Taxation of Software — Recent Developments

The Information Technology/Software Industry in India is
subjected to multiple indirect taxes like Excise Duty (ED)/Countervailing Duty (CVD)
and Service tax by the Centre and VAT by the States. Apart from incidence of
multiple taxation, what is affecting the industry most is the uncertainty over
the correct applicability of a particular tax on its activities and the
confusion is in the minds of the taxing authorities — both the Central and the
States. This results in divergent practices being followed and dual taxation as
a precautionary measure.

An attempt is made to discuss some important recent
developments in regard to this complex subject.

Information Technology Software Service (ITSS) was
comprehensively brought under the levy of service tax through the insertion of
the sub-clause (zzzze) in clause (105) of section 65 of the Finance Act, 1994
(FA) w.e.f. 16-5-2008.

Since March, 2006, ED was already being levied on ‘Packaged
Software’ manufactured in India and sold off the shelf. Such ‘Packaged Software’
has been treated as ‘goods’ and classified under Tariff Item 8523 80 20 of the
Central Excise Tariff. [It needs to be noted that the issue as to whether or not
the concept of ‘manufacture’ can be applied to ‘software’ or not, is pending
before a larger Bench of the Supreme Court. However, in the context of income
tax it has been held in CIT v. Oracle Software India Ltd., (2010) 250 ELT
161 (SC), that the process of software replication which renders a commodity or
article fit for use which otherwise is not so, would fall within ‘manufacture’.

Though basic customs duty is not payable on Imports of IT
software, CVD under customs became payable on such imports due to levy of ED on
it.

W.e.f. 16-5-2008, the ‘Licence to use the IT software’ has
been subjected to levy of service tax. However, the levy was confined to the
services in relation to IT software for use for commercial exploitation. It is a
matter of common knowledge that in case of supply of software, two cost
components are usually involved viz. :

On the other hand, based on the ruling of the Supreme Court
in Tata Consultancy Services v. State of A.P., (2004) 178 ELT 22 (SC)
many States have imposed VAT or WCT on software classifying it as ‘goods’ or
‘works contract’ under respective VAT legislations. For example, under the
Maha-rashtra Value Added Tax Act, 2002 (MVAT), intangible goods are covered by
entry C-39 and liable to tax. ‘Software packages’ are notified under entry C-39
and hence, are liable to VAT.

Hence, in the context of software taxation, it becomes very
important to determine whether ‘software’ is sold as ‘goods’, and is liable to
VAT or provided as ‘service’, so as to attract levy of service tax under the FA.

Further, pursuant to the 46th Amendment of the Constitution
of India by the Constitution (Amendment) Act, 1982, the tax-base underwent a
sea-change due to the insertion of clause (29A) in Article 366. The States
acquired the powers to levy sales tax on certain types of ‘deemed sale’. As a
consequence of this constitutional amendment, all the states have made changes
in their respective VAT Legislation in this regard. One such ‘deemed sale’ that
can be subjected to levy of VAT/sales tax is 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. Thus, States have been levying or
attempting to levy VAT/sales tax on such activity of ‘providing licence to use
IT software’.

The IT/Software Industry was slapped with the demands raised
by the authorities either for customs duties i.e., CVD or for service tax. Even
though CVD was paid on the licence value, service tax was being demanded thereon
and vice versa. Even simultaneous demands under customs and service tax have
been raised in many cases.

It would appear that it was never the legislative intent that
the value addition in the form of software licence should be taxed more than
once. It should either be taxed by way of ED/CVD or by way of service tax.

IT/Software Services were comprehensively brought under the
service tax ambit w.e.f. 16-5-2008 through introduction of a specific entry viz.
section 65(105)(zzzze) in the FA.

Relevant extracts from the Ministry’s Circular/Letter DOF No.
334/1/2008-TRU, dated 29-2-2008 clarifying the scope of service are as under :

Information Technology (IT) software service includes:

Software consists of carrier medium such as CD, floppy and coded data. Softwares are categorised as ‘normal software’ and ‘specific software’. Normalised software is a mass market product generally available in packaged form, off the shelf in retail outlets. Specific software is tailored to the specific requirement of the customer and is known as ‘customised software.’

“4.1.3

Packaged software sold off the shelf, being treated as goods, is leviable to excise duty @ 896. In this Budget, it has been increased from 8% to 12% vide Notification No. 12/2008-CE, dated 1-3-2008. Number of IT services and IT-enabled services (ITeS) are already leviable to service tax under various taxable services.”

“4.1.5

Software and upgrades of software are also supplied electronically known as digital delivery. Taxation is to be neutral and should not depend on forms of delivery. Such supply of IT software electronically shall be covered within the scope of the proposed service.”

Software downloaded from Internet:

    a) The Finance Minister in his Budget Speech on 28-2-2006 observed as under:

“Para 138

I propose to impose an 8% excise duty on pack-aged software sold over the counter. Customised software and software packages downloaded from the internet will be exempt from this levy.

In cases where the software is made available only through the medium of the Internet, there is no express, exclusion in Entry 27 stated above. However, the Explanatory Notes, which form part of the Budget papers read as under:

“Excise duty of 8% is being imposed on packaged software is also known as canned software on electronic media (software downloaded from the internet and customised software will not attract duty). [Serial 27 of Notification No. 6/2006)]”.

    b) The Central Excise Rules, 2002 contemplate payment of excise duty at the time of removal of excisable goods from the factory and at the rates prevalent on the date of removal from the factory. Where a customised software solution is sold to the customer through the medium of Internet, the transaction can be considered as an e-commerce transaction and there is no physical removal of goods in a tangible form from the factory gate, which is the requirement of levy of excise duty. Further, the software is not available in any medium for it to be considered as goods as per the rationale of the Supreme Court in TCS case.

    c) The following judicial rulings need to be noted:

    i) In Digital Equipment (India) Ltd. v. CC, (2001) 135 ELT 962, the Tribunal has held that information transmitted via e-mail cannot be akin to import of record media in 85.23. In an e-mail transfer, no media as a movable article is crossing the international boundaries and there is no movable property movement involved. Therefore, transfer of information or idea or knowledge on e-mail transfer would not be covered within the ambit of goods under the Customs Act. If they are not goods, then they cannot be subject to any duty.

    ii) The Supreme Court in the case of Associated Cement Company v. CC, (2001) 128 ELT 21 had held that where any drawings or designs or technical materials are put in any media or paper, it becomes goods. Hence only if an intellectual property is put in a media, it is to be regarded as an article or goods.

    iii) In Multi Media Frontiers v. CCE, (2003) 156 ELT 272, the Tribunal has observed that a software cannot exist by itself and for it to be put to use it has to necessarily exist on some suitable media such has floppy disc, tape or CD.

    iv) In Pantex Geebee Fluide Power Ltd. v. CC, (2003) 160 ELT 514 (Tri), it has been held that a transfer of intellectual property by intangible means like e-mail would not be liable to customs duty.

    d) The Geneva Ministerial Declaration on Global Electronic Commerce Document WT/MIN (98) DEC/ 2, dated 25-5-1998 which is a declaration of an intent by members of WTO that they would continue their current practice of not imposing customs duty on electronic declaration.

    e) MVAT does not contain specific provisions to tax supply of software electronically.

    f) Providing the rights to use information technology software supplied electronically is specifically covered under the scope of ITSS[section 65(105) (zzzze)(vi) of FA.]

Amendments by the Union Budget for 2009-10/Clarification regarding packaged or canned software:

Relevant Extracts of Ministry’s Circular Letter D.O.F. No. 334/13/2009-TRU, dated 6-7-2009 are as under:

I.3 — Packaged or canned software:

Partial exemption from excise duty has been provided to packaged or canned software so that the duty payable on that portion of the value which represents the consideration for the transfer of the right to use such software, is exempted. The benefit of the exemption is available to the manufacturer of such software when he declares to the Central Excise authorities that the right to use is transferred for commercial exploitation and fulfilment of some other conditions. The details are contained in Notification No. 22/2009 — Central Excise, dated 7th July, 2009. On the portion of the value which is exempted from excise duty, service tax will be leviable under the ‘Information Technology Software Service’.

II.9 — IT Software:

On packaged or canned software, CVD exemption has been provided on the portion of the value which represents the consideration for transfer of the right to use such software, subject to specified conditions. This portion of the value is leviable to service tax as ‘Information Technology Software Service’. Although, the CVD exemption has not been made conditional upon the payment of service tax, it is requested that a mechanism be put in place to ensure regular exchange of information on details of importers availing of the exemption between the customs and service tax formations so that, where necessary, action for recovery of service tax may be taken.

Amendments by the Union Budget for 2010-2011:

    a) Realising the difficulties faced by the IT/Software Industry, few steps were taken to address the same, as under:

(b) The following needs to be noted :

a) Important Ruling of Madras High Court:

    The Madras High Court, in a landmark ruling in Infotech Software Dealers Association v. UOI, (2010) 20 STR 289 (ISODA), has upheld the constitutional validity of section 65(105)(zzzze) of the FA, introduced with effect from 16-5-2008.

    b) The writ petition filed by ISODA had raised the following issues, in particular:

    c) During the course of hearing, ISODA had submitted that its members are re-selling software products under the three categories, viz.,

ISODA also submitted that the transactions entered into by its members are only a sale of software being goods and that no element of service is present and that only the State Governments are empowered to levy tax in terms of Entry 54 of List II of Schedule VII of the Constitution and con-sequently, the Parliament has no legislative compe-tence to levy service tax on the same transaction u/s.65(105)(zzzze) of the FA.

    d) Some of the important contentions of Department were as under:

    e) The Madras High Court made the following important observations:

    f) The Madras High Court dismissed the writ petition of ISODA and held as under:

    g) Some of the important issues arising from the aforesaid landmark ruling of the Madras High Court are as under:

Para 31

“….the dominant intention of the parties would show that the developer or the creator keeps back the copyright of each software, be it canned, packaged or customised, and what is transferred to the network subscriber, namely, the members of the association, is only the right to use with copyright protection. By that agreement, even the developer does not sell the software as such. By that Master End-User Licence Agreement, the members of petitioner — association again enter into an end-user licence agreement for marketing the software as per the conditions stipulated therein. In common parlance, end user is a person who uses a product or utilises the service. An end user of a computer software is one who does not have any significant contact with the developer/ creator/designer of the software. According to Webster’s New World Tele-com dictionary, an end user is “the ultimate user of a product or service, especially of a computer system, application or network.” On a careful reading of the above, we are of the considered view that. “…. when a transaction takes place between the members of ISODA with its customers, it is not the sale of the software as such, but only the contents of the data stored in the software which would amount to only service. To bring the deemed sale under Article 366(29A)(d) of the Constitution of India, there must be a transfer of right to use any goods and when the goods as such is not transferred, the question of deeming sale of goods does not arise and in that sense, the transaction would be only a service and not a sale.”

It is a settled law that for a tax to be levied by the States on the transfer of right to use goods, there is no need for goods, as such, to be transferred. The above observations of the Madras High Court appear to unsettle the settled law.

MRP levy introduced for packaged software — Recent Notifications:

In an important development, the Government has brought the entire packaged software industry, under the MRP-based excise levy by issuing Notification Nos. 30/10-CE and 53/10-Service Tax, both dated 21-12-2010.

In terms of the Notification No. 30/10 CE, Notification No. 49/08 CE, dated 24-12-2008 has been amended, providing for an abatement of 15% of what has been given on the MRP of the packaged software based on which the central excise duty will have to be paid by the manufacturer and CVD to be paid by the importer. In terms of Notification No. 53/10-ST, dated 21-12-2010 no service tax shall be payable on the licence value in terms of section 65(105)(zzzze)(v) of FA.

Some of the more important implications that arise from the Notifications are as under:

    a) MRP-based levy would be applicable only for the physical mode used for licensing of the pack-aged software licences as contrasted to the electronic mode of transfer. Hence electronic transfer of licences for packaged software would continue to be taxed under service tax in terms of specific provisions u/s.65(105)(zzzze) of the FA.

    b) Importers of packaged software licences would have the choice of either importing the licences in the electronic mode, or in the physical mode. Up-till now importers were either paying CVD on the physical imports or service tax on the electronic imports on the transaction values. Now with the MRP-based levy for CVD on physical imports, it is possible that importers could be better off, shifting to the electronic import, as the value-added margins for imports could be much higher.

    c) The local manufacturers may find it better to shift to the electronic mode of transfer of software licences, as paying service tax at 10.3% on the transaction value could be cheaper as compared to paying central excise duty at 10.3% on MRP less 15% abatement.

    d) In terms of Notification No. 49/08-CE, dated 24-12-2008 (as amended) ‘retail sale price’ means the maximum price at which the excisable goods in packaged form may be sold to the ultimate consumer and includes all taxes local or otherwise, freight, transport charges commission payable to dealers, and all charges, towards advertisement, delivery, packing forwarding and the like as the case may be, and the price is the sole consideration for such sale.

Notifications issued could result in practical difficul-ties for the importers. To illustrate:

    i) In many cases the concept of MRP may not work for imported packaged software products. In such cases, issues would arise as to whether the customs authorities can treat the ultimate selling price charged by the importer, as the MRP where there is no MRP for the software product imported/ or would the authorities go by the retail prices published by the foreign suppliers of software packages which could be substantially higher than the price at which these are sold in India.

    ii) MRP regime may not be practically workable inasmuch as a large number of transactions get conducted through contracts entered into between the parties. A software player holding valid IPR can transfer licences to various customers at varyingprice arising out of customisation etc. In such cases, how can MRP-based duty be computed.

    e) In cases of imports at significantly reduced special price (e.g., non-profit bodies), the same could get covered under the MRP levy, resulting in higher overall costs.

    f) The new MRP-based levy would also affect importers of software licences for their internal purposes at discounted prices. Such importers would have to pay CVD on the MRP less 15% abatement, which could mean increase the overall costs.

    g) By issuing these Notifications, the Government seems to be confirming that packaged software is nothing but goods. However the electronic transfer of software licence would be service in terms of clause (vi) of section 65 (105)(zzzze) of FA. Hence, the same product can be ‘goods’ or ‘service’ depending upon the mode of delivery.