Eximenterprise.com

B.N. Gururaj, B.A., LL.B. ADVOCATE  

1. Prefatory:

Software sector has generally been a cause of thinly disguised envy for other sectors of economy, especially in taxation matters. For over a decade, this sector has enjoyed almost unprecedented tax advantages. But, gradually, these advantages are wearing out, be it Income tax, or Central Excise duty or Service tax or VAT. The tax net is spreading over this sector, which has been generally perceived as pampered one. Even the privileged SEZ has not spared this sector under some circumstances. In this article, the discussion is limited to the aspects of indirect taxes relating to software.

2. Classification and rates of taxes under different laws:

Ignoring for the moment, the complex nature of software business, for the purpose of this article, I may broadly group the taxable transactions as under:

A. Customs. - Under the Customs law, information technology software is classified under TI 8523 80 20 and is free of duty. There is a definition of “information technology software” in the Supplementary Note to Chapter 85. Someone wrote an article in a prominent website and thought it funny that there is another software related entry in the Customs Tariff, of all the places under Chapter 49, which encompasses printed material. This is under TI 4907 00 30, dealing with “documents of title conveying the right to use information technology software”, attracting 10% duty. SI. No. 157of Notification No. 21/2002-Cus, dated 1-3-2002 unconditionally prescribes the effective rate of duty as nil for both Tariff Items, though for the first one, there was no need to prescribe nil duty, when the tariff entry showed “free” against entry in the rate of duty column.

B. Central Excise.- Under the Central Excise Tariff also, the classification is under the Tariff Item 8523 80 20, attracting 12%.  Notification No. 6/2006-C.E., dated 1-3-2006, SI. No. 27 of the Table unconditionally exempts customized software (as described in that entry itself). Packaged software attracts 8% effective rate duty. Besides, the applicability of Notification No.8/2003-C.E. is also relevant, where the manufacturer of packaged software is small.

C. VAT/CST.-As regards VAT liability, since it is not possible to consider all the State VAT laws, I shall refer to the Karnataka VAT Act, 2003, with which, I am more familiar. The Third Schedule specifies the goods on which VAT is chargeable at 4%. Entry 34 of this schedule, though generally deals with licences issued under the Foreign Trade policy, has a newly inserted phrase with effect from 1-4-2007  “… including software licences by whatever name called”. Further, the Sixth Schedule, which lists specific, works contracts, at SI. No.11 providers for taxing  “programming and development of software” at 4%. Since VAT laws are more or less uniform through the country, at least as far as tax rates are concerned, this reference may be considered adequate for the purpose of this article.

D. Service Tax.- Coming to Service tax, [refer footnotel for the text of Section 65(105) (zzzze) of Finance Act, 1994],under sub-clause (v), acquisition of right to commercially exploit the software is a taxable service. The provision makes no reference to mode of acquiring the software. Conservatively, it is possible to assume that not only software received by the distributor on physical media, but also those downloaded from Internet would be covered by this entry. This assumption would be reasonable insofar as Service tax liability is concerned. But, for the purpose of VAT/CS, this is a matter of much debate, based on sound legal grounds. More about this later.

E. Next, sale of key to the customer, which will enable the customer to download the software is an ambiguous entry. Under sub-clause (vi), no doubt, this would be an electronic download and be taxable in the hands of the person providing the software. However, what is the position if the software is downloaded from a server located abroad, though sold by a re-distributor located within India? This will be discussed in the later part of this article. Further, for the purpose of VAT/CST, whether the sale of “software key” can be construed as “software licence” is also in doubt.

F. Grant of licence for use of software should clearly be treated as a transaction in goods and not in services. Both the Customs Tariff and the Central Excise Tariff treat documentary licence as goods and prescribe rate of duty in the tariff. Under the Karnataka VAT act, 2003 also the Third schedule has a specific entry to cover software licences. Further, the decisions of the Supreme Court in Tata Consultancy Service v. State of Andhra Pradesh, 2004 (178) E.L.T. 22 (S.C), and Infosys Technologies Ltd v. State of Tamil Nadu, (2008) 17 VST 256 (Mad.) support charge of duties and taxes on software as goods, be they packaged software or custom built software.

Other software services described in sub-clause (zzzze) have one interesting feature. The definition carefully keeps clear of any transaction, which can be brought within the scope of the Central Excise duty or the customs duty. The tariff rates, as administered by the Central Excise and customs notifications clearly maintain separation between software that might attract duty of either excise or customs, and software that might attract Service tax. A careful examination of sub-clauses (i) to (iv) of clause (zzzze) shows that none of the transactions can be ambiguously construed so as to attract both the levies. This is definitely a positive feature as far as the central taxes are concerned.

3. Dichotomy of levy between VAT and Service tax:

In Tata Consultancy Services v. State of Andhra Pradesh, 2004 (178) E.L.T. 22 (S.C), the Supreme Court rejected the arguments against taxability of software as goods, on the ground of being intellectual property and hence, not being goods. Once software was put on media and distributed or sold, irrespective of the media, software was held to be goods, eligible to tax. This decision would also make it clear that packaged software sold to the dealers, distributors, channel partners etc. will not attract Service tax as these would be transactions in goods and cannot, simultaneously be goods also.

Whether software delivered over Internet constitutes goods. -  It is also important to notice that in this decision, distribution of software over Internet was not an issue to be determined, nor any argument advanced on this issue before the Supreme Court. Though Internet is a media, it is not a deliverable media like a CD or flash memory. Therefore, it is highly doubtful whether software delivered through internet in electronic form can be construed as “goods”. At least, at this time, there is neither judicial support nor statutory provision to construe software delivered over Internet as goods.

Deliver of software upgrades in physical media whether goods.- Sub-clause (iii) of Section 65(105) unambiguously refers to “adaptation, up gradation, enhancement, implementation and other similar services related to IT software.” Where a software vendor or developer also provides annual or periodic upgrades, they would come within this category. The media by which these upgrades are provided, be it compact discs, or through Internet would not make any difference to the taxability as long the software developer, as service provider upgrades the software already supplied to the customers and the customers receive and use such upgrades.

In the context of VAT/CST liability, the knotty issue is the up gradation supplied by means of CDs. To a lay person or the assessing authority, since the new supply of software as well as upgrades are on CDs, both might seem identical hence, be liable to VAT/CST. However, the fact remains that the CD is merely the media for supply of upgrades cannot be determinative factor. The nature and character of the software is the subject matter and that should be taken into consideration for determining whether or not upgrades are liable to VAT/CST, rather than the fact that the upgrades are provided on CDs. That media cannot make difference for chargeability to tax is also the view of the Supreme Court as enunciated in State of Andhra Pradesh v. Tata Consultancy, 2004 (178) E.L.T. 28 (S.C).

Upgrades are not IT software in themselves as defined in the Central Excise law and as adopted in the notifications issued under the VAT Acts. They are merely changes to the existing software. Hence, it is apt to consider upgrades as a post-sale service at a cost, rather than supply of software. This is in the nature of changes to existing software rather than sale or supply of software. On the basis of this reasoning, it is possible to contend that upgrades even though on CDs are not liable to VAT/CST, but the liability would be restricted to Service tax alone.

Customized software as works contracts. - Supply of customized software would still be liable to VAT as works contract. An assessee can explore the possibility of re-classifying the customized software as works contract under the VAT Acts. It is not legally prescribed that customized software should be developed from the scratch. Further development of software based on existing substratum or platform would also be development of software. The advantage that could accrue to the developer by resorting to re-classification of customized software as works contract would be that instead of charging VAT on entire value, the developer could claim abatement of labour and other charges permissible under Rule 3 of the KVAT Rules, 2005. This would also reduce the liability of Service tax on customized software.

Advantage to works contract in Service tax valuation.- Rule 2A of the Service Tax (Determination of value) Rules, 2006 as amended with effect from 1-6-2007 provides for exclusion of VAT and value assessed to VAT under the VAT/CST from the value chargeable to Service tax. In other words, if you resort to reclassification of customized software as works contract, the value charged to VAT/CST would be liable to Service tax and vice versa. Thus, dual taxation of same sale consideration under two laws can be legitimately avoided.

4. Whether VAT and service tax are mutually exclusive:

General perception of the taxpayers, as lay persons is that same transaction must not attract more than one kind of tax. If it were to happen, a lay taxpayer would construe that there is double taxation, though legally it is not so. For examining the correctness of this perception the constitutional and statutory basis for this proposition has to be examined.

It must appreciated that Service tax is a Central charge of tax under the Finance Act, 1994. The legislative competence for this law is traceable to Entry 97 of the List I of the Schedule VII to the Constitution of India. Entry 92C has been inserted in the List I, which provides for “Taxes on services”, though it is yet to come into force from a date, to be notified. In any case, Service tax is the exclusive legislative preserve of the Union of India. Whereas, VAT or sales tax are traceable to two different entries. Legislative power of VAT or State sales tax is traceable to entry No. 54 of the List II to schedule VII of the Constitution. Legislative power for CST is traceable to entry No. 92A of the List I, though it is actually administered and collected by the States. Procedural law applicable for collection and assessment is the State law. Thus, the fields of taxation for Service tax and VAT / Sales tax are quite different. Laws are made by different legislatures. Neither law excludes its applicability where the other tax is charged. No where do the Finance Act, 1994, or the KVAT Act, 2003 or the CST Act, 1956 provide for exclusion of taxable value when the other taxes are charged on the same transaction. In fact, in the context of goods, such duality of taxes already exists. Excise duty is charged on the manufactured good, and customs duty on the imported goods. When these goods are sold, VAT or sales tax is also charged on the very same value, in fact on the value inclusive of duties. The sole basis is that the taxable events under each law are different. This has not been found objectionable by anyone. In facts, courts have repeatedly upheld the validity of such levies. Thus, prima facie, it would seem that there is no legal basis for concluding that same transaction cannot suffer both Service tax and VAT/CST.

In this context, the decision of the Supreme Court in Imagic Creative Pvt. Ltd. V. Commissioner of Commercial Taxes & Ors2, becomes relevant. In this case, the issue before the Hon’ble Supreme Court was very same: whether same transaction would attract both sales tax and Service tax. The dispute arose when the designs of advertisement were delivered on physical media to the customer. Though the assessing authority agreed that there was no sale and excluded this value from the taxable turnover, subsequently, the Revenue commenced the recovery proceedings. In this case, though the Apex Court observed that service tax and VAT are mutually exclusive, regrettably, the Apex Court did not discuss the mutual excludability quite clearly. The extract from the judgment given below follows elaborate discussion on the taxability of works contracts and judicial decisions relevant for that discussion:

“24. We have, however, a different problem at hand. Appellant admittedly

is a service provider. When it providers for service, it is assessable to a tax

 known as service tax. Such tax is leviable by reason of a Parliamentary statute.

In the matter of interpretation of a taxing statute, as also other statutes where the applicability of Article 246 of the Constitution of India, read with Seventh Schedule thereof is in question, the Court may have to take recourse to various theories including aspect theory, as was noticed by this Court in Federation of Hotel & Restaurant Association of India, etc. v. Union of India & ors. [(1989)3SCC634].

 25. If the submission of Mr. Hegde is accepted in its entirety, whereas on the one hand, the Central Government would be deprived of obtaining any tax whatsoever under the Finance Act, 1994, it is possible to arrive at a conclusion that no tax at all would be payable as the tax has been held to be an indivisible one. A distinction must be borne in mind between an indivisible contract and a composite contract. If in a contract, an element to provide service is contained, the purport and object for which the Constitution had to be amended and clause 29A had to be inserted in Article 366, must be kept in mind.

26.We have noticed hereinbefore that a legal fiction is created by reason of the said provision. Such a legal fiction, as is well known, should be applied only to the extent for which it was enacted. It, although must be given its full effect but the same would not mean that it should be applied beyond a point which was not contemplated by the legislature or which would lead to an anomaly or absurdity.

27.The Court, while interpreting a statute, must bear in mind that the legislature was supposed to know law and the legislation enacted is a reasonable one. The Court must also bear in mind that where the application of a Parliamentary and a Legislative Act, comes up for consideration; endeavours shall be made to see that provisions of both the acts are made applicable.

28.Payments of service tax as also the VAT are mutually exclusive. Therefore, they should be held to be applicable having regard to the respective parameters of Service tax and the sales tax as envisaged in a composite contract as contradistinguished from an indivisible contract. It may consist of different elements providing for attracting different nature of levy. It is, therefore, difficult to hold that in a case of this nature, sales tax would be payable on the value of the entire contract; irrespective of the element of service provided. The approach of the assessing authority, to us, thus, appears to be correct.”

In the discussion extracted above, at Para 24, the Court no doubt refers to a distinction between indivisible contract and composite contract, but does not actually bring out the distinction. Presumably, the court meant by indivisible contract, such contracts, which were not permissible to be divided in terms of Article 366(29A), and by composite contract, meant such contract which was amenable to bifurcation. At the end of para 27, having observed “where the application of a Parliamentary and a Legislative Act comes up for consideration; endeavours shall be made to see that provisions of both the acts are made applicable”, in the next breath, the Apex Court holds that Service tax and VAT are mutually exclusive. The discussion which follows does not also support the cryptic inference at para 28, that payments of Service tax as also the VAT are mutually exclusive. The statutory or judicial basis for this inference is not found between paras 24 to 28, and certainly not in the paragraphs which precede these. Thus, in this judgment, we have a decision, but not the ratio or reason for the decision. According to the doctrine of precedents adopted from English law and followed in India, what binds the lower courts is the reason for the decision and not the decision itself. It is the reason or ratio, which has probative force.

At this point of time, no doubt, this judgment, in unequivocal terms asserts and declares that Service tax and VAT/Sales tax are mutually exclusive. Being the declaration of the Apex Court, unless altered legislatively or by subsequent decision, this view would hold field. But, a judgment can always be distinguished by the assessing authorities and the courts/tribunals below on factual basis. In fact, it is necessary that the material facts must be similar for applying a judicial precedent.

In fairness to the Apex Court, it must be stated here that the advertising service provided in that case was not works contract, covered by Article 366(29A) of the Constitution. Therefore, the High Court and the Advance Ruling Authority were held to be wrong in treating entire contract as chargeable to VAT. Not being works contract, the advertisement design contract could not have been split up for charging VAT. This ratio may not be entirely applicable in respect of software development.

In the case of software development etc., there can be no doubt that adaptation of software or customization of software is indeed works contract under the VAT Acts, though it is not explicitly included in the definition of works contract under clause (zzzza) of Section 65(105) of the Finance Act, 1994. These activities would fall within the scope of generic term “Programming and providing of computer software” used in SI. No. 11 of Schedule VI of the KVAT Act. Therefore, the ratio of Imagic case cannot be directly applied to cases where the transactions are clearly works contracts. Being works contracts, these are amenable to splitting of value and chargeable to VAT/CST on works contract.

 The observation of the Supreme Court in para 28 that Service tax and VAT are mutually exclusive would not, in the case of works contract, help the assessee claim that only one of the taxes is payable on the transactions and not both. Better option would be to choose either composition or regular assessment under the Service tax law. While composition would give the benefit of reduction of tax rate, regular assessment can help you by excluding portion of the value from each tax.

5. Taxability of software delivered over Internet, under VAT/CST:

There is a significant issue about taxability of software delivered through Internet under VAT/CST laws. At present, neither CST Act, nor VAT Acts provides for charging VAT/CST on transfer of right to use software through Internet. Hitherto, taxability of software has always been related to delivery by physical media such as CDs, hard disc, floppy discs, pen drives and the like. In the absence of explicit provisions of law bringing software delivered through Internet to tax, it is possible to contend that it is in the nature of service, specifically covered by the Service tax law and not covered by VAT. It is well settled law that the provisions requiring charge of tax must be construed strictly and any ambiguity must be construed in favour of the assessee and against the Revenue. In the absence of explicit provision to charge Internet delivery of software to tax, an assessee would be justified in excluding this part of the turnover from the charge of VAT/CST. See also discussion on strict construction of charging provisions, infra.

6. Applicability of Section 66A:

There are certain transactions wherein, the distributor does not provide the software, but a key, which would enable the purchaser to download the software from a server, which is probably located abroad. In any case, the location of the server would be indeterminate. Though this may appear as a case right of commercial exploitation, upon detailed examination, it would not seem so. By purchasing the software keys from the foreign suppliers or from the Indian distributors, the distributor does not acquire any software for the purpose of commercial exploitation such as sale, coping, distributing, reproducing etc. In fact, the distributor will not possess the software at all. What the distributor buy and sell is merely the key which gives the purchaser the right and power to download the desired software. In such a case, there is also no reproduction or distribution of software. The distributor’s role would be that of an intermediary who passes on what he receives from the supplier, be he the manufacturer or the distributor. Under the circumstance, it is difficult to conclude that sub-clause (v) of Section 65(105) (zzzze) would apply.

As regards last sub-clause (vi) dealing with right to use software downloaded electronically, is concerned, the plain language itself shows that in order to be taxed, the person must acquire the right to use the software supplied electronically. This sub-clause clearly applies to an end user who acquires such right. In other words, the purchaser of such software, would become an assessee, if the software were delivered electronically from abroad.

7.Software delivered over Internet not yet covered b VAT/ST Acts

In Tata Consultancy decision, distribution of software over Internet was not as issue to be determined, nor any argument advanced on this issue before the Supreme Court. That decision would not help in deciding whether software downloaded via Internet would be chargeable to VAT.

 At present, neither CST Act, nor VAT Act provides for charging VAT/CST on transfer of right to use software through Internet. Hitherto, taxability of software has always been related to delivery by physical media such as CDs, hard dise, floppy discs, pen drives and the like. In the absence of explicit provisions of law bringing software delivered through Internet to tax, it is possible to contend that it is in the nature of service, specifically covered by the Service tax law and not covered by VAT. It is well settled law that provisions requiring charge of tax must be construed strictly and any ambiguity must be construed in favour of the assessee and against the Revenue. The Supreme Court in ITO v. T. S. Devinatha Nadar, observed thus:

“The language of a statute imposing tax, duty or charge must receive a strict construction in the sense that there is no room for any intendment, and regard must be had to the clear meaning of the words. It is now well settled that if the interpretation of a fiscal enactment is in doubt, the construction most beneficial to the subject should be adopted even if it results in obtaining an advantage to the subject; the subject cannot be taxed unless he comes within the letter of the law and the argument that he falls within the spirit of law cannot avail. If the words of the taxing statute fail, so must the tax.” (Para 24 to 30, ibid).

In fact, the Supreme Court goes on in this vein for next four paragraphs relying extensively on the decisions of the Judicial Committee of Privy Council, British courts and its own earlier decisions. The law stated herein has remained undisturbed, and has been consistently followed by all the courts and the tribunals, including the Supreme Court itself.

For this reason also, in the absence of explicit provision to charge Internet delivery of software to tax, or to treat the software delivered over Internet as “goods” as defined in the VAT Acts, or the CST Act, an assessee would be justified in excluding this part of turnover from the charge of VAT/CST.

8. Supply of software and service by units in the SEZs:

There is sometimes, a mistaken notion that SEZs are tax havens. They are not, at lest not for the benefit for persons in the DTA who receive the goods and services from SEZ units. Section 26(a) exempts charge of customs duty on the goods or services imported into, or services provided in a SEZ or to a SEZ Unit. Similarly, clause (e) ibid, exempts Service tax ion taxable services provided to a developer or a Unit. No doubt, clause (b) ibid exempts goods and services exported from or provided from a SEZ or by a Unit. As far as DTA clearances are concerned Section 30(a) provides for charge of customs duties on the goods removed from a SEZ to the DTA. But, there is no whisper about services provided from SEZ to DTA. The significance of these provisions is that is customized or packaged software is cleared to the DTA; the SEZ is bound to charge the customs duties, which has to be borne by the DTA purchaser. In the absence of similar provision in respect of services, an output service provider situated in the SEZ has to charge Service tax also. Since this is not a case of service being provided from abroad, the service provider, i,e, the SEZ unit itself has to become the assessee, though it is supposed to be governed only by the SEZ Act, 2005. This is one of the significant points on which the Service tax law is not in harmony with the SEZ Scheme.

9. Conclusion:

This article is not meant to be the last word on the taxability of software under the Indian Idirect Taxes, nor can I claim to be throughly familiar with the operations of software sector. In this article, an attempt has been made to consolidate all the significant aspects of idirect tax laws applicable to software and software services. Further debate by the learned readers would help clarufy the ambiguities.

January, 2009