Business process outsourcing companies may face another tax blow with the Centre considering a proposal to tax royalty income earned by companies that use standardised imported software for their clients.

The issue is under consideration by the Central Board of Direct Taxes. A decision will affect, among others, BPOs that use non-proprietary software imported from their overseas parent companies.

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However, software tailored to suit the needs of individual clients will not be taxed.

Board officials are likely to hold discussions with the infotech industry later this month before finalising the proposal.

Tax treatment of proprietary software has emerged as a major issue in transactions between BPO companies and their principals abroad.

The tax department feels that a tax on income derived from the use of such software will not hurt the industry as it will earn tax credit abroad for the same.

An expert committee appointed by the board on the emerging areas of taxation, in its report, has divided software into two categories. It has said taxability would be determined by these categories.

Accordingly, payments for software that are specialised and custom-made for individual clients will be out of the tax net.

But software that is standardised and marketed for the use of certain classes of clients like banks may be considered as royalty under Section 9 (1) (VI) of the Income Tax Act, 1961.

Last month, the board had clarified that multi-national companies setting up BPOs in India would not be subject to tax on their operations here, provided the latter provided only non-core services and maintained an arm's length fair pricing relationship with the former.

The question of treatment of software for tax is based on the fact that proprietary software imported by BPO companies from their parent companies abroad are considered as final services and are, therefore, liable to be subjected to a withholding tax.

Under the Indian Copyright law, a computer programme falls under the purview of literary work. Therefore, any payment made for use of such copyright material will fall under the definition of royalty and be taxable.

However, the department may have to contend with an anomaly in the treatment of such software as the Customs department treats software as a product and exempts it from tax.

Industry experts said the government must ensure that there was no dichotomy in the treatment of the same item by its two revenue collection arms.