Supreme Court Declares Software Payments as Business Income, Not Royalties

The Supreme Court of Pakistan’s review bench has determined that payments for the use of computer software are to be treated as “business income” rather than “royalty.”

The bench, comprising Justice Syed Mansoor Ali Shah, Justice Athar Minallah, and Justice Aqeel Ahmed Abbasi, delivered its judgment in Civil Review Petitions No. 988 to 1001 of 2023 (M/s Inter Quest Informatics Services vs. Commissioner of Income Tax, etc.).

Case Background

The petitioner, a Netherlands-based company that is not a resident of Pakistan for income tax purposes, had agreements with Schlumberger Seaco, Inc., which operates in Pakistan. The company claimed exemption under Article 7 of the Convention Between Netherlands and Pakistan for the Avoidance of Double Taxation and classified receipts under these agreements as “business profits.”

However, the tax authorities classified the proceeds as “royals” under Article 12 of the Convention and levied a 15% income tax. The taxpayer is granted a favorable judgment by the Supreme Court, which invalidates the tax department’s classification.

Legal Journey

• Initial Tax Assessments: The Income Tax Officer and the Commissioner of Income Tax (Appeals) determined that the payments were royalties and levied a 15% tax.
• Tribunal’s Decision: The Tax Tribunal upheld this classification, affirming the tax liability.
• High Court Ruling: The petitioner contested these evaluations, leading to a ruling in their favor by the High Court. A recent ruling by the court determined that payments made for leasing software do not meet the criteria for royalties as outlined in the DTA, thus rendering them exempt from income tax in Pakistan.
• Supreme Court Majority Judgment: The tax department appealed to the Supreme Court, which initially overturned the High Court’s decision in a majority ruling, restoring the tax assessments.
• Review Decision: In its latest review, the Supreme Court reversed its previous decision, ruling that the payments were business income and not royalties, exempting the petitioner from Pakistani income tax under Article 7 of the DTA.

Implications of the Decision

This ruling is a major milestone for both local and international companies conducting software-related business in Pakistan.

• Tax Clarity for Software Transactions: Payments for the use or lease of software are now definitively categorized as business income rather than royalties. This adjustment guarantees that these payments will not incur withholding tax in Pakistan unless the entity receiving them has a permanent establishment (PE) within the nation.
• Boost to Foreign Investment: By harmonizing the tax treatment of software payments in Pakistan with global standards, this decision is anticipated to foster partnerships between foreign companies and local firms, especially within the technology industry.
• Encouragement for Innovation: The ruling alleviates tax pressures on software dealings, promoting development and creativity in Pakistan’s IT and software sectors.
• Reinforcement of International Agreements: The court’s decision highlights Pakistan’s dedication to the equitable and uniform enforcement of international tax agreements, enhancing its standing in the realm of international business dealings.

This case highlights the complexities of tax laws in a digital economy and sets a significant precedent for interpreting international agreements in Pakistan’s tax landscape.