Wednesday, 27 July 2016

India: ITAT clarifies treatment of web hosting services

The Mumbai Income Tax Appellate Tribunal (ITAT) issued a decision on 31 March 2016 clarifying that a payment for web hosting services will not be treated as a royalty subject to withholding tax under India’s domestic tax law in a case where the taxpayer receiving the services does not have a right to physical access or control over the equipment used to provide the services (Savvis Communication Corporation).
The rapid development and evolution of technology has been a major factor in the shift to a digital economy that is based on intangible property and digital goods and services. Most businesses today, whether local or multinational, use many information technology (IT)-enabled services. “Web hosting” is one such tool. In simple terms, web hosting services provided by a company involve the provision of storage space for data and applications on a server the company owns or leases for use by its clients, as well as the provision of internet connectivity (typically, in a data center). Generally, the clients of web hosting companies do not have any control over, or right to use, the server or equipment used by the web hosting company, and the services the web hosting company provides are restricted to the backup, maintenance and security of data and the uninterrupted use of services, and not for any use of equipment.
Similar to other IT services, the taxability of payments made for web hosting services has been a contentious issue in India, with an ongoing debate on whether payment for such services qualifies as a royalty for the use of equipment that is subject to withholding tax under India’s domestic law.
Since India expanded its domestic law definition of “royalty” in 2012, the tax authorities have tried to impose the broader scope of the definition to encompass most IT services, including web hosting services, since a payment for the use of equipment now may be considered a royalty even if the equipment is not in the possession and control of the service recipient. This conflicts with the principle set forth in the commentary to the royalties article in the OECD model tax treaty, with respect to the taxability of “transponder leasing payments.” The commentary notes that where
payments are made by customers that do not acquire physical possession of the transponder, but simply the use of its transmission capacity, such payments would be regarded as services taxable as business income. If the same rationale is applied to payments made for web hosting services, where the customer does not have the physical possession of the equipment, the payments would not be taxable as royalties.
In a welcome development, the Mumbai ITAT held in Savvis Communication (a US-based web hosting service provider that provided services to Indian entities) that payments received for the provision of web hosting services in a case where the client did not have the right to use the equipment that was used to provide such services, or any physical access to that equipment, were not taxable as royalties under India’s domestic law.
The Mumbai ITAT opined that the true test of whether a payment is a royalty is whether the consideration is paid for the provision of services, which may involve the use of scientific equipment, or paid for the use of equipment. In a case of the provision of services, the payment is not taxable as a royalty.
The ITAT held that the taxpayer was providing web hosting services with the help of sophisticated scientific equipment in the virtual world. The payment could not be treated as consideration paid for the use of, or the right to use, scientific equipment, so it was not taxable as a royalty under India’s domestic law. The Mumbai ITAT relied on its own prior ruling, in which it held that “a payment cannot be said to be consideration for use of scientific equipment when [the] person making the payment does not have an independent right to use such an equipment and physical access
to it.”
While the Mumbai ITAT ruling should be a welcome decision for taxpayers, it is noteworthy that there is no discussion in the ruling on whether web hosting services could be classified as “fees for technical/included services” under India’s domestic law or an applicable tax treaty. Nevertheless, taxpayers purchasing standard services involving the use of technology and equipment may rely on this decision as support that payments for the services should not be treated as royalties, as long as the taxpayers do not have physical control and possession over the equipment.
Source: Deloitte