De-Coding Software Taxation

The Indian Government has issued a notification on June 13, 2012 (notification), pursuant to which tax will no longer be deducted on multi-level software payments made to a resident, subject to certain conditions discussed below. The new provision will come into force from July 1, 2012.

However, before we plunge into the details of this new change and its impact, it is necessary to understand the software taxation and its evolution over the years. The taxation of software primarily depends on the treatment of software as 'goods' or 'services', as the indirect tax treatment is different for the two. As a starting point, the industry relies on the Supreme Court ruling on a TCS sales tax dispute in 2005, which brought out principles on when software shall be treated as 'goods'.

In May 2008, the center treated licensing of 'electronic software' as 'services' by levying service tax on the same. This lead to a scenario wherein the industry now faced the imposition of dual levies on 'electronic download of software', one where it became treated as goods due to the TCS judgment (2005), which made the company's liable to VAT/CST and the service tax law as it is being treated as service.

The new laws in place treated licenses for 'packaged software' as a service, thereby introducing a service tax levy on packaged software, which was till such time only subjected to customs/excise duty. Due to efforts of multiple entities like MNCs, association and others, the government had to work out a solution to resolve this 'dual levy' of taxes. The government flipped-flopped on the levy of customs/excise and service tax on packaged software over the years, trying to achieve an 'ideal' system to tax all possible transactions relating to software only once.

Pavan Sanghvi of Technofirm Software says, "With changes in taxation policy; in terms of finance it will definitely help the channel community to get relaxation, as there will be no due with the government." Furthermore Sanghvi says, "But at the same time, one has to be very much careful in terms of finance. We need to show the first importers PAN number who has paid withholding tax to the government. So on every invoice we need to give the declaration using PAN number. TDS is already paid, so requested not to deduct the TDS against the invoice. One has to be more accurate on the same. Any type of mistakes will create problems in the whole channel and allow the laymen to raise the query and our account may come into scrutiny."

S M Lodha of Sujata Computers says, "Distribution industry for software is already running haywire, and government is just playing with this industry to get maximum chunk out of it. Now they have added word royalty to software, it clearly indicates the intention of govt in which direction they are thinking." He further adds "Basically there is difference in software making and software distribution. Government has placed both in the same pane. It will be very risky to do business without knowing the hidden meaning of the laws."

This solution, however, did not resolve the issue but resulted in creating other pain points.

BACKGROUNDER
The taxation of software has been a longstanding matter of debate and dispute. It seems the challenge of double taxation has been there since ages. To understand the implications of these laws, it is therefore very important to understand the background and history of the policies and its evolution. The Indian tax laws, until recently, were capable of varying interpretations on characterization of income from software payments in view of the conflicting decisions of the various courts on whether or not payment for use of software is royalty.

In recent developments, the Finance Act, 2012 clarified the above issues by inserting explanations to section 9 (i) (vi) of the Income Tax Act, 1961 (IT Act) with retrospective effect from June 1, 1976 stating that the consideration for use or right to use of computer software is royalty. Although, the Finance Act, 2012 cleared the ambiguities surrounding the characterization of software payments, under the existent provisions, withholding tax on royalty payments is applicable at the rate of 10% without any exceptions. In case of multi- level software distribution, this would mean that the withholding tax would be applicable at every level of the software distribution chain for eg from a non-resident software owner to a resident distributor, from a resident distributor to the resident retailer and finally to the end consumer, resulting in multi-level taxation on such payments.
The government has pursuant to the powers given under section 197A (IF) notified that tax is not required to be deducted at each level for acquisition of software if the stipulated conditions are complied with.

Paresh Shah, one of the members of ISODA adds, "Today, in the sale of software, we make margins as low as 5-6%, due to the 10% TDS at every level. My entire working capital is getting slaughtered every year and we get tax return after 3 years. In this current scenario, our funds are getting locked for long durations, and hence we are crossing our fingers and praying for the notification to work in our favor."

Before getting into further details, it is important to understand the entire gamut of software related taxes applicable in the country. Over the past 15 years, the software industry has exploded into a high growth and productive business. Traditionally, sales tax has applied only to the sale of tangible personal property. Thus, the sale of services is a transaction exempt from sales taxation. Similarly, sales of non-tangible goods are also exempt from taxation.

TAXATION OF SOFTWARE
Bharat Goenka of Tally Solutions says, "Any software which is delivered in non-physical form-that is, delivered electronically-comes under the ambit of service tax instead of excise duty. Second scenario of delivering upgrades electronically-since no new 'license' is being transferred, would attract only Service Tax and not VAT." He further adds that AMC also would attract Service Tax and not VAT for the same reasons; since no new license is being transferred. Training and implementation are pure services, and would attract only Service Tax. Basically, only when a License is sold, does VAT come into the picture. The rest of all scenarios are between Excise Duty (if goods), and Service Tax (if services). The 'ambiguity' of 'goods being delivered electronically' is specifically called out and covered under Service Tax.

There has been ambiguity, or to put it mildly, uncertainty with regards to taxation of software for sales tax purpose. One of the key reasons for this scenario is lack of rules and regulations, the way in which a particular software has be to be treated. The classification has to be understood to get a hang on the applicable taxes and so is the nature of tax whether it is tangible or not. So how does one define tangible personal property.

To put it in definable term, tangible personal property means personal property which may be seen, weighed, measured, felt, or touched or is in any other manner perceptible to the senses. It does refer to stocks, bonds, notes, insurance, or other obligations or securities. Historically, the statutory difference between 'tangible' and 'intangible' has been relatively easy to apply in the sales tax arena. However, over the years, advancement in technology and in the software, has only diluted the line between tangible and intangible nature of the product.

Computer software can be easily termed as a technology that defies easy classification. The complexity arises as the industry does not have a clear definition about the term 'software' and furthermore to add to it is the problem that the information residing in a 'software' can be transmitted through several mediums. Like for example, the information can be delivered on a computer through disc, digital transmission over telephone lines or cables, through direct input by an individual, or through a magnetic tape transfer (not so commonly used). The law in this area became confused early in its development. Initially, taxpayers sought to characterize software as tangible personal property in order to claim an investment tax credit for expenditures on software for federal income tax purposes.

In the early years, taxpayers contesting sales tax liability utilized precedent to argue successfully that software was not subject to sales tax because the intangible information, not the tangible media, was actually what was being sold. As the time progressed, the software began to be sold to general public in packages, which led to the scenario wherein authorities now consider software as a tangible personal property. This has resulted in all chaos that the industry is in today.

POINTERS TO BE NOTED
With all the information available with regards to taxation, the companies now have to determine whether the purchase is exempted from sales tax with regards to its nature. For example, if the deployment is at non-profit organization, governmental institutions and schools, these are exempted from tax.

Another pointer is to identify and differentiate between various software. There are guidelines available which are to be referred for assistance in identifying whether writing of software fits within the personal service exemption. In this regard, companies which write software for a specific customer clearly provide personal services which are not subject to the tax. In such cases, the purchaser often acquires title to the copyright for the specific application written by the consultant. On the other hand, if company retains the copyright to the software, the services for the first customer may be exempt as a personal service transaction, but the license of the software to a second customer with slight modifications on the original software may be subject to sales tax.

One important factor which now has to be understood is the difference in charges between purely selling software and consulting services. The sale of software often involves uniform pre-written software which is sold to the customer like in case of box selling of anti-virus products. While on the other side, substantial consulting services are generally involved in applications which may exempt from sales tax. In fact, it is not uncommon that the cost of the standardized software is less than the charges for overall services provided to the customer. In these circumstances, it will be important to document and allocate the costs between the software and the consulting services. As this will help the companies to manage taxes with ease and effectiveness. This will clarify the scenarios wherein assuming the transfer of the software may be subject to sales tax, the consulting services should be exempt from tax as personal service transactions.

With the advent of internet and wide usage of the medium has resulted in extensive usage of this medium for transmission of software. With some customers, it may be possible to transmit the software electronically without the use of tangible media. There is further clarification required in this area with regards to taxes applicable as per the medium used.
Another issue of great interest and concern to the community is the taxation of the capitalized cost of computer software with regards to proportion to the estimated value of the goods taxed tax purposes, which can be also called ad-valorem tax purpose.

Taxation for ad-valorem taxes differs from state to state. In some states, all tangible personal property is subject to ad-valorem tax but intangible property is not. In other states, both tangible and intangible personal property are subject to tax. Thus, the question arises whether the software is tangible or intangible property. If the software is utilized in the state where only tangible personal property is taxable but intangibles are not taxable, the question arises as to whether software will be categorized as a taxable tangible personal property or a non-taxable intangible personal property. In states where both tangible and intangible personal properties are taxable, the classification nonetheless remains important because in many states intangible property is taxed at a lower or different rate base than tangible personal property.

This also leads to the subject of taxation of off the shelf software products. There is an argument that since the software can (and does) exist separately from the physical media, that it is not tangible personal property. Alternatively, companies may contend that such inventories should only be valued based upon the value of the actual media on which embodied. This fact cannot be negated and it can be directly compared with the likes of DVDs, CDs and others. If such software is tangible personal property, under appropriate circumstances such software inventory may qualify for a Freeport exemption.

The biggest challenge is understanding the taxation of software as intangible. However to put it in a simple way, there different ways of addressing this. One wherein there is taxation of all property, both tangible and intangible, secondly, taxation of all intangible personal property and taxation of only certain specific category of tangible property.

Following this is the challenge to address it with regards to taxability of other software, especially with regards to capitalized development costs. Most states have addressed this issue and have concluded that software at least unbundled software is not tangible personal property for ad-valorem tax purposes and therefore is generally not taxable. However, in states where intangible property is separately taxable, the issue will remain.

WHERE ARE WE TODAY
For import of packaged software (in media form), with an intention for retail sale, service tax is exempted if customs duty is remitted on 85% of the retail price of the software. On the other hand, if it is not for retail sale, customs duty is exempted if service tax is discharged by the distribution chain. This seemed like a feasible option, however, the companies at the time of import are mostly not able to determine the endues of software leading to dubiety.
Now, the existing scenario is such that in any of the models for packaged software (ie, with media or without media), the tax cost on account of the central levies is almost 12% of the retail sale price, apart from the state levy of VAT at around 5%. This leads to a situation, wherein if companies are not able to get their tax positions right, the additional tax demand of 12% that comes with interest and penalty will take away the entire profits earned by the software companies in the earlier years.

The new introduced changes that can also be called the negative list regime, which comes into force from July 1, the definition of 'service' specifically excludes an activity that constitutes 'transfer of title in goods' or 'transfer of right to use goods'. Therefore, upon such specific exclusion of transactions involving 'sale' or 'right to use' goods, the sale/right to use software (whether packaged or electronic) should get excluded from the definition of 'service' itself.

Going ahead, once these changes are brought into effect, the levy of the service tax (VAT) on software will be determined by whether there is a transfer of the right to use such technology software or whether there is a mere permission granted for the use of such software, without any transfer of control and possession thereof. This results in a scenario wherein the companies will have to effectively determine and mention each transaction while identifying correctly whether the software is to be treated as goods or services. This might result in continuing double taxation or on the other hand, resolve the problem for the company.

However, there are miles to be covered before this industry will have a quality ecosystem in place with regards to taxation. But all initiatives are to be welcomed and should be taking it from there to resolve the next issue.

The impact of the new notification will be analyzed in the next issue of DQ Channels.