Unlike Indian scenarios and rulings on taxability of IT software rentals, the Supreme Court of Pakistan has held that the IT software rentals constitute ‘royalty’.
The bench of Justice Syed Mansoor Ali Shah has observed that there is distinction between the use of copyright and the use of copyright product. No copyrights were leased out to the lessee which merely acquired a program copy of FLIC tapes (software programs) for its operations. The transaction of lease of FLIC tapes software programs between the respondent and the lessee did not involve payments made for the use of or the right to use secret formula or process, or information concerning industrial, commercial or scientific experience. Income resulting from the lease of FLIC tapes amounts to business profits and cannot be treated as income arising from royalties. Therefore, Article 12 of the Convention is not applicable.
The petitioner seeks a review of the majority judgment (authored by Mr. Justice Qazi Faez Isa and concurred by the Chief Justice Mr. Justice Umar Ata Bandial) dated 8 September 2023. By the majority judgment, the civil appeals filed by the respondent with leave of the Court against the judgments of the Sindh High Court, dated 12 October 2007 and 11 November 2010, were allowed.
Consequently, the udgments were set aside and the decision of the Income Tax Appellate Tribunal (Tribunal) was restored. In disagreement, the minority judgment authored by one of us (Syed Mansoor Ali Shah, J.) dismissed the appeals of the respondent and upheld the judgments of the Sindh High Court. Both the majority and minority judgments have been reported as CIT v. Inter Quest Informatics Services.
The petitioner, a company incorporated in the Netherlands and thus a non-resident for income tax purposes in Pakistan, entered into two agreements with Schlumberger Seaco, Inc., a company operating in Pakistan. These agreements were titled the “Agreement for Lease of FLIC Tapes”, dated 1 February 1986, and the “Software Rental Agreement” dated 1 January 1995.
The petitioner, in its tax returns, declared the receipts under the Agreements as “business profits” and sought exemption from income tax in Pakistan under Article 7 of the Convention Between the Kingdom of the Netherlands and the Islamic Republic of Pakistan for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income.
However, the tax department treated these receipts as “royalties” under Article 12 of the Convention and subjected them to income tax at the rate of fifteen percent. The Income Tax Officer, Commissioner of Income Tax (Appeals) and the Tribunal concluded that the payments received by the petitioner fell within the definition of “royalties” under paragraph 3(a) and (b) of Article 12 of the Convention and were therefore liable to income tax in Pakistan.
The petitioner challenged the assessment orders, appellate orders and Tribunal judgments before the High Court through references. The High Court ruled in favour of the petitioner, holding that the amounts received by the petitioner for leasing FLIC tapes (software programs) under the Agreements did not qualify as “royalties” under the Convention and were not subject to income tax in Pakistan.
The respondent appealed to this Court and the majority judgment under review allowed the appeals, setting aside the High Court’s judgments and restoring the Tribunal’s judgments as well as the original and appellate orders of the Income Tax Officers. The minority judgment, however, dismissed the respondent’s appeals and upheld the High Court’s judgments. Hence, these review petitions.
For a payment to constitute royalty under the Convention, it must fall at least in one of the three categories provided in Article 12(3) of the Convention. One can start by narrowing down the possibilities envisaged in Article 12(3) of the Convention. The agreement for the use of FLIC tapes (software programs) concluded between the respondent and the lessee on 1 February 1986 did not involve payments made for the use of or the right to use any patent, trademark or tradename, design or model, or cinematograph films and tapes for television and broadcasting.
“We may also note that we need to interpret and apply the expression ‘profits derived from sources within the other Contracting State’ only to the extent required for purposes of the present proceedings, and we do not regard the foregoing observations as necessarily exhaustive of the meaning of this expression,” the court said.
IT Software Rentals Constitute ‘Royalty’ As per Indian Laws
The payment for a right to use computer software is taxable as a royalty, regardless of the medium through which the software is transferred.
Royalty is generally a consideration received by a person – a creator or an innovator for allowing his work of art or scientific invention to be used commercially. But in commercial and industrial terms, the concept of Royalty is wider.
Royalty is generally a payment received by the owner of an intangible right or know-
how under license in any technology transfer. Such intangible rights are often for making use of intellectual property such as patents, inventions, models, secret formulae, processes, designs, trademarks, service marks, trade names, brand names, franchises, licenses, commercial or industrial know-how, copyrights, cultural activities, films or television rights, literary, artistic or scientific works, computer software, exclusivity rights, etc. Royalty essentially signifies payment for ‘user right’. Such user right could be an annual payment or a pre-decided periodical payment.
