Service Tax - Time for revamp from ground up

There are multiple indirect taxes in India, which apply to different transactions with different bases, rates and taxing authorities. These taxes are regarded as onerous and burdensome by the industry and trade - more due to their complexity than due to the tax cost imposed on transactions and businesses.

The government has tried hard to simplify these taxes in the past few years. Though there has been considerable simplification in customs and excise duties, the industry continues to grapple with the complex and ambiguous service tax provisions. Litigation abounds in this sphere.

Unlike sales tax, excise duty and customs duty, which apply on all instances of sales, manufacture or import of goods, respectively, with some exemptions, service tax is applicable to only a specified list of taxable services. This list was introduced in 1994 with three categories of taxable services and has been widened to include 81 services. The disputes that arise in service tax are primarily in relation to the coverage and scope of these identified 81 taxable services.

In certain cases, a service is not clearly and squarely covered under any taxable category but is possibly referred to in a tangential manner with respect to a taxable service. While the industry argues that the service is not taxable, the revenue contends that the scope of the category is wide enough to include that service.

Similarly, there are certain services that are overlapping in nature. Disputes arise when one of them is taxable and the other is exempt. While the tax payer contends that the service falls in the category which is exempt, the revenue argues that it should get covered in the taxable category.

In the above situations, service providers usually prefer to be conservative and subject their services to service tax. Their clients and customers, however, refuse to reimburse the service tax portion of the invoice citing legal advice they have received saying it is not taxable.

An example of an industry facing all these perplexities is the computer software industry.

The government's intent seems to be to exempt all kinds of indirect taxes in relation to software. Accordingly, while excise duty is exempt on all kinds of software, no customs duty is applicable on information technology software. The service of writing software would normally be taxed as services of a 'consulting engineer'. However, services related to 'computer software engineering' have been excluded from the ambit of service tax under the taxable category of a consulting engineer's services.

Additionally, 'information technology services' have been excluded from the category of business auxiliary services. Information technology service has been defined as 'any service in relation to designing, developing or maintaining of computer software or computerised data processing or system networking or any other service primarily in relation to operation of computer systems'. Further, services provided by a call centre are exempt including 'assistance, help or information' provided by call centres.

However, there are categories of taxable services that accidentally overlap the services excluded from the service tax net: 'technical testing and analysis services' and 'maintenance or repair services'.

If a software services company has a contract to test a new software release, is it providing technical testing and analysis services (taxable) or consulting engineer's services in relation to computer software engineering (not taxable)?

Further, it is not in all cases that the testing services can be identified separately. Only when testing is undertaken by a different company from the one developing a software product or solution or separate contracts are entered with the same company for development and testing of the software that the testing activity would have a separate identity. Otherwise, in all cases, developed software is always extensively tested before release.

In cases where testing is not a separate activity, should consideration for the testing scope of work be severed and offered for service tax? Or would the same be considered a part of software development activity and thus not liable to service tax?

Even if testing of software is treated as a taxable service, any attempt to collect tax from the customer would be resisted since the customer would be either a software product company that is engaged in selling software or a software developer for a client. In the first case, the customer would be engaged in a sale of goods, not subject to service tax, and in the second case a service provider who is a non-taxable consulting engineer. In both cases, the customer of the software testing company would not be able to utilise credit of the service tax paid by the software testing company and thus would oppose the levy. Hence, it becomes imperative for a testing company to determine whether the service is liable to service to or not.

Similar to testing services, there are ambiguities regarding the applicability of service tax in relation to software maintenance contracts.

Service tax is applicable to maintenance or repair of 'goods' and 'equipment'. There has been historical dispute regarding the applicability of service tax to maintenance or repair of software on the grounds whether the same is 'goods'. For about a year (from August 21, 2003 to July 9, 2004), maintenance or repairs of computer systems was exempt from service tax. Further, it was clarified by the service tax department that since software is not goods, maintenance or repair of the same shall not be liable to service tax.

Recently, the dispute as to whether software is 'goods' or not was considered by the Supreme Court. The apex court held that while canned (off-the-shelf) software is goods, even uncanned (customised) software could be treated as goods if supplied on a tangible media.

The service tax department acted on the above pronouncement, and clarified that maintenance or repair of any software, whether canned or uncanned, would be covered within the scope of maintenance or repair services.

The department has since been issuing show-cause notices to the software industry asking them to pay service tax on their annual maintenance contracts. However, all software services are provided by software engineers. Therefore, the question that arises again is whether a software maintenance contract should be taxed under maintenance or repairs of goods or be considered non-taxable as consulting engineer's services in relation to computer software engineering?

Finally, taxing software maintenance contracts under maintenance or repair services betrays a lack of understanding of how the industry operates.

Typically, in case of software product companies, under annual maintenance contracts, the customer is provided upgrades to the software. This is a sale of goods and not a service. Customers are also provided help desk support via telephone or email. This is advisory work (consulting engineer's services in relation to software) and not maintenance nor repairs. If the service is provided by a call centre, it could also get covered by the call centre exemption mentioned earlier. If there are bugs that are discovered in the software, these are typically rectified by providing 'patches' which are executable programs that are supplied through CDs or that can be downloaded from the product company's website. This would also seem to be a sale of goods rather than a service.

Admittedly, in the software services industry, a contract to maintain customised software would have some work done on the software that could reasonably be termed as repairs. However, even in this case, there would be a large amount of advisory services that would be provided. That portion should be considered non-taxable as it would be consulting engineer's service in relation to computer software. However, the relative value of the advisory services provided and the repairs performed during the year would be almost impossible to determine if one were to take the approach of taxing the repairs and exempting the consulting and advisory services.

Understandably, the revenue is unaware of these intricacies of how the industry operates. Therefore, there is currently a broad-brush attempt to levy service tax on all annual maintenance contracts.

Even if it is clear what should be taxed and what should be exempt, what is the philosophy behind not taxing the main activity of writing software, but taxing closely related activities? Therefore, while the legislative intent of the government seems clearly to not tax various services related to software, the tax collection arm of the same government is aggressively pursuing various players in the industry contending that they are in default of their service tax obligations as they provide 'technical testing and analysis services' or 'maintenance or repair services'.

There are numerous such issues in other industries as well including the oil and gas industry, the construction industry, the telecom industry... the list goes on.

The root cause of complexity in the service tax regime is the selective application of the tax to specified services and ambiguities regarding coverage of the identified categories.

This requires a complete revamp of service tax from ground up. Tinkering and patchwork will not solve the problem.

(Courtesy: Ernst & Young)