Taxation of AI Services – Royalty, FTS, or Business Income?
The taxation of AI services is a complex area, and the income can be characterized as Royalty, Fees for Technical Services (FTS), or Business Income depending on the specific nature of the service, the contract terms, and whether a relevant Double Taxation Avoidance Agreement (DTAA) is applicable.
Key Factors for Characterization:
Nature of Rights Transferred: The primary distinction lies in whether the transaction involves the transfer of the copyright itself or merely a right to use a copyrighted article.
If the payment is for the right to commercially exploit the intellectual property (IP), it is generally considered a royalty
If the payment is merely for the use of the AI product/software (e.g., access to a database through a web browser for internal use) without gaining any rights in the underlying copyright, it is generally treated as business income.
Human Intervention: For a service to be classified as FTS, Indian courts have often held that human intervention is a pre-requisite.
If the AI service is fully automated (e.g., an online, self-service AI tool where the customer has no interaction with the service provider’s personnel), it would likely not be classified as FTS.
If the service involves significant human input, technical expertise, and consultancy by the non-resident’s personnel (e.g., custom AI development or specialized consultancy), it may fall under FTS.
Permanent Establishment (PE): If the income is classified as business income, it is generally not taxable in India for a non-resident unless they have a PE in India. The current tax laws struggle to apply the traditional “physical PE” doctrine to digital services, leading to potential gaps in domestic taxation.
DTAA Provisions: Taxpayers can choose between the provisions of the Indian Income Tax Act, 1961, and the applicable DTAA, whichever is more beneficial. DTAAs often provide for lower withholding tax rates on FTS and royalties (e.g., 10% or 15% in many treaties vs. 20% under domestic law as of April 1, 2023).
1. Introduction:
AI is delivered today through SaaS models, APIs, subscription platforms, and enterprise licensing.
Key question: Payments made to non-resident AI providers are they royalty, fees for technical services (FTS), or business income (taxable only if there is a PE)?
2. Legal position in Income Tax Act:
Section 9 deals with various types of income deemed to accrue or arise in India. It includes income arising from business connections, royalties, fees for technical services, capital gains on assets situated in India, and similar scenarios.
Explanation 2 of Section 9(1): This explanation within Section 9(1) provides the definition of business connection for taxation purposes, delineating the scope of activities or relationships constituting a business connection in India.
Royalty [Sec 9(1)(vi)] – payments for transfer of rights in patents, inventions, models, processes, copyright, or for the use of industrial, commercial, or scientific equipment.
FTS [Sec 9(1)(vii)] – consideration for managerial, technical, or consultancy services (excludes those not “making available” technical knowledge in treaties with “make available” clause).
Business income [Sec 9(1)(i)] – taxable only if the non-resident has a Permanent Establishment (PE) in India.
3. AI Service Models – Possible Classification
AI SaaS (Software-as-a-Service):
E.g., subscription to ChatGPT or enterprise AI software.
Tax issue: Is this payment for “use of copyright” (royalty)?
AI APIs (Application Programming Interfaces):
Pay-per-use model for natural language processing, image recognition, etc.
Argument for royalty: APIs are “processes” akin to software.
Argument for business income: No transfer of copyright, only access to functionality.
Custom AI Solutions / Consulting:
AI training, fine-tuning models for clients.
Could fall under FTS (managerial, technical, consultancy).
Treaty relief if “make available” clause applies.
AI + Cloud Infrastructure:
Bundled services with storage, compute, and
AI.
4. Judicial Precedents Relevant to AI
Software Royalty Debate settled by SC in Engineering Analysis (432 ITR 471)- payments for software use without transfer of copyright not royalty.
Web Hosting Charges- payment made towards web hosting charges Ahmedabad ITAT held in the case of ESM Sys Pvt. Ltd. that these services are outside the scope of said Explanation 2(iva) to section 9(1)(vi) cannot make the assessee liable to deduct tax at source.
Online advertising- Delhi ITAT in the case of Lenskart Solution Pvt. Ltd. that there was no tax liability on payments made for advertising services, in the absence of a permanent establishment of the service provider in India.
5. Practical Impact:
Indian payers face uncertainty on whether to deduct TDS at 10% (royalty/FTS) or treat payments as business income.
AI SaaS/API services without copyright transfer would likely escape royalty/FTS.
Team- Intellex Strategic Consulting Private Limited
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