20 Nov 2013 2013mber 2012
EY Tax Alert Madras High Court rules payment for dedicated bandwidth is “royalty”
Executive summary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor.
This tax alert summarizes a recent decision of the Madras High Court (HC) in the case of Verizon Communications Singapore Pte. Ltd. (Taxpayer)[1] . The issue was whether the payment made by the Indian customers to the Taxpayer for providing bandwidth/telecom services by way of International Private Lease Circuit (IPLC) is taxable as “royalty”. The HC confirmed the Tribunal’s ruling and held that such payments amount to “royalty” both under the Indian Tax Laws (ITL) and the Double Taxation Avoidance Agreement (DTAA) between India and Singapore.
[1]
Tax Case (Appeal) Nos. 147 to 149 of 2011 and 230 of 2012
Background and facts The ITL defines the term “royalty” to mean, inter alia, the consideration for use or right to use any industrial, commercial or scientific equipment (equipment royalty). It also includes consideration for the use of any patent, invention, model, design, secret formula or process or trademark or similar property. The 2012 amendments to the ITL have retroactively expanded the definition of “royalty” pursuant to which, irrespective of possession, control with the payer or use by the payer or the location in India, the consideration would nevertheless be treated as “royalty”. Further, the amendments also retroactively clarified that the expression “process” includes transmission by satellite (including up-linking, amplification, and conversion for down-linking of any signal), cable, optic fibre or by any other similar technology, whether or not such process is secret. The Taxpayer is a Singapore based nonresident company engaged in the business of providing international connectivity services in the Asia Pacific region. IPLC is an end-toend managed dedicated bandwidth service that provides internet service to customers for various applications. As the Taxpayer is not a licenced service provider under the Indian laws, in terms of the service agreement entered into by the Taxpayer, Videsh Sanchar Nigam Ltd. (VSNL) provides the Indian leg of the international service. Some of the assets which are necessary to avail the dedicated bandwidth service are located at the customer’s premises. The facts of the case are graphically represented below:
Outside India
IPLC
Customer’s location
India
Service rendered by Taxpayer using equipment outside India
Service rendered by VSNL using gateway/station belonged to it
Customer’s location
The Tax Authority (TA) held that the payment received by the Taxpayer in providing IPLC is taxable as equipment royalty under the ITL and the DTAA. The Taxpayer contended that the contract between the Taxpayer and the customer, being the one for providing services, the consideration received for rendering services cannot be termed as “royalty”. The TA contended that, so long as there is nexus between the user (the customer), the situs of the usage (in India) and the purpose of the use (for offering seamless internet facility), the economic exploitation of the equipment gives rise to the income to be taxed as “royalty”. Further, right to access and exploit a part of segment of a larger system to use the capacity of the system and the consideration paid therefore clearly falls under the definition of “royalty”. Even otherwise, it is a consideration for right to use a process and a right to use equipment falling under the definition of “royalty” as per the ITL. The arguments of the TA were confirmed by both the First Appellate Authority and the Tribunal. Aggrieved by this, the Taxpayer filed an appeal before the Madras HC.
HC’s decision The HC agreed with the Tribunal and held that the payment for use of IPLC is taxable as “royalty”. The HC agreed also on the ground that even if the payment is not treated as one for the use of the equipment, it should be considered as for use of the process provided by the Taxpayer, whereby through the assured bandwidth, the customer is guaranteed the transmission of data and voice. The provisions of the DTAA dealing with royalty taxation are pari materia with the ITL. Hence, the payment is taxable as royalty both under the ITL and the DTAA.
the customer's end is delivered by the Taxpayer itself.
In concluding as above, the HC observed as follows: Arrangement with Indian customer is under a One Stop Shopping (OSS) basis for IPLC services by the Taxpayer: ►
►
In the background of the service agreement with the customer, the service agreement with VSNL and the one between customer and VSNL, it is clear that these are part and parcel of one composite agreement split into various components, for the purpose of convenience. The nature of services to be offered through the different agencies has a bearing on each other. The ultimate aim was however to give the customer a point-to-point private line to communicate between offices that are geographically dispersed throughout the world for the purposes of accessing business data exchange, video conferencing or any other form of telecommunication. A reading of the agreement with VSNL also shows that the configuration at the customer's end and at the VSNL end and in the other half circuit managed by the Taxpayer match with each other and are compatible for ensuring the integrated service to the customer. Thus the two half are mirror images of each other. Going by the terms of the agreements, the Taxpayer renders service in India and the consideration received attracts the incidence of taxation in India. Further, the service is provided by the Taxpayer under an OSS arrangement with Indian customer. The intention of this is to allow the customer to place a single order with the Taxpayer for two private leased circuits for offices in different countries. Hence, the entire arrangement is considered to be a consolidated one.
IPLC service involves use of equipment and hence triggers equipment royalty taxation: ►
To achieve high speed internet connection, the equipment at the customer's end must have the capacity to send and receive data at the required speed. In order that the contracted bandwidth is provided, the equipment at
►
The Taxpayer had provided the necessary equipment such as routers, switches, PBXs (Private Branch Exchanges), telephones, key system facsimile products, modems, voice processing equipment, video communication equipment and circuits at customer’s premises, configured and customised to ensure that the customer gets the uninterrupted connectivity. The contract between the customer and the Taxpayer ensures that the customer has a dedicated active internet at a particular speed.
►
Throughout the contract period the Taxpayer has the right to use the equipment and supervise its maintenance. The customer cannot in any manner tinker with it or its rights in any manner alienated.
►
It is ensured that the necessary equipment placed at the customer’s end in the Indian half is compatible with the equipment in the other half outside India, so that the switching facility converts and receives the signal in the network and transmit through the transmission network cable to the ultimate destination.
►
Since there is use of equipment and cable in the transmission of the data/voice from one end to the other, the case of the Taxpayer that the nature of transaction is only that of service is unacceptable. The agreement provides an indefeasible right to the customer to use the facility of communicating the data/voice and has an internet in the matching half circuits for providing the required telecommunication services at the assured speed.
►
The provision of service is not possible without the use of the equipment ensuring the assured bandwidth for transmission of data/voice which provides the internet access to the customer to and fro.
►
The amendment to the ITL gave an expansive meaning to the term “royalty” and the decisions/rulings relied on by the
Taxpayer[2], were all rendered prior to the amendment to the ITL and hence are irrelevant. ►
►
Hence, this payment is towards equipment royalty and falls under the definition of “royalty” as per the provisions of the ITL.
Comments The issue of whether the payment for bandwidth services is royalty has been a subject matter of tax controversy in India. The ITL was amended in 2012 to clarify with retrospective effect to expand the scope of royalty taxation. This decision of the Madras HC has opined that in view of this amendment, the earlier decisions in favor of taxpayers no longer hold good. In arriving at its conclusion, the HC held that it is difficult to accept the case of the Taxpayer that the nature of transaction is only that of service and that the transaction does not involve use of equipment. Further, the HC has held that even if the payment is not considered as equipment royalty, it should be taxable as process royalty, with no DTAA relief available.
Process royalty taxation: ►
The customer has a significant economic interest in the Taxpayer's equipment to the extent of the bandwidth hired by the customer. The bandwidth capacity made available on a dedicated basis for the entire contract period and the amount received by the Taxpayer in a way is for the use of process. Thus, the Taxpayer provides the Indian customer an integrated communication system which cannot be dissected as two independent contracts having no bearing at all on each other.
►
The fact that the bandwidth is shared with others has to be seen in the light of the technology governing the operation of the process and this by itself does not take it outside the purview of royalty.
►
Hence, the payment for the bandwidth amounts to “royalty” for the use of the process.
Taxation as equipment/process royalty under DTAA: ►
The definition of “royalty” under the DTAA and the ITL are in pari materia.
►
“Process” is defined in the ITL to mean and include transmission by satellite, cable, optic fibre or by any other similar technology, whether or not such process is secret. By reason of the long distance, to maintain the required speed, boosters are kept at periodical intervals.
►
Therefore, apart from equipment royalty, the payment for bandwidth amounts to “royalty” for the use of the process.
In any event, the payment was rightly assessed as “royalty” and would constitute so for the purposes of the DTAA.
One may recall that the Delhi HC in the case of Nokia Networks OY[3] had observed that the retroactive amendments to the definition of “royalty” cannot be read into a DTAA.
[2]
Asia Satellite v. DIT [332 ITR 340]; Dell International Services (India) Pvt. Ltd., In re [305 ITR 37]; Cable and Wireless Networks India (P) Ltd., In re [315 ITR 72]
[3]
[TS-700-HC-2012(DEL)]
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