IPLC Payments Not ‘Royalty’ u/s 9 of Income Tax Act: Madras HC sets aside Disallowance u/s 40(a)(i) in Cognizant's Case [Read Order]

The Madras High Court, in a recent case, has held that payments made by Cognizant Technology Solutions India Pvt. Ltd. to Sprint USA for International Private Leased Circuit (IPLC) services are not “royalty” under Section 9 of the Income Tax Act of 1961.As a result, disallowance under Section 40(a)(i) for non-deduction of tax at source was set aside.

The assessee Cognizant Technology Solutions India Pvt. Ltd. is a company engaged in the business of software development and export. The return filed by the assessee was processed under Section 143(1) of the Income Tax Act,1961, and subsequently selected for scrutiny by the issue of a notice.

In the assessment year 2003-2004, the AO, after finding that the amount paid by the assessee to Sprint USA, for International Private Leased Circuits (IPLC), was without deduction of tax at source, disallowed it under Section 40(a)(i) of the IT Act. The disallowance of the claim of the assessee by the AO was affirmed by the CIT(A).

Aggrieved, the assessee filed an appeal before the ITAT. and the Income Tax Appellate Tribunal (ITAT) ruled that the payment is in the nature of royalty and subject to deduction of tax at source. Cognizant then appealed to the Madras High Court.

The ITAT had relied on the case of Verizon Communications Singapore PTE Ltd v. ITO for ruling in favour of the revenue.

Counsel for Cognizant submitted that the facts of the present case and those of Verizon Communications Singapore PTE Ltd v. ITO are poles apart, as none of the services of Sprint USA is rendered in India, and they were rendering services of data transmission outside India. He added that when services are not rendered in India, there can be no tax incidence for the assessment years in question.

It was further submitted that the decision of this court in Verizon Communications Singapore PTE Ltd v. ITO is no longer good law in view of the judgment of the Supreme Court in Engineering Analysis Centre of Excellence Pvt. Ltd v. CIT5, wherein, while considering the effect of an amendment to the Act without making any change in the DTAA, it was held that the amendment to the Act does not alter the DTAA.

It was further argued that IPLC payments are for standard connectivity services and do not constitute royalties. Even assuming that the payments could be treated as royalty, Article 26(3) of the India–US DTAA prohibits discrimination against US enterprises.

It was further submitted that in the case of the Engineering Analysis Centre of Excellence Pvt. Ltd v. CIT (supra), the Supreme Court has emphatically held that persons who pay TDS in the nations governed by a DTAA have a right to know exactly where they stand in respect of the treaty provisions. Reliance was placed upon the Organisation for Economic Co-operation and Development (OECD) Commentary for provisions of the OECD Model Tax Convention.

It was also contended that the meaning of “Royalty” in respect of clause (iva) to Explanation 2 to Section 9(1)(vi) of the Act, the meaning in respect of Royalty under DTAA will have to be interpreted on the strength of OECD commentary, as per which the meaning of “Royalty” under the DTAA will be only in respect of use of equipment, where the possession/control is with the payer.

The Revenue contended that DTAA does not override domestic law obligations of tax deduction at source. It argued that IPLC payments involve the use of equipment and therefore qualify as royalty under Section 9(1)(vi) of the act.

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He also submitted that the definition of royalty under the DTAA is also similar to what is found in the Act and, therefore, even under the tax treaty, the payments made by the assessee would fall within the definition of royalty, as the treaty does not have any restricted meaning to the term “royalty”.

It was further argued that no reliance can be placed on another tax treaty, which, according to the assessee, is more beneficial, unless there is a Most Favoured Nation (MFN) clause in the India-USA tax treaty, which alone permits the reliance on other tax treaties (third country tax treaties) that have more beneficial clauses to the assessee. Further, the reliance on the OECD model tax treaty is over the fence, as, admittedly, India is not even a member of the OECD.

The Division bench of Chief Justice Manindra Mohan Shrivastava and Justice Sunder Mohan examined the definition of “royalty” under Section 9(1)(vi). It noted that royalty generally refers to payments for the use of intellectual property, patents, copyrights, or technical know-how.

The High Court observed that IPLC charges are payments for connectivity services, not for the use of intellectual property or transfer of rights in equipment. The customer merely avails bandwidth connectivity, without acquiring any proprietary rights in the underlying infrastructure.

The Court noted that mere use of infrastructure does not constitute royalty. It distinguished between payments for services and payments for the use of intellectual property. The Court relied on OECD commentary and judicial precedents that clarified that payments for standard telecom services are not royalties.

The Court rejected the Revenue’s contention that IPLC payments involve use of equipment. It held that the assessee does not use the equipment itself; it only avails a service provided by Sprint USA. The ownership and control of the equipment remain with Sprint USA, and Cognizant merely receives connectivity.

The Madras High Court held that IPLC payments made by Cognizant to Sprint USA are not royalties under Section 9(1)(vi) of the Income Tax Act. Consequently, disallowance under Section 40(a)(i) for non-deduction of tax at source was unsustainable

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