Taxation of software: ambiguities unresolved

In India, the taxation of software has been the subject of constant dispute and legislative review. One such issue is the unresolved overlap between value added tax (VAT) levied by the state governments on transactions entailing sale of goods, and service tax levied by the centre on the supply of software.

A recent view

In Infotech Software Dealers Association v UOI, Madras High Court expressed its views about this duality of taxes. This case pertains to the levy of service tax on supply of shrink wrap software under the information technology software service (ITSS), a taxing entry introduced by the Finance Act, 2008. This taxing entry seeks to levy service tax on the supply of customized software alone, with effect from 16 May 2008.

The members of Infotech Software Dealers Association (ISODA) resell software as shrink wrap software, through multiple user software licences or internet downloads. They enter into master end user licence agreements (master EULA) with the developers of software, and end user licence agreements (EULA) with their customers. Software supplied under EULA, whereby the end user was given a limited right to use the software was the subject matter of the detailed findings of the court. In view of the Supreme Court decision in Tata Consultancy Services v State of AP, all such transactions attract VAT and sales tax.

Through this case, ISODA challenged the levy of service tax on software, on the basis that was against the Indian constitution and that since software constitutes goods, the state government and not the central government was competent to tax it.

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The issues for consideration before the high court were: (i) whether software is goods; (ii) whether the supply of software under EULA constitutes a sale or service; and (iii) whether the central government can levy service tax on software under ITSS?

In this context, Madras High Court while relying on the decisions in Tata Consultancy Services v State of Andhra Pradesh decided by the Supreme Court, and Antrix Corporation Ltd v ACCT decided by Karnataka High Court, held that “goods” as defined by article 366(12) of the Indian constitution includes both tangible and intangible property. The test to identify goods is that it must be possible to abstract, consume and use them and also transmit, deliver, store and possess them. Since software fulfils these prerequisites, it was held to constitute “goods”.

Sale or service?

While examining whether the supply of software under a EULA constitutes a sale or service, the court, taking into account specific clauses of EULA, observed that the developer or the creator retains the copyright of the software. As such what is transferred to the distributors is only a limited right to use the copyrighted software.

The high court held that when a transaction takes place between the members of ISODA and its customers, there is no sale of software but only the contents of the data stored in the software are transmitted, which would constitute a service. To bring a transaction under the ambit of article 366(29A)(d) of the Indian constitution, there must be a transfer of the right to use the goods. When the goods are not transferred, the question of deeming the sale of goods does not arise and in that sense, the transaction would be a service alone and not sale.

The court reiterated the importance attached to the nature of a transaction in determining its taxability, while upholding the sanctity of the dominant intention test laid down by the Supreme Court in Bharat Sanchar Nigam Ltd v UOI to determine whether a transaction is a sale or a service.

Parliament levying service tax?

As regards the competency of parliament to levy service tax under the ITSS, it was decided in the affirmative. It was also held that the question of whether a transaction is a sale or service depends on the facts of each case and that the constitutionality of the levy cannot be challenged on this basis alone. Accordingly, the court took note of the provisions of the master EULA and the EULA and concluded that the nature of the transaction is a service and would therefore attract service tax.

While packaged software has been held to be goods and accordingly liable to VAT and sales tax, it must be noted that all software whether packaged or customized is licensed to the end user. The installation of the software is possible only after the end user accepts the terms and conditions of the licence. As such, all supply of software would be a service since it is licensed to the end user. This however contradicts the first part of the decision where software has been held to be goods.

Given this ambiguity, it is critical that the proposed goods and service tax (GST) incorporates special rules in relation to the taxation of software supplies. As and when GST is implemented, these rules need to be uniformly and consistently applied, more so since in the initial three years both goods and services would attract different rates of tax.

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Economic Laws Practice is a full service law firm headquartered in Mumbai and has offices in New Delhi, Pune and Ahmedabad. The authors can be reached at gauravbhandari@elp-in.com and anuradhamohanty@elp-in.com.