Last week, the Supreme Court pronounced a landmark ruling in the case of Oracle India holding that the process of duplication of software from master copy tantamount to ‘manufacture’. The Apex court allowed Oracle much awaited relief with respect to a tax holiday claim available for new undertakings engaged in manufacture and processing of articles and things.
The facts suggest that Oracle India, a wholly owned subsidiary of Oracle USA, imported master copies of the software for duplication as permitted under the then policy of the Indian Government. Oracle India paid a lump sum consideration for import of master copies and in addition, a royalty of 30 per cent on the published price. Though, the retail price is invariably lower than the published price, royalty computation on the published price was an intended DOT and FIPB objective to allow higher royalties (to software companies) in an era where there were regulatory constraints on royalty out go. The policy was hailed by the industry until the taxman pulled the sledge hammer from its tool box by disallowing tax incentive on duplication activity. Oracle achieved success at the Tax Tribunal which was later affirmed by the Delhi High court level though, the Revenue Department continued to pursue an appeal before the apex court.
Relying on its earlier rulings in the case of TCS Ltd (under Sales tax law) and Gramophone Ltd’s case (under Central Excise laws), the apex court upheld the High Court’s order and ruled that the process of copying the software on blank discs is indeed ‘manufacture’.
Definition of ‘manufacture’ has been controversial!
Several provisions of the Act link tax incentives to an undertaking engaged in ‘manufacture’ or ‘processing’ of articles or things. However, absence of a precise definition under such incentive provisions had led to judicial controversy on what constitutes ‘manufacture’ or ‘processing’. ‘Manufacture’ has been defined under the Central Excise law as ‘transformation of a substance into a new commercial commodity known as distinct and separate commodity having its own character use and name, whether by one or several processes’. The inclusive definition under the Excise law have been imported by the Courts in supporting judicial views in deciding eligibility for tax incentive.
In the context of Income-tax law, the broad tests for a process to qualify as ‘manufacture’ were laid down first by the apex Court in DCM’s case wherein it was held that ‘manufacture’ is generally understood to mean ‘bringing some change in a substance’ and not merely ‘to produce some change in a substance’. The Court also quoted a passage from ‘Parliamentary Edition of words and Phrases’, ‘Manufacture implies a change, but not every change is a manufacture……….. But something more is necessary and there must be a transformation’. Later the apex Court reiterated these principles in P C Cherian’s case and held that to qualify as manufacture, there should be a complete transformation of the old substance to produce a commercially different article.
Interestingly, in Gramophone’s case, the debate was whether recording of audio cassettes on duplicating music systems amount to manufacture. The court took the view that a blank audio cassette is distinct & different from a pre-recorded audio cassette and the two have different use and name.
Court thinking out of the box !
Though, in Oracle’s case, the court could have merely followed its earlier principles, it took pains in understanding the process of software duplication. After all, duplication of music is akin to duplication of software from a legal principles stand point. In an unusual court proceeding, Oracle representatives were granted permission to explain the software duplication process, international precedents etc. in an open court proceeding.
On such delicate examination, the court not just concluded that duplication is manufacture, it observed that the Revenue should study the actual process undertaken by the tax payer where a unique issue of this nature arises. This indeed is an extremely welcome observation since in my view, most conflicts arise as a result of tax administration’s failure to recognise and appreciate the process and technological nuances of the tax payer’s business.
Recent jurisprudence – liberal
The judiciary have taken a liberal interpretation of ‘manufacture’ in the context of incentive provisions and has held that the process of bringing into existence a distinct article or product would qualify as ‘manufacture’, even though the original article may not have undergone a complete transformation.
In the middle of December last year, the Court took a similar view in Arihant Tiles case which was engaged in the business of converting marble blocks into slabs and tiles, thereafter polishing and selling them in slabs.
The Court, holding that ‘production’ is a wider term than manufacture, observed that the process of cutting marble block in tiles is beyond manufacture and the said process has resulted in a new product coming into existence. Further, if the activity was not held to be ‘manufacture’, it would have serious Revenue consequences as the taxpayer would plead it is not liable to pay excise duty & sales tax.
Amendment in Finance Act, 2009
The Finance Act 2009 has sought to partly bury the controversy by introducing the definition of ‘manufacture’ to provide that ‘manufacture’ shall mean: … a change in a non-living physical object or article or thing, resulting in transformation of the object or article, or thing into a new and distinct object or article or thing having a different name, character and use, or bringing into existence of a new object or article or thing with a different chemical composition or integral structure’
Though, the definition under the Act differs from the Central Excise law and state VAT laws, yet it underpins the principles and judicial views upheld by Courts. It is anticipated that the new definition would lead to clarity and substantially put an end to the controversy.
Decision is a relief to IT industry
Undoubtedly, it’s a big relief to the industry which has been fighting a battle with the Tax administration on several fronts. Oracle decision also appears in consonance with the amended definition of ‘manufacture’, which highlights the importance of ‘processing’ an article to bring into existence a distinct article and does not over-emphasise need for a complete transformation of substance under process.
Oracle principles should result in reduced litigation; yet I suspect that interpretation of other terms of the same specie such as ‘processing’ or ‘production’ would continue to be litigated.
More importantly, I see that the ongoing controversy on software (whether sale of good or service) characterisation would be the next battle for the industry, though, I see a silver lining in the principles of the recent case furthering the cause of industry. If Software is a goods or articles, duplication of software is manufacture, I don’t see a rationale for it being characterised as Royalty – it should logically be goods and not services!
(The author is a Partner with BMR Advisors and views are entirely personal)
