Facts of the Case

ZTE Corporation, a tax resident of China, was engaged in supplying telecom equipment and mobile handsets to Indian telecom operators. It did not file its income tax returns in India on the ground that it had no Permanent Establishment (PE) in India under Article 5 of the India-China DTAA.

A survey under Section 133A was conducted by the Revenue authorities, and documents along with statements of senior executives were recorded. Based on such material, the Assessing Officer formed an opinion that the assessee had business connection and PE in India.

Reassessment proceedings under Section 148 were initiated. The assessee filed NIL income return, claiming its revenues were not taxable as business profits in India.

The Assessing Officer held that:

  • ZTE had Fixed Place PE
  • Installation PE
  • Dependent Agency PE

Further, the AO treated software payments as royalty under Section 9(1)(vi) and Article 12(3) of DTAA.

The CIT(A) partly allowed the appeal.

Both Revenue and assessee approached ITAT.

ITAT held software receipts to be business income and not royalty.

Revenue challenged before Delhi High Court.

Issues Involved

  1. Whether consideration received for software embedded in telecom equipment constitutes “royalty” under Section 9(1)(vi) of the Income Tax Act?
  2. Whether such payments are taxable as royalty under Article 12(3) of India-China DTAA?
  3. Whether software supplied along with hardware can be separated for tax purposes?
  4. Whether interest under Section 234B is leviable upon the non-resident assessee?
  5. Whether Explanations 5 and 6 to Section 9(1)(vi) alter the taxability?

 

Petitioner’s Arguments (Revenue’s Contentions)

  • Software was separately priced under the contract.
  • The software was licensed and not sold.
  • The customer received right to use software.
  • Such right amounted to transfer of copyright rights.
  • Therefore consideration constituted royalty under Section 9(1)(vi).
  • Explanations 5 and 6 inserted by Finance Act, 2012 expanded the royalty definition retrospectively.
  • Royalty was not effectively connected with PE and therefore taxable independently under Article 12.

Respondent’s Arguments (Assessee’s Contentions)

  • Software was integral to telecom hardware.
  • It had no independent commercial existence.
  • No copyright rights were transferred.
  • Only copyrighted article was transferred.
  • Customers could not modify, reproduce, sublicense, or commercially exploit software.
  • Supply of software and hardware formed one indivisible transaction.
  • Therefore receipts constituted business income and not royalty.

It also argued that Section 234B interest was not applicable.

Court Findings / Court Order

The Delhi High Court dismissed the Revenue’s appeals and held:

1. Embedded Software is Not Royalty

The Court held that software embedded in telecom equipment is inseparable from hardware and forms part of goods supplied.

Mere licensing terminology does not alter transaction substance.

No copyright rights under Section 14 of Copyright Act were transferred.

Only copyrighted article was transferred.

Thus consideration does not amount to royalty.

2. Supply Contract Cannot Be Artificially Split

The Court held that hardware and software form one composite transaction and cannot be taxed separately under different heads.

Separate invoicing does not change transaction character.

3. Section 234B Not Applicable

The Court followed earlier precedent and held that interest under Section 234B is not leviable on non-residents where tax is deductible at source.

Final Order

Revenue’s appeals dismissed.
Questions answered against Revenue and in favour of assessee.

Important Clarifications

  • Embedded software forming integral part of hardware is not royalty merely because separately invoiced.
  • Transfer of copyrighted article is different from transfer of copyright rights.
  • License terminology is not conclusive.
  • Substance over form principle applies in tax characterization.
  • Retrospective amendments under Section 9(1)(vi) do not override treaty interpretation where DTAA applies.

 Sections  Involved

  • Section 9(1)(vi), Income Tax Act, 1961 – Royalty income
  • Explanations 5 & 6 to Section 9(1)(vi)
  • Section 234B, Income Tax Act, 1961 – Interest for default in payment of advance tax
  • Section 148, Income Tax Act, 1961 – Reassessment proceedings
  • Section 133A, Income Tax Act, 1961 – Survey proceedings
  • Article 5, India-China DTAA – Permanent Establishment (PE)
  • Article 7, India-China DTAA – Business profits
  • Article 12(3), India-China DTAA – Royalty
  • Article 12(5), India-China DTAA – Effective connection rule
  • Section 14, Copyright Act, 1957 – Meaning of copyright

Link to download the order - https://delhihighcourt.nic.in/app/case_number_pdf/2017:DHC:424-DB/SRB24012017ITA9042016.pdf

 

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