Appellant’ Case; Claude Kamau Mwangi
4.The witness is an Advocate of the High Court of Kenya, with LLB & Masters’ Degree from Strathmore University and is specialized in Property law & Intellectual property. He relied on the filed Witness Statement on line and testimony in court made on February 26, 2021.
5.He said that royalties as a term can only be used to describe payments made with respect to either of the 2 categories; Licenses and Assignments. Royalties is a tax term under section 2 on Income Tax Act and an Intellectual property term/concept that connotes fees due to a copyright owner by Assignee of Licensee. According to the Witness, the Appellant acquired physical medium in which copyrighted software is embedded and did not acquire software through license or assignment. The software gives the physical item the copyright item and it is not synonymous with acquisition of a right under license of assignment.
6.He stated that to distinguish trading in a market with tax component one needs to identify the tax character;
7.At paragraph 20-25 of his Statement, the witness described an assignment is a transfer of ownership. It maybe partial, in the sense of transferring only some of the owner’s exclusive rights or in transferring ownership for only a limited period, as opposed to the whole term of copyright. To be effective, an assignment must be in writing signed by or on behalf of the Assignor.
8.He averred that an assignment is in exchange of payment of royalty. A License does not involve transfer of ownership, but grants permission to carry out certain acts that fall within exclusive rights of the owner. In a license no proprietary interest is passed to Licensee, it merely is merely permits the Licensee to do the acts with respect to the copyright which would amount to infringement if the license was not granted.(section 33 of Copyright Act).
9.According to the Witness, Payments in respect of licenses and assignments are considered royalty and are payable under section 34(2) of ITA if pursuant to an agreement, the [Purchaser] does not acquire any rights to use or reproduce the copy right work, it is not an assignment or License.
10.There is a distinction between a copyright and copyright- embodying article. Copyright itself attracts royalty taxes, the sale of copyright articles would only attract business income tax.
11.The Witness relied on the case of Tata Consultancy Services vs State of Andhra Pradesh (271ITR 401) 2004 Pg 99- 122 where Indian Court held that software when put in a medium is goods for sale not copyright.
Respondent’s Case; David Mugo Mwangi
12.The Witness holds degree in Economics & Government from University of Nairobi, he is a trained Tax Auditor with 29 years’ experience in Tax Administration.
13.The witness relied on Witness Statement of October 24, 2019, and testimony in court on March 16, 2021 and stated that the appellant is an Information Communication Technology (ICT) Company that provides ICT Infrastructure, Technical Personnel, ICT Equipment, Software & Consultancy in the field. The appellant was profiled for an indepth audit for the period from January 2010- 2013 due to phenomenal growth in turnover without corresponding growth in taxes paid.
14.The Witness stated that notice was issued on October 18, 2013 of the intended audit and identified documents to be availed as outlined in Paragraph 11& 14 of the Witness Statement. The Witness led the audit team and audit was from February to October 2014.
15.The Audit revealed various clients that the appellant serviced through ICT needs both locally and within the East & Central African region. The Audit revealed that the appellant deducted Withholding tax on payment of consultancy and contractual fees but not on software licenses. The respondent took the view that payment of software Licenses amounts to payment of royalties and therefore subject to withholding tax under section 35(1)(b) of Income Tax Act.
16.The Witness noted at Pargraph 29-33 of the Witness Statement, that the appellant did not produce the Software Sales Agreement signed between Callidus Software Inc & the appellant Company and the Respondent relied on the Schedule to the Agreement. The Contracts and Invoices confirmed purchase of Licenses.
17.The Software Purchase Agreement has the License Schedule and depicts its true nature as a mere license to use licensors software as distinguished from a purchase Agreement. What was transferred to the appellant is only a license or permission to use software supplied by Callidas USA under those terms and conditions of License. The payments of license Fees was consideration for the right to use the software, which is within the definition of a royalty under Income Tax Act.
18.It was the appellant’s submission that in order for a payment to be considered a royalty it must be made in consideration for the use of or the right to use a copyright. The ITA does not provide a definition of a 'copyright' nor does it define a 'literary work'. The appellant therefore relies on the provisions of the Copyright Act, 2001 for the definition of these terms. Section 22(1)(a) of the Copyright Act, 2001 determines works eligible for copyright as follows:Section 22 Works eligible for copyrightSection 2(1) of the Copyright Act, 2001 defines a ‘literary work' as follows:
19.From these provisions, there is an unequivocal statutory basis that provides that computer programs may be literary works which are eligible for copyright.Section 2(1) of the Copyright Act, 2001 defines a
20.From this definition, what is copyrightable is the set of instructions rather than particular medium (copyrightable material) on which the software is incorporated.
22.The appellant submitted that by purchasing software, it acquired copyrighted material and it did not in any way acquire the rights to the Intellectual Property, that is, the Copyright in the software.
23.Moreover, in the case of Republic v Commissioner of Domestic Taxes Large Tax Payer's Office ex-parte Barclays Bank of Kenya Ltd (2012] eKLR the court observed that:
24.The appellant submitted that by purchasing software, it acquired copyrighted material and it did not in any way acquire rights to Intellectual Property, that is the Copyright in the software.
25.The distinction between ‘copy right’ and ‘copy righted material’, the respondent ought to consider the rights which the grant of copy right confers.Section 26(1)of Copy Right Act 2001 defines what cannot be considered as infringement of copyright. Section 2 of the Copy Right Act defines ‘License’ as permitting the doing an act controlled by copyright. Therefore, payment may only be deemed to be a royalty where it results in section 26(1) of Copy Right Act 2001.
26.When a developer sells copyrighted material he does not sell his right to the invention as the developer sells a copy of the invention to a purchaser which can be used by the purchaser but cannot be developed by the purchaser, the purchaser also does not have the right to make copies of the invention. In purchasing the copyrighted material, the appellant did not acquire any of the rights setout under section 26 of the Copyright Act, 2001. Reference was made to the case of Dassault Systems KK v DT 322 ITR 125 (AAR) to buttress the point payments received by software developers from 3rd party sellers on account of supply of software products to the end users did not result in royalty income.
29.The apellant further submitted that Paragraph 10.1 of the OECD (Model Tax Convention) MTC Commentary to article 12 provides that:
30.Paragraph 14.4 of the OECD Model Tax Convention (MTC) commentary to article 12 provides that:
31.When a party acquires copyrighted material; it does not acquire any right in the intellectual property of the copyright. Commercial exploitation would only be possible if the appellant would have the right to make copies of the software which right the appellant does not hold. Distribution of the copyrighted article, that is, the software to third parties does not fall within the definition of using the intellectual property in the software.
32.The respondent submitted that Callidus Inc USA is a non-resident person who received consideration for software procured by the appellant, hence tsection 35(1)(b) of the Income Tax Act (ITA) as read with section 2 of the ITA. The consideration paid was for the use of or right to use the copy right of a literary work, in this case the software.
33.The respondent further submitted that the appellant exploited the intellectual property in the software when it resold the software to its customers and therefore, the proceeds from the same are also royalty as envisaged under the aforesaid sections of the ITA. Without entering into a license Agreement the appellant was not permitted or allowed to use the software, which exclusively belongs to Callidus USA
34.That the appellant pays a cost for use of the software and that by use of the software, a right is conferred on the appellant. The appellant was given a right to use the software whether for own use, resale or distribution purposes, on payment of a cost stipulated in the Software Purchase Agreement.
35.Section 2 of the Income Tax Act defines of Royalty as follows:
36.It is clear from the finding of the Tribunal that the appellant could use the software for its own use and for resale and that consideration paid for the same would amount to royalties. This is because there are some rights that were embedded in the software, which both the appellant and its customers enjoyed when they each used the software.
37.The respondent submitted that in this case what was transferred when the appellant used the software or sold it to its customers were rights that were embedded in the software which were enjoyed by the appellant and its customers. It is therefore misleading for the appellant to suggest that no rights were enjoyed by it or its customers when it bought the software. The respondent therefore submitted that what was transferred in this case was a right in respect of a copyright and not a right in the copy copyright.
38.The appellant was given a license for the software and that going by the aforesaid decision any consideration paid for any rights to the software (ie whether for own use or resale) in this case is subject to royalty. This is because in either of the circumstances there are rights in respect of copyright that are being enjoyed by the appellant and or his customers from the use of the software.
40.The respondent submitted that the court should therefore arrive at the same finding that the monies that were paid out by the appellant to the owners of the software, Callidus Inc (USA), (a non-resident person) as consideration for the use of or right to use the software by itself and or its customers attracted were royalties as envisaged under section 35(1)(b) of the ITA as read with the definition of "Royalty" under section 2 of the ITA.
41.The respondent argued that it would be absurd to separate the copyright from the copyrighted material because the software in this case is an intangible and the right being enjoyed is the right in respect of the copyright that is embedded in the software. Whether the software was purchased for resale or for own use the Withholding tax would still be collected as they are royalties under definition in the ITA. Therefore, the appellant's arguments that the transactions in this matter be considered to be in relation to copyrightable material is mischievous and aimed at defeating the collection of tax that is due.
42.The consideration paid by the appellant to use the software for personal use within its business amounts to royalty. This is because the appellant by using the software is enjoying a right in respect of copyright in the software.
43.In addition, the assessments of taxes for the taxes in this matter were conducted in accordance with the sections 35(1)(b) as read with section 2 of the Income Tax Act as already explained in all the forgoing paragraphs and that the Judgment by the Tribunal must therefore be upheld.
44.Further, that in arriving at the assessments followed the due process, carried out the necessary tests and verification exercises and further admitting any information and records from the appellant in arriving at the taxes due. All information and records availed by the appellant both at objection of the Commissioner's decision and Appeal to the Tribunal levels were put into consideration when arriving at the taxes due.
46.To buttress the point, the appellant made payments for acquiring the software for its use through a license. The payments were made to Callidus Software Inc. who is non-resident person which the Appellant was obliged to deduct appropriate non-resident Withholding tax as required under the Income Tax Act.
47.The court considered the pleadings filed on the appeal experts’ evidence and written submissions by parties through their respective Counsel.
48.The issue that emerged for determination is as set out in the memorandum of appeal condensed as follows;
a. Whether Withholding tax should be taxed on payments made for purchase of software and licenses and whether the payments amount to royalties paid to non-resident under section 35 of ITA or not.
49.The Tax Appeals Tribunal found as follows;
50.The appellant contended that the Tribunal erred in failing to consider that the appellant is a vendor of copyrighted material and not the user of a copyright and in this regard does not receive any right to exploit the copyright. Further, that payments for the acquisition of copyrighted material do not fall within the ambit of this definition hence Withholding tax does not apply.
51.The appellant's case hinges on payment made to a non-resident person as consideration for software procured and whether the payment qualifies to be taxed under "royalty"
52.The appellant contended that by purchasing software, it acquired copyrighted material and it did not in any way acquire the rights to the Intellectual Property, that is, the Copyright in the software. It was also the appellant’s argument that the Tribunal erred in failing to consider that it is a vendor of copyrighted material and not the user of a copyright and does not therefore receive any right to exploit the copyright.
53.The appellant’s expert gave detailed intellectual property processes and circumstances where tax would be applied. Admittedly, the expert vide his statement at paragraph 27 opined that ‘it is not in dispute that payment of license Fess as consideration of the right to use software falls within the definition of a royalty. If a purported assignee or licensee, however, does not therefore pursuant to an agreement acquire any right to use or reproduce the copyright work, this cannot properly be termed as either an assignment or a license.’
54.The appellant took the view that Withholding tax was not payable under section 2 & 35 of ITA as the appellant did not pay royalties to the non-resident in purchase of software. They bought software which was not changed in any way and it was for resale and own use. They acquired a copyrighted article and not a copyright and no rights of the copyright were transferred or used by the appellant.
55.This was a sales of goods transaction. The respondent on the other hand contended that the appellant purchased licenses and documents presented during audit referred to the respondent as end use licensee with details of license fees to be paid. The license is covered in the definition of royalty. For software which is deemed as literary works this would only be used or passed through sale of a license.
56.The respondent’s expert also gave in detail the conduct and outcome of the audit conducted to the appellant and the appellant made payments for acquiring software for its use through a license.
58.The respondent’s Expert informed the court that during audit, several documents were availed by the appellant Callidus Software Purchase Schedule and Purchase Invoices of Licenses and the appellant failed to produce the Software Sales agreement signed between Callidus Software Inc dated 30th September 2009.
59.Therefore, the Agreement between the appellant and non-resident Callidus Software Inc and from the documents presented during the audit, the issue of whether royalty was paid to Callidus Software Inc or not the Monies/Fees were for purchase of software and license to access the information in the software is contested as the respondent takes the view that the payment for license amounted to deriving a right from the copyright. It is upon determination of payment of royalty that the Withholding tax would be payable.
60.The appellant’s stated as outlined by its Expert, that the Appellant acquired physical medium in which copyrighted software is embedded and did not acquire software through license or assignment from the holder of the copyright. The appellant while admitting payment to Callidus Software Inc for software categorically denies it was royalty so as to attract withholding tax but states it would amount to business tax under Section 34 of ITA.
61.The respondent stated that the business tax payment inapplicable under section 34 ITA as the non-resident would have to file Tax Return for investigation and assessment.Section 2 of the Income Tax Actdefines royaltyFurther, section 22(1) of the Copyright Act **defines Literary work to include Computer Programs.Section 35 of ITA provides for deduction of tax from certain income
62.License has been defined under section 1 of the Copyright Act as;
63.The respondent through its expert confirmed that the respondent had filed Tax Returns for Corporation Tax , Value Added Tax (VAT) & Pay As You Earn (PAYE) and paid self -assessed tax for the period under audit. After the audit the respondent section 35(1) ITA was payable. The appellant contested the Withholding tax on the basis that they did not pay royalties.
64.This court was referred to the case of Engineering Analysis Centre of Excellence Private Ltd vs Commissioner of Income Tax Supreme Court of India Civil Appeals No 8733-8734 where it reads in part;In all these cases, the licence that is granted vide EULA, is not a license in terms of section 30 of the Copyright Act , which transfers an interest in all or any rights but a licence that imposes restrictions or conditions for the use of computer software………What is licensed by the foreign, non-resident supplier to the distributor and resold to the end -user or directly supplied to the resident end -user is in fact the sale of a physical object which contains an embedded computer program and is therefore sale of goods.
65.The case applied to the instant appeal , means that the parties ought to have established from the Agreements documents , relationship of the parties’ and totality of the circumstances of the matter, whether the software purchased by the appellant was a copy right or copy righted article in a sale of goods or license.
66.The appellant reiterated its position, that it purchased copy righted article for its own use and resale as was confirmed from the audit while the respondent contended that by virtue of section 2 & 35 (1) ITA the appellant paid royalty and out to have withheld Withholding tax.
67.This court was also referred to the case of National MicroFinance Limited vs Commissioner General Tanzania Revenue Authority N(2019) after the court considered Clauses 2.0 & 2.1 of the Software License Agreement (SLA)that set out the terms of the license, that as long as the software continues to exist and function to the satisfaction of the licensee and subject to the terms and conditions hereinafter appearing, a non-exclusive and non-transferrable right to use the software for internal purpose only.The Court of Appeal of Tanzania held;To us, it is clearly discernable from the foregoing article of SLA that what was transferred to the Appellants is only a license to use software which was to be supplied by Neptune under certain terms and conditions. To that extent a proper construction, we do not entertain a flicker of doubt that SLA constituted a lease within definition of the term under section 3 of the ITA,2004. Likewise, we are just as well fully satisfied that the payment of the license fee was a consideration for the right to use software which was within the definition of a royalty under clause (a) of its definition under section 3 of ITA 2004.
68.The bone of contention is whether the appellant paid royalty to non- resident Callidus Software Inc or or not.
70.From the above outline, this court finds that the Appellant paid for software and license to access the medium in the software. Whether the payment/consideration was royalty would depend on whether, the payment was to copyright holder or that the license purchased on the software was unrestricted and unlimited and it conferred right to use the copyright.
71.Ideally, as in the case cited above by the parties the Software Lease Agreement between the parties on purchase/sale of software and/or Licenses was presented and detailed the terms of the license as continuous as long as the software existed but subject to certain conditions and terms set out in the Schedule. That is why the court upheld the payment of lease was royalty based on the terms of the Agreement.
72.In the instant case, the agreement would shed more light on the legal questions. Whereas it is not denied that there are distinctions of copy right and copyright embedded article and where licenses are purchased it does not automatically amount to assignment of the copyright it depends on the terms of the Agreement between the parties on the outcome of the audit by the Respondent. The audit revealed annual subscription and payment for licenses. The Software Purchase Agreement stipulated the end user or licensee is the Appellant. The Agreement does not set restrictions or limitations of the license. Respondent submitted that the Software Purchase Agreement had a license Schedule within to depict it as a license to use the licensors software as opposed to a Purchase Agreement only.
73.The appellant relied on the following provisions to establish a copy rightSection 33(1) of the Copyright Actfurther provides that;
74.The definition of copyright as has been defined under section 26 of the Copyright Act to include literary works and provides that:
75.The court finds that it is not disputed that that copyright is transmittable by license, that payment of license Fees as consideration of the right to use software falls within the definition of a royalty. However, an agreement would spell out the terms of any right to use or reproduce the copyright work or the license is to access copyrighted article. The annual subscriptions of licences do not confirm payment as royalty[royalty] as defined refers to some device, formula or contraption which the user applies to make something else and in return for that advantage, the user must pay the original creator of the capital asset as described in Republic v Commissioner of Income Tax & anor eKLR supra.
76.In the absence of the Software Sales agreement signed between Callidus Software Inc and the respondent, Software Supply Contract has no restrictions. The terms of the license are not stipulated so as to confirm whether rights were transferred or it was only for the purposes of accessing software or not. Secondly, if the license was restricted for software to be used internally only or for resale without transfer. For these reasons, it has not been proved that funds paid to Callidus Software Inc were royalty so as to attract Withholding Tax.
77.What then is the difference between copyright and copyrighted material? The Tribunal established in its holding that the appellant is primarily into the business of provision of integrated business and technology solution procured from various Enterprise Resource Planning software manufacturers & Developers. The software procured is mainly sold to end users who are their clients, and the appellant is merely a distributor of the software in Kenya.
78.In the Organization for Economic Co-operation and Development (OECD) Model Tax Convention on Income and on Capital. Paragraphs 13.1 and 14.4 of article 12 provide that;
79.The International guidelines are part of the law in respective countries but are international best practices that guide in interpretation of laws and regulate the international business transactions.
80.In this regard, the Tribunal erred in concluding that by buying and selling computer software, which is a copyrighted item, the appellant was commercially exploiting the copyright in that copyrighted item. Contrary to the above definition of a license, and in the absence of the Agreement(s) that set out the terms of the license, in the instant case the appellant was a vendor of a copyrighted item and was therefore copyright was not transmissible.
82.Taking into consideration that the Tribunal held that the appellant was merely a distributor of the software in Kenya, and by the case of Engineering Analysis Centre for Excellence Private Ltd vs Commissioner of Income Tax (supra), where the dispute was whether payments for use and resale of computer software made to foreign suppliers or manufacturers through End User License Agreements (EULA) and distribution agreements could be characterized as royalty payments. The Supreme Court of India held such payments could not be considered payments for the use of underlying copy rights in software and were instead sale of goods. Similarly, in the instant case, the TAT found the Appellant a distributor, and at the same time ‘exploiting the computer software commercially which is the very essence of a copyright.’ As a distributor one purchases and resells as is without tampering or modification right as is exercised by copyright holder so if as stated the Appellant was a distributor then it is not compatible with exploiting the copyright.
83.The issue of whether it was sale of goods or assignment or license of copyright remains hotly contested, the issue of the appellant having purchased copyright or copyrighted article is debatable and the issue of whether the license transferred a right to the appellant or merely facilitated the access to software is also unproven. All these issues center on the proof that the appellant paid royalty to non-resident so as to attract Withholding tax. The experts gave relevant information that guided the court and parties but the principles and processes were/are subject to proof which from the facts of the matter remain contested.
84.The upshot of the above excerpts and the case is that the appellant in this case paid the license fee did not acquire any partial rights in copyright and thus not subject to royalty as argued by the respondent.
85.In addition to the above, the OECD Model Tax Convention on Income and on Capital provides that in such transactions, distributors are paying only for the acquisition of the software copies and not to exploit any right in the software copyrights. Therefore, payments in these types of transactions should be dealt with as business profits and not as royalties.
86.The Tribunal erred in failing to consider that the appellant is a vendor of copyrighted material and not the user of a copyright and in this regard does not receive any right to exploit the copyright.