Recently, the Madras High Court was called upon to adjudicate if computer software provided along with an End User Licence Agreement could be characterised as ‘sale of goods’ or ‘service’. The question before the Court was whether the Parliament has the legislative competence to levy service tax on such transaction.
The position of Software Dealers Association, who filed a writ petition, was that software is ‘goods’ and there is no element of ‘service’. Since the right of possession and effective control is transferred (outright) to the purchaser, such transactions are amenable to VAT alone. On the other hand, the Revenue argued that there is no element of sale where standardized software is supplied as it is merely licensed for limited use. Further, there is no question of absolute ownership of software since the user cannot tamper or modify the software and, more importantly, it does not have the right of commercial exploitation.
Amendment in Constitutional provisions The controversy on dual Indirect tax levy owes its origin to the Constitutional amendment of Article 366 with regard to definition of ’tax on sale of goods’. Prior to the 46th Amendment (of 1982), composite contracts such as works contracts and hire-purchase agreements were not liable to sales tax or VAT as it is understood now. The locus classicus holding the field was the judgement of the Supreme Court in Gannon Dunkerley’s case which specified three primary conditions governing sale of goods - (i) an agreement to transfer title in goods, (ii) supported by consideration, and (iii) an actual transfer of title. In the absence of any one of the three elements, it cannot be construed as sale of goods.
This recommendation of the Law Commission pursuant to the ruling lead to an amendment. The amendment specifically allowed composite contracts viz works contracts, hire-purchase contracts, etc, by legal fiction to be divisible contracts where the sale of goods element can be isolated and subjected to sales tax /VAT. Indian states amended their laws after 82 to levy sales tax /VAT on such transactions.
Arrival of Service Tax on Computer Software
In 1994, service tax on certain services was introduced by the Parliament in exercise of its residuary powers under the Seventh Schedule to the Constitution. The Finance Act, 2008 further introduced levy of service tax on “Information technology software service”.
Legislative development paved way for levy of service tax on software transactions and triggered the debate whether both VAT and service tax can be levied on such transactions. Income characterisation in software transactions is vexed!
The issue whether the supply of a copy of software results in a sale or is merely a right to use resulting in corresponding income being characterised as royalty has simultaneously been controversial for Income tax purposes.
The issue being a thin dividing line between consideration for use /right to use the ‘copyright‘ in a computer program and the consideration for the copy of the program being purchased outright. Tax administration argues that purchase of a mere copy of the program results in use of the software/
IPR in the program resulting in such payment (to non residents) liable to tax as royalties. However, the Courts have largely taken a view that in the absence of any right in such IP transferred /used, the transaction is merely sale of a copyrighted article.
The moot point being should the mode of delivery of service alter characterisation of income.
Whether one buys a music CD in physical form or downloads via internet should not alter income characterisation. The Commentary on Article 12(3) of the OECD Model Convention dealing with income from sale of software provides that income characterization would depend on nature of the rights the transferee acquires for use and commercial exploitation.
There is no doubt that all forms of packaged or ‘off the shelf’ software is taxed as sale of goods.
Incidentally, in the TCS case, software on a media was held to be ‘goods’ by the Supreme Court, relying on Article 366 of the Constitution and hence, liable to sales tax. Though, the decision was in the context of VAT law, the apex Court’s decision was analysed threadbare by the Bangalore tax tribunal in the case of Samsung Electronics holding that in sale of software program, the incorporeal right to the software is not transferred; instead, it remains with the originator and what is sold is a copy of the software. Though, the Samsung matter recently came up before the Supreme Court on the issue of withholding tax on payments for software, the characterisation issue was not adjudicated.
Last week Mumbai and Delhi tribunals rendered conflicting principles in the case of Tata Communications and Microsoft cases, respectively on software income characterization. Whereas the Mumbai Tribunal ruled that sale of software is akin to sale of goods, the Delhi Tribunal held that grant of license in software results in royalty income. Ironically, both the interpretations have been rendered in the context of India USA treaty. The conflicting decisions are bound to enhance uncertainty for software suppliers.
Do we deserve certainity?
Whether the transaction is for the sale of ‘goods‘ or ’services‘ or for right to use copyright, remains primarily a matter of contract and intention.
What the Tribunals and Court are confronted with is a situation where each contract has to interpreted taking into account the intention of the parties and thereafter determine the characterisation and leviability of tax .
In the absence of unequivocal and consistent views from the judiciary thus far, it is going to be an uphill task for taxpayers to achieve certainty. The Madras High Court in the Software Dealer’s Association case while upholding the constitutional validity of the levy of Service tax on software transactions observed that actual leviability would need to be decided on a transaction to transaction basis. The Supreme Court in the Samsung case remanded the matter back to the tribunal to determine (as a matter of fact) whether the contract was for exploitation of the copyright or a copyrighted product. Last weeks Mumbai and Delhi tax tribunal decisions are conflicting, at least on principles/Practically, most software resellers levy both service tax and value added tax on the value of software licences to avoid controversy. This practice is likely to prevail since neither the legislature nor the Court has laid down specific principles to determine the nature of the transaction. The fact is that income is taxed twice and goes against the grain of the 46th constitutional amendment.
Tax on software is clearly vexed and it seems it would continue to be so for times to come keeping Tax advisers and lawyers busy. I had wished that the law makers had pul-led few leafs from the rec-ommendations of the empowered committee on e-commerce task force way back in 2000; if they did, India could have perhaps avoided some wasteful litigation!
(The author is a Partner with BMR Legal and was assisted by Arijit Prasad and Sumit Singhania; views are entirely personal)
