Extension of S. T. to I. T. Sector -A Wonderland of Taxation

[This article appeared in “Service Tax Today” Vol. 14 Part-6 dt. 6-6-2008]

Extension of Service Tax to Information Technology Sector – A Wonderland of Taxation-III

(Part 3 of a series of 3 Articles)

by CA. Pradip R Shah

e-mail: pradip_shah@vsnl.com

Going to the Roots:

1.0      Software defies a simple tangible / intangible characterization as it inherently embraces both tangible and intangible elements. It ranks as perhaps the leading technology which defies easy classification. One problem is that the industry itself does not clearly define the term software. The programme is the intangible element which includes the intellectual contents of the program like function, internal design, algorithms as well as property rights viz. patent, copyright, trade secrets etc. The ambiguity crops up when the program is expressed in some tangible medium such as a CD or a floppy. This tangibility aspect leads sales tax authorities to levy tax on it.

Perhaps it is because of the multiplicity of forms which can embody software that much of the difficulty arises in the tax area. Software can assume at various times aspects of a service transaction, tangible personal property or intangible property. Because tax statutes often tax each of these differently, this results in confusion under the tax regimes.

Indian Scenario:

2.0      With the judgement of the Supreme Court (SC) in the case of Tata Consultancy Services Vs. State of Andhra Pradesh (SC) 2004 271 ITR 405 confusion regarding taxability of software under sales tax has come to an end. In order to appreciate the complexity of the problem in totality i.e. VAT, Service Tax (ST) and Excise Duty, it will be worthwhile to have a look at the reasons cited and various other aspects touched upon by the SC. Briefly stated they as follow:

Factual Matrix

2.1      TCS provide consultancy services including computer consultancy services. As part of their business they prepare and load on customers’ computers custom made software known as “uncanned software” and also sell computer software packages off the shelf known as “canned software”. The canned software packages are of the ownership of companies / persons, who have developed those software. TCS is licensees with permission to sub-licence these packages to others. The canned software programmes are programmes like Oracle, Lotus, Master Key, N-Export, Unigraphics, etc.

The question raised in the appeal was whether the canned software sold by TCS can be termed to be “goods” and as such assessable to sales tax under the AP Sales Tax Act.

           Submission of TCS:

2.2      On behalf of TCS it was submitted:

1) The term “goods” in section 2(h) of AP Sales Tax Act only includes tangible moveable property and the words “all materials, articles and commodities” also cover only tangible moveable property and that computer software is not tangible moveable property.

2) Computer software is nothing but a set of commands, on the basis of which the computer may be directed to perform the desired function. Software is completely unlike a book or a painting. In the case of software, the consumer does not get any final product but all that he gets is a set of commands which enable his computer to function. Having regard to its nature and inherent characteristic, software is intangible property which cannot fall within the definition of the term “goods” in section 2(h) of the said Act.

3) Majority of the American courts have held that software is an intangible property. The reasoning for arriving at this conclusion is basically that the information contained in the software programs can be introduced into the user’s computer by several different methods, namely,  (a) it could be programmed manually by the originator of the program at the  location of the user’s computer, working from his own instructions ; or (b) it  could be programmed by a remote programming terminal located miles away  from the user’s computer, with the input information being transmitted by  telephone ; or (c) more commonly the computer could be programmed by use of punch cards, magnetic tapes or discs, containing the program developed by  the vendor.

Contentions of Revenue

2.3      On behalf of the Revenue, it was pointed out that:

The difference of opinion among the various American courts has arisen because under the American statutes what is taxable is “tangible personal property”. It is this definition,  which required the American courts to consider whether software is tangible or intangible. The definition of the term “goods” in the AP Sales Tax Act is a very wide definition. The term “goods” have been defined to mean all kinds of moveable property except those specified, namely, actionable claims, stocks, shares and securities.

Views of Supreme Court

2.4      Views expressed by the Supreme Court:

1) For the purposes of sales tax the term “goods”, cannot be given a narrow meaning. Properties which are capable of being abstracted, consumed and used and/or transmitted, transferred, delivered, stored or possessed etc., are “goods” for the purposes of sales tax. In India the test, to determine whether a property is “goods”, for the purposes of sales tax, is not whether the property is tangible or intangible or incorporeal.  The test is whether the concerned item is capable of abstraction, consumption and use and whether it can be transmitted, transferred, delivered, stored, possessed, etc. Admittedly in the case of software, both, canned and uncanned, all of these are possible.

2) In the case of Associated Cement Companies Ltd. v. Commissioner of Customs  reported in [2001] 124 STC 59, the question was whether  customs duty was leviable on technical material supplied in the form of drawings, manuals and computer disc, etc. It is true that what the appellants had wanted was technical advice on information technology. Payment was to be made for this intangible asset. But the moment the information or advice is put on a media, whether paper or diskettes or any other thing, then what is supplied becomes a chattel. The foreign collaborators part with them in lieu of money. It is, therefore, sold by them as chattel for use by the Indian importer. The drawings, designs, manuals, etc., so received are goods on which customs duty could be levied.  Therefore, the intellectual input in such items greatly enhances the value of the papers and ink in the aforesaid examples. This means that the charge of duty is on the final product, whether it be the encyclopedia or the engineering or architectural drawings or any manual.

3) The term “goods” as used in article 366(12) of the Constitution of India and as defined under the AP Sales Tax Act are very wide and include all types of movable properties, whether those properties be tangible or intangible. The copyright in that programme may remain with the originator of the programme. But the moment copies are made and marketed, it becomes goods, which are susceptible to sales tax. Even intellectual  property, once it is put on to a media, whether it be in the form of books or  canvas (in case of painting) or computer discs or cassettes, and marketed  would become “goods”. We see no difference between a sale of a software programme on a CD/floppy disc from a sale of music on a cassette/CD or a sale of a film on a video cassette/CD.

Branded and Unbranded Software

2.5      It was pointed out that so far as ‘unbranded software’ is concerned, it is undoubtedly intellectual property and is outside the ambit of ‘goods’.” It was submitted on behalf of TCS that the High Court correctly held that unbranded software was “undoubtedly intellectual property”, the High Court fell in error in making a distinction between branded and unbranded software, and erred in holding that branded software was “goods”.  However, SC opined that there is no distinction between branded and unbranded software. In both cases, the software is capable of being abstracted, consumed and use. In both cases the software can be transmitted, transferred, delivered, stored, possessed, etc.  Thus, even unbranded software, when it is marketed / sold, may be goods. Since the SC was not dealing with this aspect and , therefore, did not express opinion thereon because in case of unbranded software other questions like situs of contract of sale and/or whether the contract is a service contract may arise.

(Emphasis supplied)

In a Nutshell:

3.0      It is true that software is intangible and knowledge, the moment it gets recorded on a media it gets the characteristics of the goods. Accordingly, for tax purposes it should be treated as goods only. Secondly, whether it is branded or unbranded does not make any difference, it remains as goods. Thirdly, there may be service contract under which software is supplied on a media. However, no views were expressed. Since taxation of goods under the Constitution  of India is State subject, sales tax / VAT can be levied.

An offshoot of this is that, in terms of Article 366(29A)(d) of the Constitution making available right to use the goods being treated as Deemed Sale of goods, sale of software can be subject of Sales Tax / VAT.

Excise and Software:

4.0      In terms of Tariff Entry No. 8523 80, canned software is subject to Excise Duty (ED). It should be remembered that customized software is outside the purview of ED.

Canned Software

5.0      Software can also be classified as “canned software” and “customized software”. ‘Canned software’ means software which is not specifically created for a particular user. It is a prewritten program requiring no modification for consumer use.

Customised Software

6.0      Customized software is a programme developed for specific customer needs. Two principles are followed for classifying software as intangible: viz. (1) software is knowledge, and (2) software encompasses an array of services.

6.1      According to the Knowledge Principle, the sale of software is the sale of knowledge, an acknowledged intangible. The tangible means of transmitting this knowledge is merely incidental to the transaction. Therefore, the more separable the content is from the container, the more the transaction looks like a sale of intangible knowledge.

According to Personal Services Principle the consumer of custom software actually buys the programmer’s service, knowledge, and labor in solving a particular problem. The software is merely incidental to the rendering of the service. The personal services principle is a narrower justification for intangibility than the knowledge principle.

6.2      Distinguishing features of the difference between canned software and custom software can be classified as follow:

(a) whether the transfer of property was incidental to effect the transaction’s primary purpose;

(b) whether the value of the service far outweighed the value of the property on which the program is transferred; and

(c) whether the product transferred was valuable primarily to the user rather than the general public.

These are important aspects to be kept in mind while structuring the transaction and avoid VAT.

Tax implications of Canned Software

7.0      The sale or lease of, or granting a licence to use, canned software is not automatic data processing and computer services, but is the sale of tangible personal property. A programmer provides no specific personal services to a canned software purchaser because canned software is sold ‘off the shelf.’ Therefore, the property transfer cannot be incidental to a rendering of a specific service.  For service contract, the product’s primary value should be to the user rather than to the general public. Canned software is not written for the specificity of a single user, but for the general use of the public. Therefore, it will be treated as goods and attract sales tax / VAT. As explained, it will not attract ST as no service is being rendered. It is for these reasons ED is being levied on canned software. In order to plug the loophole of treating customized software as canned software paying ED @8.00% instead of ST @12.00%, rate of ED on canned software has been raised from 8.00% to 12.00%.

Grey Area:

8.0      When a vendor, in a single transaction, sells canned software that has been modified or customized for a particular consumer, will raise various issues. Will it be subject to ED or ST? Will it attract VAT or not? This will remain a grey area.

Alice in Wonderland of Software Taxation

9.0      Even Alice would have certainly been baffled by all these. Having tried to understand the characteristic of software as goods, service aspect of the software, basic definition of ITS, various types of activities termed as services, applicability of ED, VAT and ST, let us try to put it in a comprehensive way which can be understood easily and follow it in day-to-day life. An attempt has been made here to tabulate the same. Nature of the activity treated as services as defined u/s 65(105)(zzzze) has been treated as driving one to evaluate for applicability of ED, ST and VAT.

Overlapping Activities

10.0    Real problem arises in respect of item no. 20 to 24. At a glance it will look like trading activities and difficult to comprehend it as services. What is more disturbing is the language used in S. 65(105) (zzzze)(v). Read the following clause carefully:

                     S. 65 (105)

                     “taxable service” means any service provided or to be provided  to any person, by any other person in relation to information technology software for use in the course, or furtherance, of business or commerce, including,        acquiring the right to use information technology software for commercial exploitation including right to reproduce, distribute and sell information technology software and right to use software components for the creation of and inclusion in other information technology software products,

(Emphasis supplied)

10.1    In order for any activity to be taxable, the service provider has to provide / render the service. However, the inclusive part of the clause (v) refers to acquisition by the recipient of the services. One can acquire something from other when that other person is providing it. However, if that aspect of the activity i.e. providing the right to use is included then it will attract the Article 366(29A)(d) regarding deemed sale which is meant exclusively for the State Government. It is for the Courts to decide whether it is legally permissible for the Central Government to encroach in the area of State Government.

10.2    Secondly, the definition goes further and embraces the activities like distribution and sell of ITS. Is it permitted to bring to taxation the activities by clothing or naming it artificially and putting it into unnatural form? Apart from that, leaving aside legal semantics, how can one be considered to be rendering the service when the other person is acquiring the right to use the goods? How can two aspects of the same transaction have different characteristics? Can it be said that from the perspective of a seller it is sale of goods attracting VAT and from the perspective of a buyer it is receiving the services attracting ST?

Apparent Contradiction:

11.0    One may get an impression that the draftsman may be oblivious of the fact of the definition of deemed sales as provided in Article 366(29A)(d) of the Constitution. However, look at the insertion of the services relating to “Supply of Tangible Goods without transferring Right”. Read the relevant clauses of Letter No. D.O. F. No.334/1/2008-TRU Dt. 29^th  February, 2008 explaining the provisions in this respect:

4.4 SUPPLY OF TANGIBLE GOODS FOR USE:

4.4.1 Transfer of the right to use any goods is leviable to sales tax / VAT as deemed sale of goods [Article 366(29A)(d) of the Constitution of India]. Transfer of right to use involves transfer of both possession and control of the goods to the user of the goods.

….

4.4.3 Proposal is to levy service tax on such services provided in relation to supply of tangible goods, including machinery, equipment and appliances, for use, with no legal right of possession or effective control. Supply of tangible goods for use and leviable to VAT / sales tax as deemed sale of goods, is not covered under the scope of the proposed service..

So, CBEC and the draftsman are fully conscious of the right of the State Government in this respect. The only guess one can make is that the Central Government must be having some innovative argument in this respect and making it confident of the extension of ST to acquisition of right for ITS.

Defining the Danger Zone

12.0    As discussed above, with the insertion of certain activities related to ITS as services under ST, a danger zone has appeared on the horizon. This is for the reason that certain clauses of the provisions of S. 65(105) (zzzze) will encroach in the area of VAT making the activity liable to both the taxes i.e. VAT and ST(or ED as well). It will be too burdensome to bear the burden of both of them. In many cases, it may appear economical to pay ST as it will help in availing CENVAT Credit, which at present cannot be utilized. To that extent the burden may not appear to be so high. However, the case of a dealer / distributor dealing in software products, paying VAT as at present, will be the worst as transfer of right, even limited one, will attract ST @12.36%. In these cases, CENVAT Credit element may not be there, making the life more difficult. The most interesting case will be that of a person who, apart from developing the software, also trades in. In such cases, the activity attracts both the taxes although in limited sense to certain aspects of the transactions only. Insertions of ITS will give an opportunity to ST Department to have a look at the transactions which fall exclusively within the realm of VAT. In the same manner, VAT Department will get an opportunity to have a look at the transactions which are predominantly of service nature. Both of them will try to poach in others’ area at the cost of the taxpayers. Let us examine various scenarios emerging.

Service being subjected to VAT

13.0    Reading of SC judgement in the case of TCS, one may get a feeling that even delivery of customized software on a CD will be treated as goods and subject to VAT. However, at certain point it had come to deal with this aspect but left it without discussing it. It did not express opinion about unbranded software and stated that it may also be goods. At the same time, it also hinted at the service aspect of the contract between the parties. Although not stated specifically, what emerges is that if the delivery of software on a CD is a part of the performance of the service as agreed upon, the question of VAT being applied should not arise. Therefore, software developers will have to be more cautious while fixing the terms and conditions and executing the agreement. However, in view of the proposed amendment in the Finance Act, ST will be applicable.

Sale of software products being subjected to ST

14.0    The worst condition will be that of the distributors / retailers as they will fall prey to both the taxes. As far as VAT is concerned, after the SC judgement in TCS, they do not have any choice. Almost all the State Governments have made sale of software as taxable under VAT. Since the rate of tax is moderate, at almost 4.00%, it did not raise any major issue. However, if the same distributor / dealer has to pay ST @12.36% over and above 4.00% VAT, certainly it will be last straw.

14.1    Another issue that will crop-up is regarding charging ST in the case of software being used for business / commercial purposes. How to ensure end-use will be a major headache. This is particularly for a retailer who is in the last point in the chain and sales software products to actual users. His composition of customers will be comprising of both i.e. for business / commercial and personal use as well. All these are bound to lead to unhealthy practices.

A case of Triple Taxation?

15.0    The proposal may, in some cases lead to triple taxation i.e. ED, ST and VAT. Consider the case of a developer of software who develops, canned it, store and sell. As far as ED and VAT are concerned there is no doubt about its applicability. However, consider the case of a dealer who buys it from the developer for retail trade. Software purchased already contains ED and VAT charged by the developer. Such developers are permitted to distribute / sell only. They do not own the software. They acquire limited right to distribute / sell only. Will this act of acquisition not covered under clause (v) i.e. acquiring the right to use information technology software for commercial exploitation including right to reproduce, distribute and sell information technology software? If so, what will be the overall tax burden?

15.1    What will be the additional burden? Let us have a look at pre Budget scenario.

15.2    Post Budget Scenario:

If the said software has been purchased for personal use, ST will not be applicable. However, if it is sold to someone using it for business / commercial purposes, question of applicability of ST will arise. Should it be added @ 12.00% on Rs. 134.08 or Rs. 128.92? If it is computed on Rs. 134.08 ST will be Rs. 16.09 otherwise Rs. 15.47. 

15.3    Additional impact is for the following reasons:

a)    Raising of ED from 8.00% to 12.00%

b)    VAT on additional ED

c)    ST on ED and VAT

d)    Additional VAT on incremental taxes as above

15.4    Above working is on the presumption that the distributor / dealer is entitled for CENVAT Credit for ED paid. However, it involves the hassles of paying the ST on acquisition of ITS products, claiming the same as input credit on sale of it. It also involves blocking of working capital and lots of paper work.

15.5    One may also be wondering levying of ED and charging of ST on the same transaction. However, it should be appreciated that ED has been paid on the canning of software while ST gets attracted on acquisition of the right to use ITS as provided for in the budget proposal. Is it permitted under the Constitution or not is matter of debate.

In any case, the dealer / distributor who were not within the net of ST, will fall into it, with all the associated hassles.

A ray of Hope:

16.0    In the case of software developers who were exporting the same, and not within the ST net so far, will find it quite advantageous. This is for the reason that development of software not being taxable it was not possible to seek refund of CENVAT Credit paid on various inputs and input services. However, with the scope of ST being extended, export of software will fall into exempted category making it possible to claim refund of the same. Of course, the benefit of the refund will not be available to the full extent, as we all know the cost of claiming refund of ST and human resources to be devoted for the same.

Any Alternative?

17.0    Is the subject of software so complex which can lead to this kind of jungle of taxation? Is it not possible to have functional approach? Can we not adopt a system in which software is differentiated according to function? Perhaps, it can remove the disparity problem by shifting the focus away from the inherently dichotomous goods / services characterization of software. Is it possible to differentiate it as operational and applications software? The taxing structure might be defined such that operational software would be subject to ED and VAT and applications software is subject to ST as the intangible program is the basis of the bargain.  This alternative contains the prime attributes of efficiency, certainty, equity, and positive economic effect. In the initial years, it may perhaps, involve loss to the Central Government in some form. But, in the same manner, State Government may loose in some other form as well. However, taxes levied with certainty and equity can lead to 1+1=3 rather than this kind of confusion which makes it to 1+1=0.5.

Conclusion:

18.0    Various conclusions can be drawn from all these. We claim that India has tremendous technical manpower making technological wonder. But always remember, in India, it can never surpass the administrative power the bureaucrats have in wilting it. No one has any complain against paying the taxes. What hurts the most is lousy drafting of the laws forcing the human resources of high caliber to divert their energy and skill to unproductive things.

Concluded