The software industry tax muddle

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“Collecting more taxes than is absolutely necessary is legalized robbery”.
As of today, there is massive increase in taxes and Government is imposing several taxes on a single item leading to the problem of double taxation. Recently, it has been observed that the Indian Government has imposed several taxes on Information Technology software (packaged or canned) which had added to the problem.
Until May 2008, Information Technology Software was subjected to VAT/Sales Tax as well as Customs or Excise duty, but in budget 2008-2009, Indian Government levied service tax on packaged or canned software. Levy of service tax on information technology software (packaged) created many issues and problems like double taxation. Subsequently, software industry had to pay both excise duty and service tax which resulted in igniting the problem of multiple taxation and various other controversies. The Government Ministries have issued various Notifications clarifying the taxation provisions in this regard. However, certain issues still remain unanswered which have added to the prevailing confusion and uncertainity in the Software Industry.
This Article commences with defining, classifying and explaining the concept of a “Software.” It further seeks to examine the various tax provisions to which the Software Industry is subject as well as the numerous interpretations of these provisions which have given rise to a lot of confusion. Last but not the least, this Article also provides certain suggestions which in our opinion, would be the remedy to this multiple taxation mess and would also bring the existing tax provisions in line with the provisions of the Constitution.
In general terms, a Computer software, or just software, is a collection of computer programs and related data that provide the instructions telling a computer what to do and how to do it. 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, it can be stated that a software is a set of one or more computer programmes which performs the function of the program it implements, either by directly providing instructions to the computer hardware or by serving as input to another piece of software.
The basic distinction between a software and hardware is that while the latter has physical existence, a software is mainly ‘intangible’ and primarily consists of lines of code written by computer programmers that have been compiled into a computer program. Software programs are stored as binary data that is copied to a computer's hard drive, when it is installed.
In 2008, Section 65 of the Finance Act, 1994 was amended to make service tax applicable to “Information Technology software” and bring it within the purview of “taxable services.” Section 65 (53a) was inserted which defines “information technology software” to mean any representation of instructions, data, sound or image, including source code and object code, recorded in a machine readable form, and capable of being manipulated or providing interactivity to a user, by means of a computer or an automatic data processing machine or any other device or equipment.
Types of Softwares:
For the purpose of levying taxes, software can be divided into the following types.
1. Packaged Software: Packaged software can simply be referred to as ready- made application software. Packaged software are also commonly known as canned software, branded software, shrink- wrap software etc. These kind of software are sold off-the-shelf to customers at retail outlets or can also be downloaded electronically. They are designed to meet the requirements of a variety of consumers. The common examples of packaged software include Microsoft Office, Norton Anti-Virus, Picassa etc.

2. Customized Software: Customized software are specifically created for a particular consumer to meet his special requirements. In other words, this type of software is tailored to satisfy the exact needs of a particular customer taking into account his preferences and expectations. For example, A website designed for a particular business organization. In the case of Steag Encotec, India,1CESTAT held that customization of pre- existing software to the needs of a particular customer is modified packaged software and not customized software. Customized software has to be developed from the basic building blocks, whereby a new software product should emerge as per the specific requirements of the client so as to qualify itself as a custom designed software.

The concept of Software Licence and the ‘Right to use’ a Software:
The nature of software is an extremely controversial issue. Whether a software is a goods or a service is not correctly ascertained till date. However, there is no dispute in the fact that regardless of being a “goods” or “service,” a software is basically an Intellectual Property as it is protected under the Copyright Act, 1957. It can downloaded electronically or can be transferred or transmitted through tangible medium such as CD’s, DVD’s, floppies etc.
The sale of a 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. A buyer can therefore use, abstract, consume, deliver, store, possess, transfer and transmit such property in consonance with the licence agreement. However, he cannot resell or exploit it commercially for his own gain or profit. Thus, it may be noted that on purchasing the software, the buyer does not become the “owner” of the software but a mere “licensee.” This basic nature of a software distinguishes it from other forms of traditional goods and services.
Sales tax is a tax which is imposed by State Governments and rate of sales tax may vary from one state to other. In simple words sales tax is a tax on sale or purchase of goods. In 2005, the Supreme Court held that the transfer of branded software constitutes a sale and is exigible to sales tax, levied by State Governments under Entry 54, Schedule VII of the Constitution (Tata Consultancy Services v. State of A.P2).In this context sales tax is applicable on the following:
• transfer, otherwise than in pursuance of a contract, of branded 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.

• supply of goods by any unincorporated association or body of persons to a member thereof for cash, deferred payment or other valuable consideration.

2009 TIOL 1776 CESTAT MUM AIR 2005 SC 371, (2004) 192 CTR (SC) 257, 2004 (178) ELT 22 (SC), [2004] 271 ITR 401 (SC), 2004 (9) SCALE 349, 2006 (33) PTC 652 (SC), (2005) 1 SCC 308, [2004] 137 STC 620 (SC)
Custom duty is a tax or tariff levied on imports (and, sometimes on exports) by the custom authorities of Central Government of India. This duty is generally based on various factors like value of goods or upon weight, dimensions etc. of the item. In relation to branded software there is no basic customs duty but additional countervailing duty (CVD) is applicable on the import of branded software. Excise Duty is a tax levied on the goods produced or manufactured in India by the Central Government of India. Central Government in notification no. 49/2006 – CE imposed excise duty on the manufacture of Information technology software.
Service Tax is a form of indirect tax imposed on specified services called "taxable services". Service tax cannot be levied on any service which is not included in the list of taxable services. In 2008 Central Government introduced a new clause to section 65(105) of Finance Act,1994 which brought information technology software under the meaning of “taxable services”.
The provisions of Section 65(105)(zzzze) reads as under:-
"Section 65: In this chapter, unless the context otherwise requires,-- (105) "taxable service" means any service provided or to be provided-

(zzzze) to any person, by any other person in relation to information technology software for use in the course, or in furtherance of, business or commerce, including—

(i) Development of information technology software,
(ii) Study, analysis, design and programming of information technology software,
(iii) Adaptation, upgradation, enhancement, implementation and other similar services related to information technology software,
(iv) Providing advice, consultancy and assistance on matters related to information technology software, including conducting feasibility studies on implementation of a system, specifications for a database design, guidance and assistance during the startup phase of a new system, specifications to secure a database, advice on proprietary information technology software.
(v) 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
(vi) Acquiring the right to use information technology software supplied electronically”.


It is charged at the rate fixed by each state as it is a tax imposed by state governments.


It is charged at the rate of 10% approx.(10.3%) on MRP less 15% abatement.


It is charged at the rate of 10% approx. (10.3%) on the total amount received from the buyer.

The abovementioned applicable taxes have given rise to various implications and problems which are discussed below:
Before 2008, the tax provisions regarding Packaged Software were definite and unambiguous. Supply of packaged software as well as licence to use such software was taxable as ‘goods,’ i.e., it was subject to Excise duty/ CVD and VAT. No service tax was levied on canned/ packaged software. On the other hand, contract of customized software, its maintenance and other technical support was subject to service tax.
The Apex Court, in the case of Tata Consultancy Services (TCS) vs. State of Andhra Pradesh, 3 held that packaged software like Oracle, Masterkey, Lotus etc. are goods for the purpose of sales tax. It further explained that the test to determine whether a property is ‘goods’ for the purpose of sales tax, is not whether the property is tangible 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. If the software, whether customized or branded, satisfies all these attributes, it would be goods.
The abovementioned principle of the Supreme Court was also approved and applied in the case of Bharat Sanchar Nigam Ltd. vs. UOI.4 Moreover, in the case of Associated Cement Companies Ltd. v. CC5 earlier, it was held that computer software is ‘goods’ even though it is copyrightable as intellectual property.
These Court rulings did to a certain extent, make the tax provisions relating to packaged software quite comprehensive. However, it was only after the Finance Act, 1994 was amended in 2008 that a hue and cry in the software industry was created.
In May 2008, an amendment was made to Section 65 (105), Chapter V of the Finance Act, 1994 whereby sub-clause (zzzze) was introduced which bought Information Technology (I.T.) Software under the meaning of ‘taxable service.’ Consequently, supply of packaged software as well as right to use packaged software licence became subject to both VAT and Service Tax.
This provision raised doubts as to the real identity of a software. It primarily gives an absurd impression that packaged software is a ‘goods’ as well as a ‘service’ and hence, is taxable as both. This not only creates the problem of double taxation but also goes against the very sense of reasonableness and logic. In the case of Imagic Creative Pvt. Ltd v. CCT, 6 the Court held that a transaction can either amount to a ‘sale of goods’ or ‘service’ for the purpose of taxation. Thus, by charging VAT and Service tax on packaged software, the Government is going against the principle laid down in this case. According to software dealers and manufacturers, the said amendment would force them to increase the cost of packaged software by almost 25%. This increased cost would ultimately be passed on to the consumers who would bear the brunt in the form of high prices. This, as a result, would also increase software privacy as consumers would refrain from purchasing highly priced original software.
It may be noted that Infotech Software Dealers Association (hereinafter referred to as "the ISODA), a society registered under the Societies Registration Act with its headquarters at Mumbai, filed a writ petition in this regard. However, the Madras High Court dismissed this petition in 2010, the details of which will be discussed later in this article. Meanwhile, as a response to the prevailing confusion, the Government issued certain notifications during the financial year 2009-10. These notifications provided certain tax exemptions on packaged software and hence, provided the software industry with some relief.
During the financial year 2009-10, the Government sought to provide some relief to the tax burdened packaged software industry. On July 7, 2009, it issued Notification no. 2/2009-CE and Notification no. 80/2009-Customs for providing exemption to packaged software from levy of excise duty and CVD respectively. This exemption was, inter alia subject to the condition that the assessee shall be registered under the Finance Act, 1994 for the purpose of paying service tax. Furthermore, on February 27, 2010, the Government issued Notification no. 2/2010- ST and Notification no. 17/2010- ST which provided exemption from service tax to canned or packaged software subject inter alia, to the condition that appropriate duties of Excise or Customs, as applicable, have been paid. It is important to note that these exemptions have been provided on amount representing the actual transaction value as determined under Section 4 of the Central Excise Act, 1944.
These Notifications prima facie suggest that any person dealing with packaged software has a choice between paying service tax on one hand, or paying Excise/CVD (as applicable) on the other. Though this did not solve the identity crisis as both VAT as well as service tax continued to be applicable to packaged software, it provided certain amount of relief to software dealers from the multiple tax burden.
Madras High Court in 2010 held that the software is goodss and the question as to whether a transaction would amount to sale or service depends upon the individual transaction. High court explained that even though software is a “goods” but it may not amount to exclusive sale in all cases. Court asserted that the terms and conditions of EULA (a legal contract between software application author and user of that application) are material to find out as to whether there is an element of sale involved when software is delivered to its customer.
Cases where software does not amount to sales:
If the software is sold through the medium of internet in the form of downloadable, it does not fit into the ambit of "IT software of any media". In that event, it is possible to hold that when an access control is given through an internet medium with a username and password and when there is no CD or other storage media for the item, it does not satisfy the requirement of being 'goods' or the entry used in the statute.
The original manufacturer, who creates the software, only licenses the software for the private use of the end user subject to the terms and conditions. If the end user agrees to the terms and conditions, such end user is given "right to use" (install, run and get updates) the software within the limits prescribed. At no stage an end user who runs the software installed in his computer becomes absolute owner of the software. The end user cannot tamper or modify, cannot improve and cannot rectify errors in the software and the end user should not sell the software to another person for commercial exploitation. In view of the specific licensing agreement between the original manufacturer of Standardised Software, namely, Microsoft and Symantec, and the end user, it would be clear that the software is not sold, but only licensed for the limited use for which it is licensed. In other words, in trade parlance, whenever a software product is launched, the original manufacturer releases what is known as End User License Agreement and Product Use Rights.
These aforementioned cases have been discussed by the high court in the Infotech case and HC made clear that the question whether the transaction of software being a goods would amount to sale or service depends on the rights given to the end user.
X enters into a legal contract (EULA) with Y who is the original manufacturer for the transfer of packaged software.
Case A: Where X (end user) is allowed to re-sell (for commercial exploitation), tamper or modify the concerned software.
Case B: Where X (end user) has no right to re-sell (for commercial exploitation), modify or tamper the software.
Now, In Case A transaction would amount to sale as the manufacturer has given all the rights to X including right to resell. Thus in this case it makes X an absolute owner having all rights over the software.
Whereas in Case B, X has no right to resell the software as he has only licensed for the limited use of the software. Thus, in this case it does not make X an absolute owner of the software and therefore transaction would amount to service and not sale.
On December 21, 2010, the Govt. rescinded Notifications bearing No’s. 17/2010-ST and 2/2010-ST. Simultaneously, Notifications bearing Nos. 30/2010- CE and 53/2010- Service Tax were issued. According to these notifications, service tax exemption can be availed on packaged software subject inter alia to the condition that appropriate duties of Excise or Customs have been paid on the value representing the Maximum Retail Price (MRP) less 15% abatement.
There have been a lot of questions raised with regard to the implementation of these notifications. While service tax exemption based on MRP valuation can easily be claimed on retail sale of packaged software, it is not clear as to how such exemption can be availed by manufacturers, importers and other institutional buyers since it is not possible for middlemen to determine the ultimate selling price and accordingly pay Excise/CVD. Determination of MRP when software licenses pass through multiple trading channels is indeed an impracticable requirement imposed by the Government.
It is also pertinent to note that electronic transfer of packaged software would be outside the scope of MRP based excise levy which has further lead to negative interpretations. Earlier, manufacturers and importers were either paying Excise/CVD on physical supply or Service tax on electronic supply, which did not matter as the rates for service tax and Excise/CVD were based on the transaction value and hence, were the same. Now, with the MRP based valuation being implemented, the software dealers would find it better to shift to electronic mode of software supply, as paying service tax on the transaction value would be cheaper than paying Excise/CVD on MRP less 15% abatement and also considering the complications of finding out MRP. One cannot understand as to how the mode of delivery can determine the amount of taxes a person has to pay. It is also a complex requirement imposed on a software dealer who handles both modes of delivery.
It may be submitted that the Government, in public interest, should restore the original valuation method and bring packaged software outside the scope of MRP based excise levy. This would simplify the tax provisions and further avoid unnecessary complications and impracticable interpretations.
The software industry has been bearing the multiple tax muddle for a long time. It is necessary that the Government takes up this issue and makes suitable amendments so as to simplify the tax provisions which have been haunting the software industry. It is recommended that the Government amends Section 65 (105) (zzzze) of the Finance Act, 2008 to include merely “services in relation” to I.T. software as a taxable service and not the Development of software and “right to use” software license per se. Secondly, packaged software should be brought outside the scope of MRP based valuation and levy of Excise duty should be on the basis of transaction value. This would avoid unnecessary confusion and complication. It is also necessary not to let the mode of delivery determine the amount of taxes payable by an assessee.
It must be remembered that simplified and unambiguous tax provisions lead to smooth implementation as well as less tax evasion. On the other hand, confusing the public and collecting excessive taxes goes against the very principles of equality laid down in our Constitution. Thus, it is necessary that the Government clarifies all the issues and questions this article addresses, for it is the only way the software industry can be rescued from falling deeper and deeper into the tax muddle. - -

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