India has been an active voice in the global policy debate on equipping tax rules for the digital economy, which is spearheaded by the OECD through its BEPS initiative. In 2016, India introduce equalization levy and in 2018, India extended its conception of ‘taxable presence’ to include cases where a foreign enterprise engages digitally with a significant Indian customer base even in the absence of a physical presence.
At the ground level, Indian tax authorities too have been looking to tax revenue streams generated by multinational technology enterprises through an Indian customer base either, as royalties or fee for technical services or by the constitution of a permanent establishment. Indian tax jurisprudence is replete with examples of characterization disputes on e-commerce transactions, including electronic ordering of digital products, application hosting, website hosting, software maintenance, etc.
Thus far, online advertising revenues earned by foreign search engines were ring fenced from income tax pursuant to the decisions of Rights Florists, Yahoo & Pinstorm, though subject to an equalization levy. However, in the recent decision of the Bangalore tax tribunal (“Tribunal”) in the Google Adwords case, the Tribunal held that payments made by Google India (“Appellant”) to its Irish affiliate (“Irish Co.”) for the purchase of ad space on Irish Co.’s AdWords Program would be subject to Indian withholding tax as royalties.
The matter has now been admitted to appeal by the Karnataka High Court, and at its core is the characterization issue of whether online advertisement revenues represent a passive return in the nature of royalties on the Appellant’s intellectual property, or simple business income earned from sale of ad space. In this article, we present three key facets of this case, which the tax practitioner and digital business community should watch out for.
The Appellant provided services to its affiliate Irish Co. under two agreements. First, a services agreement for the provisions of information technology (“IT”) services and information technology enabled services (“ITeS”) (“Services Agreement”). Second, a distribution agreement where under the Appellant functioned as a non-exclusive authorized distributor of Irish Co.’s AdWords program in India (“Distribution Agreement”) pursuant to a B2B model. Under the Distribution Agreement, the Appellant provided marketing, distribution, pre-sale and post-sale customer support services to Indian advertisers. The Irish Co.’s AdWords is a unique online advertising service, where advertisers pay to display brief advertising copy, product listings, and video content within the ad network to web users. The program uses keywords to place advertisements on pages where Irish Co. thinks they might be most relevant. Advertisers pay when users divert their browsing to click on an advertisement. AdWords enables an advertiser to alter and review the performance of an advertisement and to adjust its content.
The Appellant argued that payments made to Irish Co. were for purchasing online ad space in the AdWords Program from Irish Co. for onward resale to Indian advertisers. Accordingly, such payments did not qualify as royalties. Such payments were business profits that were not taxable in India because Irish Co. did not have a permanent establishment (“PE”) in India. This stand was based on various Tribunal decisions in the case of characterisation of ad revenue under distribution agreements in the past.
Nexus between the Distribution Agreement & Services Agreement
The Appellant contended that the Services Agreement and the Distribution Agreement were two independent standalone agreements. The Appellant had received a limited license to certain intellectual property from Irish Co. under the Services Agreement to in turn enable the Appellant to render IT and ITeS services to the Irish Co. The Appellant was remunerated by Irish Co for such services separately. The services under the Services Agreement were not linked in any manner to Appellant’s distribution function under the Distribution Agreement. Additionally, the Appellant argued that the right to use trademarks, brand features or other intellectual property granted to it was only incidental to the main purpose of the Distribution Agreement, which was to sell ad space.
However, the Tribunal held that Appellant was solely responsible for providing all customer support services to the advertisers through use of Irish Co.’s data and intellectual property. While the Appellant could provide these services to the advertisers under the Services Agreement (under which the Appellant received a license to Google’s data and intellectual property), such services were instead rendered under the Distribution Agreement. Customer data for providing services under the Services Agreement was also utilized for marketing and distribution functions under the Distribution Agreement. Thus, the services rendered under Services Agreement were interlinked with the activities undertaken by Appellant under the Distribution Agreement.
Having deliberated on the technical niceties of the AdWords program, the Tribunal adopted a holistic approach in construing the Appellant’s functions under the Distribution Agreement and the Services Agreement. Reminiscent of the ‘look at approach’ coined in the Vodafone case, the Tribunal laid emphasis on the fact that in the absence of the Appellant exercising its rights under the Services Agreement, it could not discharge its obligations as a distributor of ad-space under the Distribution Agreement.
Accordingly, it becomes crucial that the agreements entered into by foreign companies with the end customer and supply chain intermediaries are reviewed and examined holistically to flag or mitigate any risks associated with characterization of revenue streams and their taxation. Intellectual property received by the payer under one agreement, which is arguably used for purposes of discharging distributor functions under the second agreement, can impact the classification of revenue earned from such second agreement.
As the matter proceeds to higher courts, it needs to be examined whether the Tribunal’s decision would have varied if the services provided by the Appellant under the Distribution Agreement to the advertisers were instead covered by the Services Agreement and were remunerated for separately. Further, the outcome could have also been different if the Services Agreement could possibly have been entered with a person different than the person executing the functions of a distributor.
Business Income v. Royalty
The Tribunal held that the Distribution Agreement was not merely an agreement to sell ad space but was instead an agreement to provide services to facilitate the display and publication of advertisements to targeted customers with the aid of technology. Further, the Tribunal was of the view that the AdWords program provides an advertiser a variety of tools, which are provided using Irish Co.’s intellectual property via the Appellant. Tribunal concluded that Irish Co.’s intellectual property was not incidental to the activities of the Appellant, but was pivotal to market and distribute the AdWords Program. Therefore, payments made to Irish Co. for use of its intellectual property would qualify as royalties.
The Tribunal distinguished the rulings in the case of Rights Florists, Yahoo & Pinstorm on facts observing that in those cases the payments were made by the advertisers to the foreign company without involving any element of use or right to use of intellectual property.
At the heart of the Tribunal’s ruling is ‘product differentiation’, basis which it has distinguished prior jurisprudence on online ad revenues from the Google Ad words case. Per Tribunal’s ruling, the payment made by the Appellant was not merely for the right to resell ad space but to enable focussed and targeted ad placement by access to the unique tools and commercial information collected by the AdWords program enabling the Appellant to perform its functions under both the agreements.
Accordingly, two points emerge from the decision of the Tribunal that are relevant to flag a tax risk. First, does the digital product entail grant of any license or right to use to a supply chain intermediary or the customer. Second, is such licence or grant to use key to the service/ product.
While these tax risks relating to characterization of payments in digital transactions can be identified by companies, addressing such risk will remain difficult until there is disconnect between the businessman and the taxman.
The taxman perceives such revenue as royalties arising from the grant or use of intellectual property. The businessman, however, perceives the income as active business income realized from exploiting intellectual property as against passive income earned from the licensing of intellectual property. The Google case is notable because it falls in the midst of these views, where the supply chain intermediary makes use of intellectual property licensed to it to generate ad-sale revenues. The issue, however, remains whether the predominant character of earnings made by Irish Co. through the supply chain intermediary were for sale of ad revenues or a return for licensing the intellectual property to such intermediary. This issue will be material for the decision of the Hon’ble Karnataka High Court.
Royalty v. Equalisation Levy
The Appellant argued that the payments made by it to Irish Co. should be classified as business profits as against royalties because the Legislature also perceives such payments as business profits, which is apparent from the introduction of equalisation levy. However, the Tribunal ruled that payments made by the Appellant to Irish Co. were consideration for use of intellectual property. Further, it held that equalisation levy is charged only on consideration for specified services and not others where there is use of IPR, copyright and other intangibles.
The decision of the Tribunal on this aspect has far reaching impact on digital businesses. The Tribunal suggests that despite the introduction of equalisation levy (which although currently is only limited to advertising but is expected to expand to other services), if a particular arrangement involves use of technology, know-how, intellectual property etc. payments under it may be subject to withholding tax as a royalty.
As such, Section 10(50) of the Income-tax Act, 1961 provides that any income arising from any specified service subject to equalization levy would be tax exempt. Therefore, once online ad revenues are subject to equalization levy, they should be exempt from income tax. However, the decision of the Tribunal suggest that there could be cases where a dual characterization of a receipt as remuneration for sale of online ad space and royalties for grant of intellectual property could be subject to potential double taxation. Under the mandate of Section 10(50), clarity will be required on this issue given that a classification of payments should ideally be exclusively for use of intellectual property or for sale of ad-space to avoid double taxation. Even in cases of a composite payment, the consideration will need to be split into remuneration for online ad-space and remuneration for provision of intellectual property.
Technology has reached every sector of the Indian economy. Certain business models that have always been part of the economy have adapted to the digital marketplace. Incomes arising from products and services, which were not be treated as royalties in the brick and mortar set up, now risk such characterisation because of the use of technology in delivering such product and services digitally. As tax jurisprudence evolves in the context of the digital marketplace, technology driven businesses have to be mindful of the agreements they enter into with customers and supply chain intermediaries to mitigate the risk of business income being perceived as ‘royalties’ or ‘fee for technical services’. Admittedly, the extant tax rules and jurisprudence are still evolving to deal with the digital economy. It is hoped that the Government in re-drafting the tax code chalks out clear rules to address the tax treatment of income streams in the digital economy.
 Supra Note 1
  93 taxmann.com 183 (Bangalore - Trib.)
 ITO v. Right Florist (2013) 25 ITR (T.) 639; Pinstrom Technology Ltd., v. ITO (2012) 54 SOT 78 (Mum. Trib.) and Yahoo India Pvt. Ltd., v. CIT 140 TTJ 195 (Mum.Trib.); Set India Pvt. Ltd. ITA No.4372/Mum/2004; Taj TV Ltd., in ITA No. 4678/Mum/2007
  179 TAXMAN 129 (SC)
 Supra Note 1
- Amit Singhania - Partner, Shardul Amarchand Mangaldas
- Gouri Puri - Principal Associate, Shardul Amarchand Mangaldas
- Suyash Sinha - Senior Associate, Shardul Amarchand Mangaldas