From The Judiciary

Is income from the sale of software licenses, software embedded in hardware, and related hardware support services taxable as royalty or fees for technical services in India?

Arista Networks Limited [TS-845-ITAT-2025(Bang)]

Facts

The assessee is a company engaged in providing cloud networking solutions and related products/services. Its return of income was scrutinized for receipts from India, including software sales, hardware, support services, and training.

The dispute concerned the taxability of three income streams:

• Sale of standardized software license
• Software embedded in hardware, and
• Hardware replacement and support services involving embedded software.

The assessee claimed these income streams were not taxable in India due to the absence of a Permanent Establishment (PE).

However, the AO held that the income from these sources was taxable as royalty in India. The AO stated that distributors had potential access to confidential proprietary information, including source code, which distinguishes it from mere shrink-wrapped software.

The AO also treated maintenance services as Fees for Technical Services (FTS) due to human intervention and applied a 10% tax. Despite the assessee’s reliance on the Supreme Court rulings.

The assessee filed an appeal before the ITAT Bangalore challenging the order passed by the AO and DRP.

Held

The ITAT stated that the grounds raised by the assessee in the appeals concerning these income streams are allowed based on the following facts.

• In view of the Honorable Supreme Court’s decisions, including the Engineering Analysis Centre of Excellence Pvt. Ltd. ruling, it is held that computer software is a literary work under the Copyright Act, with copyright conferring exclusive rights such as reproduction and distribution.
• The Supreme Court has clarified that software embedded in hardware constitutes a sale, not royalty, and without a PE in India, such income is not taxable.
• Upon reviewing the agreements of the assessee, it is observed that the confidentiality clause protects the assessee’s copyright by limiting disclosure without granting rights to distributors. As an Original Equipment Manufacturer, the assessee sells hardware with embedded software and licenses standard software under strict, non-exclusive, non-transferable terms that prohibit copying or modification, granting only resale rights consistent with Supreme Court rulings.
• The distributor receives a limited license to resell software in object code form only, with no access to source code or reverse engineering; there is no evidence of source code provision, making the AO’s claim baseless.
• Hardware replacement and support services involving embedded software are treated as the sale of hardware, not fees for technical services.

Our Comments

The case clarifies that income from the sale of software licenses, software embedded in hardware, and related hardware support services without a PE in India is not taxable as royalty or fees for technical services under the Double Taxation Avoidance Agreement (DTAA).

Whether ITAT can allow a deduction claim for ESOP expenses under Section 37(1) that was not originally filed or revised before the AO?

HDFC Bank Limited [TS-961-ITAT-2025(Mum)]

Facts

The assessee, Housing Development Finance Corporation Ltd. (HDFC), a housing finance company regulated by the National Housing Bank, filed its return of income under Section 139(1) of the Income-tax Act. The return was processed under Section 143(1) by the CPC, wherein certain additions and disallowances were made.

Aggrieved, the assessee filed an appeal before the CIT(A) challenging the disallowances. Additionally, it raised a fresh ground seeking a deduction of INR 2,167.8 million 37(1) for expenses incurred under the Employee Stock Option Scheme (ESOP). This amount represented the difference between the perquisite value and the fair value of the ESOPs computed under the Black-Scholes Model. However, the claim was not made in the original return, nor was a revised return filed.

The CIT(A) rejected the claim, relying on the Supreme Court decision in Goetze (India) Ltd. v. CIT, stating that a new claim cannot be entertained unless made through a revised return. Since the claim was made for the first time before the CIT(A) and not before the AO, it was held to be inadmissible.

Before the ITAT, the assessee argued that similar ESOP-related claims had been admitted and allowed in earlier years by the Tribunal in its own case. The assessee also relied on the Bombay High Court’s ruling in Prithvi Brokers & Share Pvt. Ltd., which clarified that appellate authorities could consider new claims if the relevant facts are already on record.

The Departmental Representative (DR) supported the lower authority’s decision, stating that the claim was rightly rejected as it was not part of the original return or assessment proceedings.

Held

The ITAT allowed the appeal by the assessee, HDFC Ltd., regarding the claim for deduction of ESOP expenses under Section 37(1) of the Income-tax Act. Although the claim was not made in the original or revised return, and was first raised before the CIT(A).

Relying on the jurisdictional High Court’s decision in Prithvi Brokers and Shareholders Pvt. Ltd., the ITAT held that appellate authorities, including itself, can entertain legal claims not previously raised before the AO if the facts are on record and the issue is purely legal. The Tribunal also noted earlier favorable orders in the assessee’s case for AYs 2013-14 to 2020-21 and relevant judicial precedents supporting the ESOP deduction as revenue expenditure.

However, since the claim was not verified in the present proceedings, the ITAT remanded the matter to the AO for fresh adjudication, directing the assessee to submit necessary details and the AO to examine the claim in accordance with law after giving the assessee a reasonable opportunity to be heard.

Accordingly, the appeal (ITA No. 1828/Mum/2025) was allowed and the matter remanded for reconsideration.

Our Comments

This case underscores the importance of permitting taxpayers to raise valid legal claims at the appellate stage if facts are on record. It reinforces that procedural barriers should not override substantive justice, especially for ESOP expense deductions under Section 37(1). The ruling affirms ITAT’s power to admit additional grounds and ensure fair tax adjudication.

ITAT Ruling on Use of APA Margin for Prior Years

Phillips Foods India Pvt. Ltd. [ITA No.: 739/CHNY/2024]

The taxpayer is a captive contract manufacturer engaged in processing and exporting crab meat to its Associated Enterprise (AE). The Transfer Pricing Officer (TPO) rejected the taxpayer’s TP documentation and benchmarking analysis and instead adopted the foreign AE as the tested party and proposed an upward TP adjustment of INR 139.8 million, which was incorporated by the AO in the final order.

Aggrieved, the taxpayer appealed before the CIT(A), contending that it should be considered the tested party. In support, it submitted a Unilateral Advance Pricing Agreement (APA) entered with the CBDT on 25 August 2022 for AYs 2021-22 to 2025-26, under which a 4.5% operating profit on cost was agreed as the arm’s length margin. The taxpayer argued that its functional profile and the nature of international transactions remained unchanged across the APA years and AY 2015-16, and thus, the APA margin should be applied.

The CIT(A) accepted the taxpayer’s contention, held the Indian entity as the tested party, and directed the AO to adopt the 4.5% APA margin for AY 2015-16. The Revenue appealed to the ITAT, arguing that the APA, dated 25 August 2023, was not in existence during the TP assessment and was admitted without following Rule 46A(3). It further contended that APA margins could not apply to non-APA years.

The ITAT upheld the CIT(A)’s decision, noting no functional differences between AY 2015-16 and the APA years. It affirmed that APA margins can be a valid benchmark for prior years when commercial conditions remain consistent. It further highlighted that the various judicial pronouncements relied on by the taxpayer held that the adoption of margin mutually agreed margin under the APA can be adopted as an arm’s length profit margin for the relevant assessment year. The Revenue’s appeal was thus dismissed.

Our Comments

As per the Income-tax Act, an APA is applicable for five consecutive assessment years and can also be rolled back for four preceding assessment years. The ITAT’s ruling reinforces the relevance of APAs as a valid reference point for benchmarking even in earlier years, provided there is consistency in the functional profile and nature of international transactions. The decision is favourable to taxpayers and aligns with established judicial precedents, effectively managing transfer pricing risks by prioritizing commercial substance over mere timeline differences.

ITAT accepts the assessee's Berry Ratio as PLI for the distribution segment, and deletes the adjustment under the manufacturing segment

Samsung SDI India Pvt. Ltd [ITA Nos.3472 & 5475/Del/2024

The taxpayer was engaged in procuring battery packs exclusively from a third party, Elentec India Pvt. Ltd. and supplying them solely to its Indian counterpart - Samsung India Electronics Pvt. Ltd., without maintaining inventory or warehousing. The taxpayer’s role was limited to logistics and administrative support, and accordingly aggregated all its international transactions and deemed international transactions with AE and used the Berry ratio for benchmarking.

The TPO rejected the taxpayer's approach and applied the Transactional Net Margin Method (TNMM) using Operating Profit/Operating Cost as the PLI for both the distribution and manufacturing segments, treating the taxpayer as a medium-risk distributor due to its role in quality control and technical assistance.

Aggrieved by the TPO order, the taxpayer appealed to DRP, contending that the Berry Ratio (Gross Profit/Value Added Expenses) was the most suitable PLI for its low-risk, limited-function distribution segment, emphasizing its minimal role in pricing, quality control, and inventory. It relied on judicial precedents such as Sumitomo Corporation India & Mitsubishi Corporation India and OECD/UN guidelines. This ground was rejected by the DRP; however, for the taxpayer’s one-month manufacturing operations, DRP accepted “Other method” as selected by the taxpayer. The AO ignored the DRP’s direction to apply the “Other Method” for the manufacturing segment and continued with TNMM.

In the appeal to the ITAT, the ITAT ruled the matter in favor of the taxpayers. It held that the taxpayer operated in a special environment with predetermined suppliers and customers and did not undertake any value addition nor assume significant risks. The Tribunal accepted the Berry Ratio as the appropriate PLI for the distribution segment, noting that the taxpayer’s functions and risks were adequately captured by its operating expenses. It relied on the Delhi High Court’s ruling in Sumitomo Corporation India and other judicial precedents to support its conclusion.

Our Comments

The ITAT’s acceptance of Berry Ratio aligns with international guidelines and Indian judicial precedents, emphasizing the importance of accurate FAR analysis and segmental benchmarking. The case also highlights procedural lapses by the AO/TPO in disregarding DRP directions, which were corrected by the Tribunal. Taxpayers operating under similar low-risk distribution models may find this ruling useful in defending their transfer pricing positions.