.2012, this notification is retroactive in operation
  • Since this payment is made to the Indian Residents and not to Non-Residents and those recipients paid taxes relying on the principles laid down by the Hon’ble Supreme Court in the case of Hindustan Coca Cola Beverage (P) Ltd. v. CIT [2007] 293 ITR 226 (SC).
  • Alternate contention that the Hon’ble Special Bench of the ITAT considered the issue of section 40(a)(ia) in the case of Merilyn Shipping & Transports v. ADCIT in ITA No.477/Viz/2008 dated 29.3.2012 and held that the word “payable” used in the section refers to only the amount outstanding as on 31st March and not the entire amount.

Tax Authority’s arguments:

  • Reliance is placed on the order of the Karnataka High Court in assessee’s own case given in the contest of section 201 with reference to payment to non resident wherein on similar payments made to foreign suppliers the amounts were held as royalty as defined under Sec.9.
  • Reference to the latest amendment brought to section 9(1)(vi) by way of Explanation-4 which is as under:
    Explanation 4.- For the removal of doubts, it is hereby clarified that the transfer of all or any rights in respect of any right, property or information includes and has always included transfer of all or any right for use or right to use a computer software (including granting of a licence) irrespective of the medium through which such right is transferred”.
  • Explanation was inserted by the Finance Act, 2012 w.e.f. 01.06.1976. Therefore, the payments made for computer software is to be considered as royalty.


  • Commentary on OECD Model Convention in relation to royalty:
    – Payments made for the acquisition of partial rights in the copyright (without the transferor fully alienating the copyright rights) will represent a royalty where the consideration is for granting of rights to use the programme in a manner that would, without such license, constitute an infringement of copyright. Examples of such arrangements include licenses to reproduce and distribute to the public software incorporating the copyrighted programme, or to modify and publicly display the programme.
    – In other types of transactions, the rights acquired in relation to the copyright are limited to those necessary to enable the user to operate the programme, for example, where the transferee has limited rights to reproduce the programme. This would be the common situation in transactions for the acquisition of a programme copy. They allow the user to copy the programme, for example onto the user’s computer hard drive or for archival purposes.
  • After referring to the aforesaid OECD Commentary, the AAR in its decision rendered in the case of Dassault Systems KK 322 ITR 125 (AAR) held that reproduction and adaptation envisaged by section 14(a)(i) and (vi) can contextually mean only reproduction and adaptation for the purpose of commercial exploitation. What has been excluded under section 52(aa) is not commercial exploitation, but only utilizing the copyrighted product for one’s own use
  • AAR in the case of Dassault (supra) was a case of sale of shrink wrap software. The ruling of the AAR in the case of Dassault (supra) was approved by the Hon’ble Delhi High Court in the case of DIT v. Ericsson AB, New Delhi (supra).
  • However, in assessee’s very own case the Hon’ble Karnataka High Court in appeal on orders under section 201 and payments made to non-residents has held that the amounts are royalty in nature.
  • Therefore, in the interest of justice without adjudicating whether the amounts paid were royalty or not, we direct AO to examine the issue afresh in the light of facts.
  • With regard to the contention of the assessee in light of Mumbai ITAT decision in the case of Merilyn Shipping & Transports v. ADCIT, the disallowance under section 40(a)(ia) can only be restricted to the amount outstanding as payable as on 31/03/2008.
  • With regard to the Tax authority’s arguments on applicability of the provisions of 9(1)(vi) Exp.4 which was introduced w.e.f. 01.06.1976 by the Finance Act 2012. Even though the explanation was given by way of clarification in which the scope of royalty under section 9(1)(vi) was explained, we are of the opinion that this amendment will not apply to the disallowance under section 40(a)(ia).
  • As can be seen from section 40(a)(ia), royalty shall have the same meaning as in Explanation-2 of clause vi of sub- section 1 of section 9. Explanation-4 which was introduced w.e.f. 1.6.1976 by the Finance Act, 2012 has no effect as that explanation was not referred to in section 40(a)(ia). Since the definition of royalty was specifically mentioned in section 40(a)(ia), the examination of the issue can only be made with reference to Explanation 2 alone. Argument of the learned DR that Explanation-4 increases the scope of royalty in section 9(1)(vi) may have validity for examining the issue of royalty under section 9(1)(vi) in its entirety, but not for the purpose of disallowance under section 40(a)(ia) wherein the scope of royalty was limited to Explanation -2 to clause vi of section 9(1).

Conclusion/ Remarks:

The ruling of Mumbai ITAT provides a guiding principle with regard to the withholding taxes. Given that no reference is made under the provisions of section 194-J to the newly inserted Explanation 4 of section 9(1)(vi), payment in the nature of royalty (covered under explanation 4) made to the residents should not be subject to TDS.

It is pertinent to note that this ruling may not apply to section 195 on payments to non-residents as section 195 is applicable to any payments and royalty will accordingly fall under the amended section 9(1)(vi). However, the same contradicts provisions of section 40(a)(i) for disallowance on account of non-deduction of taxes on payments to non-residents, as the definition of royalty contained therein specifically refers to the explanation 2 to section 9(1)(vi). It is also pertinent to note that there is no similar amendment in any DTAA entered by India and therefore, Explanation 4 would be redundant in cases where payments are made to non-residents of countries with which India has entered into DTAA.

Other Issues:

Disallowance of service charges:

Allocation of expenses/ service charges by the assessee to its holding company which is claiming exemption u/s 10A  is allowable following the order of Tribunal in assessee’s own case for AY 2002-03 in ITA No. 3027/M/06, AY 2003-04 in ITA No. 3758/M/06, AY 2004-05 & AY 2005-06 in ITA Nos. 3158 & 3161/M/08.

Considering the extent of expenditure in both the cases and the fact that both the companies are reporting the above amount as service charges recovered/paid from/to each other, we do not see any reason to doubt that assessee has not incurred the expenditure and the other company has not provided any services. Further there is levy of service tax also in each month’s bill at 12.5%. If only tax avoidance is main issue in allocation of expenditure to assessee, there is no need for allocating the expenditure to assessee paying service tax at 12.5% directly on the gross amount.

14A disallowance:

The contention of assessee to the effect that the disallowance cannot exceed the amount of exempt income cannot be accepted. This is for the reason that it is the amount computed as per the mandatory method prescribed in Rule 8D which is required to be taken for disallowance.

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