Taxability of software under indirect tax law and GST

Information Technology (IT) industry has grown multi folds in last 2 decades in India. It is one of the most revenue generating sector for government, job creating sector for individuals.

The taxability of Software/Solutions/Clouds has always been a litigative area because of difficulty in its classification as goods or service due to its inherent nature of intangibility, transfer of use, license, etc. Because of this, Software distinguishes it from other forms of traditional goods and services. This article intends to give broad understanding of its taxability under the current tax laws vis-à-vis proposed GST.

Under the present tax laws, Software can be liable to taxed under Service Tax, VAT, Excise Duty, Customs Duty, etc depending on the nature of transaction whether it is sale of ‘goods’ or ‘service’ or ‘both’. The reason for its classification is VAT on sales of goods goes to State Government & Service tax on Service goes to Central Government and both governments being totally exclusive in terms of taxability and revenue sharing. There are many cases in which both VAT and Service tax & Excise Duty are applied due to no clarity from government that leads to cascading effect of taxes i.e. a tax on tax (Double Taxation). The present average tax rate is around 25-35%

However once this GST comes into place the need for its bifurcation may not be required since every transaction shall be dealt both by State (Only SGST) and Central Government(Only CGST) that too not cascading. (Please see examples for better understanding). Proposed GST rate shall be around 18%-25%.

What is Software?

Section 2 (ffc) of the Copyright Act, 1957 defines the expression “Computer programme” as a set of instructions expressed in words, codes, schemes or in any other form, including a machine readable medium, capable of causing a computer to perform a particular task or to achieve a particular result. Thus, Software is a set of one or more computer programmes which performs the function of the program, either by directly providing instructions to the computer hardware or by serving as input to another piece of software.

Further, software is a intellectual property(which can be classified as a Service or Goods) as per the Copyright Act, 1957

The sale of Software is usually coupled with and conditional to the acceptance of a software licence agreement which gives the buyer the ‘right to use’ the software subject to the certain terms and conditions stated in the agreement. Thus, it may be noted that on purchasing the software, the buyer becomes the “licensee” and “not the owner of the Software” itself. A buyer can use, abstract, consume, deliver, store, possess, transfer and transmit such property only in consonance with the license agreement. However, he cannot resell or exploit it commercially for his own gain or profit.

Division of Software in 2 categories for the purpose of taxability:

Customized Software: Customized software is specifically created for a particular customer to meet his specific needs in terms of coding, layout, reporting, etc. Customized software has to be developed from the grass root level, wherein a totally new software product is developed. It was held in various judgments that customization of pre- existing software is “Modified Packaged Software” and not customized software.

Packaged Software: These are commonly known as canned software, branded software, shrink- wrap software, ready- made application software, etc. These have features which are commonly used by most of the customers and can’t be modified. These are sold off-the-shelf to customers at retail outlets via physical media or can also be downloaded electronically. The common examples of packaged software ire Tally, Norton Antivirus, Microsoft office, etc.

Understanding the present tax laws in context of Software Taxability:

Service Tax:

“Service tax shall be levied on the Services as defined in section 65B(44) at 14%.

Section 65B(44) of the Finance Act, 1994 defines the term Service to mean any activity carried out by a person for another for consideration and includes a ‘declared service’.

Further, clause (d) of section 66E (declared services),

Information Technology Services includes:

Design - plan, scheme

Programming - process of writing a computer programmes.

Customization - modifying to meet a specific requirement

Adaptation - change to suit, adopt

Upgradation - raising standard, improving quality/version/features

Enhancement - in value, content, quality

Implementation – execution

The term ‘information technology software’ has been defined in section 65B(28) as

“Any representation of;

Instructions, data, sound or image, including source code and object code;

Recorded in a machine readable form;

Capable of being manipulated;

Providing interactivity to a user;

By means of a computer or an automatic data processing machine or any other device or equipment”

Further, as per clause (f) of Section 66E, a transfer of title in goods is a ‘declared service’ except transfers which are deemed to be sale within the meaning of clause 29A of article 366 of the Constitution.

Import and export of services is governed by the Place of provision of Service Rules, 2012.

Excise Duty:

Information technology software (Packaged as well as customized) is excisable goods under the heading 8523 80 20 and tariff rate of duty is 12.5%. However, all software are exempted under Sl. no. 27 of Notification no. 6/2006- CE dated 1.3.2006 except packaged software which is excisable on MRP valuation basis subject to the abatement of 15% of MRP. i.e. excise duty (and corresponding CVD) is payable on value which will be 85% of MRP printed on the software. However, if no requirement of MRP on software, then on ED is levied on cost.

Customs Duty:

IT Software is classified under the tariff heading 8523 80 20 of the First Schedule to Customs Tariff Act. Rate of tariff is 12%. As per the entry, Import of software [packaged or customized] is not subject to custom duty except which is stored on tangible media. However, the excise duty is payable on branded (packaged or canned) software. Hence, CVD (Counter veiling duty levied in place of excise duty) and SAD (levied in place of VAT) will be payable on packaged software if the same would have been excisable and vatable, had it been developed and sold in India.

Sales Tax/VAT:

Sales tax/VAT is applicable on the following:

Transfer, otherwise than in pursuance of a contract, of packaged software in any goods for cash, deferred payment or other valuable consideration.
Transfer of the right to use any goods for any purpose (whether or not for a specified period) for cash, deferred payment or other valuable consideration as per Article 366(29A) of the constitution of India.( Refer sub clause [d] of clause 29A of the Constitution).
Supply of goods by any unincorporated association or body of persons to a member thereof for cash, deferred payment or other valuable consideration.

Transfer of goods can be by way of hiring, leasing, licensing, or any such manner.

Further, in 2005, the Supreme Court in the case of Tata Consultancy Services v. State of A.P held that the transfer of branded software constitutes a sale and is liable to sales tax, levied by State Governments under Entry 54, Schedule VII of the Constitution.

What is Transfer of Right to use goods?

The issue of taxability of transfer of right to use goods was reviewed in many cases and to quote one was by the Supreme Court in Bharat Sanchar Nigam Ltd Vs UOI (2006 (3) TMI 1 – Supreme Court of India) in the context of telecommunication services. The relevant points of all these judgments in this regard are, a transaction must have the following attributes during the time of transfer, (However, yet litigative)

Transfer of Effective Control.
There must be goods available for delivery.
There must be a consensus ad idem as to the identity of the goods.
The transferee should have a legal right to use the goods-consequently all legal consequences of such use including any permission or licenses required therefore should be available to the transferee.
For the period during which the transferee has such legal right, it has to be the exclusion to the transferor this is the necessary concomitant of the plain language of the statute – viz. a “transfer of the right to use” and not merely a license to use the goods.
The owner cannot again transfer the same rights to others.”
Exclusive right to use license, permits, lies with the lessee.
Transfer of intangibles on exclusive basis (‘no Transfer’ when only right was given to use data stored in software & no other commercial right and thus, ‘a service’).

Summary of ‘taxability on transfer’

Given the involvement of goods and services in the model, the taxability is dependent on whether the transaction results in “transfer of right to use” the underlying goods, i.e. transfer of possession and effective control of the underlying goods to the customer since it results to applicability of VAT. Further, to add to this, this issue has been given a twist by the Courts recently, wherein the test of possession is being diluted and the Courts have accepted transactions involving ‘implied possession’ as sufficient for VAT to be applicable.

The allocation of such assets for use by customers is being viewed to result in an ‘implied possession’ of them.

The levy of service tax on such transactions shall be applicable only when the transaction does not involve “transfer of right to use” the underlying goods and therefore this aspect shall require primary focus. Cross border service shall also require addressing the applicability of reverse charge service tax for Indian cloud users under the regulations for place of provision of services.

So for the conclusion, where there is ‘transfer of right to use’ VAT shall be levied otherwise Service Tax shall be levied.

Whether a transaction is a sale of goods or/and service need to be examined from case to case.

In the case of Infotech Software Dealer Association V. UOI, constitutional validity of Service tax on software was upheld. It was held by the high court that whether a particular transaction is sale or service depends on the individual nature of transaction.

Present and proposed TAX Rates on Software

VAT (in Most of the states, as right differs across states) Customized Software Packaged Software	12.5% 5%
Service Tax	14%
Excise Duty/CVD	12.5%
Customs Duty	12%
SAD(Levied in place of VAT in case of imports and ‘refunded once sold in India & VAT is paid’)	4%
Therefore, Present Combined Average tax rate is	25%-35%
Proposed Combined GST	18%-25%

The following points can help to determine whether it is Sale or Service (Indicative not Conclusive)

Law Itself: Nothing can be a replacement to carefully reading of law itself. Try understanding the law which may require the help of professionals since it is a technical task.
SC and Jurisdictional High Court Judgments: For Ex. In case of TCS, SC held the intension is relevant. We see no difference, whether a computer software is sold by way of media, or otherwise. The purpose of sale was to gain access to software which involved transfer of right to use goods and hence VAT shall be levied.
Legal Contract (EULA): If rights including right to Re-sell(commercial exploitation) , tamper or modification allowed, then VAT, else Service tax.
Mutual Exclusive theory of taxability: A well established principle of law that a transaction can’t be taxed both as goods and service as uphold by SC in Infotech Software Dealer Association V. UOI.
Intension: For Ex. ‘no Transfer of right to use goods’ when intension was only to use data stored in software which was given as a right and thus, a service.
Situs of Development: For Ex, Imports do not attract Excise duty since developed outside India.
Department Circulars/Notifications.

A transaction cannot be leviable to both Service tax and VAT, however practically both are levied in many cases

Supreme Court in case of Imagic Creative (P) Ltd. Vs CCT & Ors, 2008 held that both cannot be levied, however, given the ambiguity and huge expenditure & time on litigation both are charged by the service providers.

What is Cloud Computing?

The Cloud is: i) on demand ii) available anywhere, at anytime (subject to the availability of an internet connection)and iii) scalable (i.e. the user can scale the amount of Cloud Computing services or goods required as their business grows and requires more resources for more users).

Cloud Computing Models

There are three major models of delivering ‘clouding computing’ services to businesses and they are as follows:

Infrastructure as a Service (IaaS) Model - Under this model, IT infrastructure in the form of data centers, virtual servers, network infrastructure, equipment, etc are sourced as a service from third party service providers. The customer does not manage or control the underlying cloud infrastructure, but has control over the operating system, storage, and deployed applications, and may be given limited control of select networking components.

Platform as a Service (PaaS) Model - Provides a computing platform and programming tools as a service for software developers. The client does not control or manage the underlying cloud infrastructure, including the network, servers, operating systems, or storage, but has control over the deployed applications.

Software as a Service (SaaS) Model - Service provider hosts several software applications for consumers to use as and when required thereby eliminating the need to install and run the software application on the consumer’s own infrastructure. It can be provided either to business customers (B2B) or to individual customers (B2C).

Transaction	VAT/ CST	Serv Tax	Customs	Excise Duty
e-downloads of software from o/s India	NA	Yes	NA	NA
e-downloads of customized software from o/s India	NA	Yes	NA	NA
Distribution of software in electronic form(packaged Software, sold off the shelf)	Yes	No(TCS SC case)	NA	If replicating and , yes
Distribution of software in electronic form(Other than packaged Software)	Yes	Yes	NA	If replicating, yes
Customization of platform software(Bespoke development, ERP customization, etc)	Yes	Yes	NA	NA
Software loaded into hardware and offered as solution	Yes	Yes	Yes	If replicating, yes
Payment of "royalties" on software distributions	No	Yes	No	No
Cloud Computing(servers outside India)	No	Yes	No	No
Cloud Computing(servers in India)	Yes	Yes	No	No
Maintenance of Software (Work Contract)	Yes(If, Work Contract)	Yes	No	No
Sale of Licenses(Software Renewal)/ End user license agreements/AMC	Yes	Yes	No	If replicating, yes
Cloud Computing(servers in India)	Yes	Yes	No	No

Internationally, software/cloud models are treated as a ‘service’.

What is GST?

“Goods and Service Tax (GST) is a comprehensive tax levy on manufacture, sale and consumption of goods and service at a national level under which no distinction is made between goods and services for levying of tax. It will mostly substitute all indirect taxes levied on goods and services by the Central and State governments in India. There would be concurrent power to state and central government to levy tax on sale of goods and services.

There shall be three forms in which GST shall be levied:

CGST, Central GST (Intra state sale of goods and services)
SGST, State GST (Intra state sale of goods and services)
IGST, (Interstate transaction and Import)

Since GST shall be destination based tax and only ultimate consumer has to bear the taxes, there would be allowability of credit against future liability of tax payment for business houses.

Credit of CGST shall be allowed against CGST, SGST against SGST and credit of IGST/CGST/SGST against IGST. In case credit can’t be utilized fully, it shall be refunded.

To gain complete understanding on GST, please refer my previous article on GST: /articles/gst-a-detailed-explanation-with-examples--23835.asp

What would be the taxability of software/cloud computing under GST?

Once the GST comes into place, there would not be any requirement to classify the software/support ‘a service or goods’. This will help to eliminate all the major classification and litigation issues.

Examples explaining comparison between current tax regime and proposed GST:

Example: (Comprehensive Comparison)
Comparison between Multiple Indirect tax laws and proposed GST
Particulars	Without GST	With GST
	(Rs.)
1. Access of Servers of a Website for Accounting, social networking, etc (Data maintained in Servers, Applications outside India)
Cost of Provider	5,000.00	5,000.00
Add: Profit Margin	2,000.00	2,000.00
Price Before Taxes	7,000.00	7,000.00
Add: Excise Duty @ 12%	-	-
Total Value(a)	7,000.00	7,000.00
Add: Service Tax @ 14%	-	-
Add: IGST @ 20%	-	-
Invoice Value	7,000.00	7,000.00
Note: ST/IGST under reverse charge payable by service receiver ( Refer note 2 & 6)	980.00	1,400.00

2. Access of Servers of a Website for Accounting, social networking, etc (Data maintained in Servers, Applications in India)
Cost of Provider	5,000.00	5,000.00
Add: Profit Margin	2,000.00	2,000.00
Price Before Taxes	7,000.00	7,000.00
Add: Excise Duty @ 12%	-	-
Total Value(a)	7,000.00	7,000.00
Add: Service Tax @ 14%	980	-
Add: VAT @ 12.5%	997.5	-
Add: CGST @ 10%	-	700
Add: SGST @ 10%	-	700
Invoice Value	8,977.50	8,400.00

3. Direct Download of software from Website-Developed in India(Packaged Software)
Cost of Provider	5,000.00	5,000.00
Add: Profit Margin	2,000.00	2,000.00
Price Before Taxes	7,000.00	7,000.00
Add: Excise Duty @ 12%(Refer note 4)	840	-
Total Value(a)	7,840.00	7,000.00
Add: Service Tax @ 14%	1097.6	-
Add: VAT @ 12.5%	1117.2
Add: CGST @ 10%	-	840
Add: SGST @ 10%	-	840
Invoice Value	10,054.80	8,680.00

4. Direct Download of software from Website-Developed outside India(Packaged Software)
Cost of Provider	5,000.00	5,000.00
Add: Profit Margin	2,000.00	2,000.00
Price Before Taxes	7,000.00	7,000.00
Add: Excise Duty @ 12%	-	-
Total Value(a)	7,000.00	7,000.00
Add: Service Tax @ 14%	-	-
Add: IGST @ 20%	-	-
Invoice Value	7,000.00	7,000.00
Note: ST/IGST under reverse charge payable by service receiver	980.00	1,400.00

5. Import of software through CD or any other physical object-(Packaged Software, Refer note 3)
Cost of Provider	5,000.00	5,000.00
Add: Profit Margin	2,000.00	2,000.00
Price Before Taxes	7,000.00	7,000.00
Add: CVD in place of Excise duty @ 12%	840.00	-
Add: SAD@ 4%	313.60
Total Value(a)	8,153.60	7,000.00
Add: Service Tax @ 14%	-	-
Add: IGST @ 20%	-	1400
Invoice Value	8,153.60	8,400.00

6. Development of software and sale on media (Packaged, Refer note 5)
Cost of Provider	5,000.00	5,000.00
Add: Profit Margin	2,000.00	2,000.00
Price Before Taxes	7,000.00	7,000.00
Add: Excise duty @ 12%	840.00	-
Total Value(a)	7,840.00	7,000.00
Add: Service Tax @ 14%	-	-
Add: VAT @ 12.5%	980	-
Add: CGST @ 10%	-	700
Add: SGST @ 10%	-	700
Invoice Value	8,820.00	8,400.00

7. Developing Customized Software-(Developer has right or claim on software for selling to others, confirmed by Karnataka HC in Sasken Comm. Tech.)
Cost of Provider	5,000.00	5,000.00
Add: Profit Margin	2,000.00	2,000.00
Price Before Taxes	7,000.00	7,000.00
Add: Excise Duty @ 12%	-	-
Total Value(a)	7,000.00	7,000.00
Add: Service Tax @ 14%	980	-
Add: VAT @ 12.5%	997.5
Add: CGST @ 10%	-	700
Add: SGST @ 10%	-	700
Invoice Value	8,977.50	8,400.00

8. Direct Download of software from Website- Developed outside/ inside India, packing in CD & selling (Packaged Software)
Cost of Provider	5,000.00	5,000.00
Add: Profit Margin	2,000.00	2,000.00
Price Before Taxes	7,000.00	7,000.00
Add: CVD/Excise duty @ 12%	840.00	-
Total Value(a)	7,840.00	7,000.00
Add: Service Tax @ 14%	1097.6	-
Add: VAT @ 12.5%	1117.2	-
Add: CGST @ 10%/IGST	-	700
Add: SGST @ 10%/IGST	-	700
Invoice Value	10,054.80	8,400.00

9. Maintenance of Software (Assumed to be work contract, else can be a service also, Refer note 7, 8)
Cost of Provider	5,000.00	5,000.00
Add: Profit Margin	2,000.00	2,000.00
Price Before Taxes	7,000.00	7,000.00
Add: CVD/Excise duty @ 12%	-	-
Total Value(a)	7,000.00	7,000.00
Add: Service Tax @ 14% on 70%( assumed)	686	-
Add: VAT @ 12.5% on 40% (assumed)	384.3	-
Add: CGST @ 10%/IGST	-	700
Add: SGST @ 10%/IGST	-	700
Invoice Value	8,070.30	8,400.00

10. Export of Services (Assumed it fulfills conditions of Export of Services rules, etc) (Note No. 9)
Cost of Provider	5,000.00	5,000.00
Add: Profit Margin	2,000.00	2,000.00
Price	7,000.00	7,000.00
Total Value(a)	7,000.00	7,000.00
Add: Service Tax @ 14%	-	-
Add: VAT @ 12.5%	-	-
Add: CGST @ 10%/IGST	-	-
Add: SGST @ 10%/IGST	-	-
Invoice Value	7,000.00	7,000.00

Notes:
1. Tax Rates are taken purely for calculation and analysis purposes which may be different practically.
2. Service tax shall be levied under reverse charge being import of service.
3.. Traders of Packaged Softwares via physical medium shall be liable to VAT(leviable at 5%) and not service tax.(Supreme court in TCS case)
4. Excise duty/CVD shall be levied if the download is replicating and it is the business of assessee.
5. Transforming blank CD into software loaded disc is ‘Manufacture’ (Supreme court in Oracle Software India Ltd, 2010 case)
6. There shall be levied IGST on import equal to combined rate of CGST & SGST.
7. Work contract is simply a transaction which involves transfer of goods while rendering service. For Ex: Beauty parlour services, Disaster Management Service, Annual Maintenance Contracts (AMC), etc.
8. Service tax liabilty has nothing to do with VAT taxable value % and vice versa i.e. combined taxable value can be more than 100%.
9. Refund shall be granted for any tax paid for input goods and services cost.

Some other natures of transaction and its taxability:

Testing of software– It is purely service in nature and liable for Service Tax.
Implementation of software/ online service /calibration of software- Service Tax.
Contract for professional/technical services under purchaser instructions: It is definitely ‘not a transfer of goods’. Liable to Service tax.
Updates and Upgrades (including patches): Liable to VAT and Service Tax.
Sale of Licenses for renewal/End User License Agreements (EULA): Transactions where license/EULA to use the packaged software is only for a particular period say one year in which a say a password, etc is provided is liable to VAT.

Exemptions for Newly setup and small entities under GST:

Threshold limit for exemption (common for both goods and services) shall be in between Rs.10-20 lacs.(No need to pay tax)
Gross turnover of goods upto Rs.1.5 crores may be assigned exclusively to states.
Gross turnover of services upto Rs.1.5 crores may be assigned exclusively to centre.
Gross turnover of above 1.5 crores shall be assigned to both central and state government i.e. SGST to state government and CGST to central government.

Summary/Conclusion:

The taxability of Software has always been a litigative issue. The Intent of the transaction, laws, judgments, must be understood thoroughly to suitably determine its classification as a Goods or Service. Lack of clarity in tax laws from government till date has stopped many software companies to enter into Indian market. The government headed by Mr. Narendra Modi is taking concrete steps to impress the IT sector (since it is the ‘Future of Indian Business’) with its pro active moves to bring in GST which shall end much litigation surrounding software taxability. The recent move to introduce Digital India to provide digital governance, infrastructure and digitally empowered society also expresses government interest in Information Technology Services. Once the GST comes into picture, there would be no or reduced requirements for classification of software as a Goods or Service.

Regards,
CA. Shivashish Kumar
Practicing Chartered Accountant
B.Com(H), ACA (Former Tax Consultant-Ernst & Young)
ca.shivashish@gmail.com
Add: F-50., Near Gurudwara, Madhu Vihar, I.P. Extension, Patparganj, Delhi-92
Network Offices in Kashmere Gate & Laxmi Nagar

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