The Software Tax Saga

The idea of 'duality' has
deep roots in Indian
philosophy-where God is supposed be dvaita as well as advaita. But such duality
is also visible in modern science.

In science, debate over the nature of light and matter dates back to the
1600s, when various scientists proposed competing theories of light. It was
through the work of Albert Einstein and many others that current scientific
theory holds that all particles also have a wave nature. Light too has a dual
nature, ie it is a wave as well as a particle. When light hits a photosensitive
material it generates electricity due to its particle nature.

Our government too has discovered another duality-in fact a new 'tri-ality'
(for want of a better word let's say this) about packaged software. It has found
that packaged software is three different things depending on how you look at
it. If you look at it from the view of state level taxes-it is classified as
'goods'. If you look at it from indirect taxes point of view it's a service. And
if you look at it from direct taxes (income tax) point of view it's a royalty
payment made to the software developer.

You will say-so what? After all, in India we have more than 5,500 laws and
more than 100 taxes. We are paying so many taxes. And double taxation is not
new.

Of course, theoretically double taxation should not be there and could be
corrected. But, for this, one needs to file a writ petition in the High Court or
Supreme Court or approach some political party for the correction in the
law/act. Another alternative is, if you are able to put up with it, pay double
tax. After all, it is not paid from the reseller's pocket. It's the customer who
is paying, then what's the big issue?

A closer look

If you look at it from state's point of view (for the purpose of value added
tax (VAT) or sales tax)-packaged software license comes under 'goods' without a
doubt. There are a number of court cases and it's a well-settled legal view that
packaged software license is considered 'goods' and attracts four percent VAT.
It is fine, up to this point.

But, if you look at it from the Center's point of view (for the purpose of
service tax) packaged software license is an IT service. The government woke up
to this reality as late as February 2008 and introduced a new service in the
list of taxable services during the 2008 budget. With effect from May 15, 2008
all IT services became taxable under service tax (ST).

So, all companies involved in the business of selling packaged software
licenses started charging service tax at 12.36 percent (inclusive of three
percent Education Cess). And then to give its due to the state they are charging
VAT at four percent on the total of license fee and service tax.

Everybody thought-that's it. We can manage it, ie, customer will understand
somehow that if duality is there in religion and science it's not difficult to
accept it in government taxes as well. More or less, most customers came to
accept the fact that they have to pay double tax-although it's against the
principal of double taxation.

Of course, we have heard that there are some software stalwarts like a large
software company from Tata Group, which refuses to accept such dual nature of
software because they deal with software licenses day-in day-out; and who would
know it better? So we understand that they have stopped purchasing packaged
software products with double tax!! Of course, one may ask-how would they manage
without purchasing any packaged software? Simple, they use open source software,
or they develop it in-house. After all they have all the resources!!

Any way, that's besides the point. There is another twist in the story. In
other words, the plot thickens now. Don't undermine our government's ability to
create situations, which would put even Hollywood film stories to shame!

The story goes like this-software dealers started billing dual tax to
customers in the routine manner (after fixing their invoicing software, of
course)-thinking that that's it. But when they got payment for the packaged
software licenses from the customer, they got a rude shock. They got cheques
worth only
89 percent of the invoice amount from customers. Upon inquiry they found that
the customer had deducted 11.33 percent as tax deducted at source (TDS) aka-income
tax, from the payment.

You would say 'big deal'-the dealers would pay that much tax less while
making advance tax payment. Theoretically yes, but practically no. Why?

A typical software reseller makes about two to four percent gross margin on
the sale of packaged software license. So, he purchases it at say Rs 96, sells
it at for about Rs 100-considering the best margin case. He bills it to
customers at Rs 117 (100 plus 12.36 percent ST and four percent VAT). And the
customer pays
him Rs 104 after deducting
Rs 13 towards TDS. Reseller pays Rs 17 to government towards ST and VAT-so the
reseller is left with Rs 87 in hand. So, he has lost
Rs 9 per 96 ie, he has lost nine percent from his cash flow. So, tell me, after
how many such transactions will he be left with no cash flow? You need to be
'panchvi pass' to answer this simple question.

So, ask the customers to pay nine plus four ie, 13 percent margin. But that's
an unlucky number. So let's earn 15 percent gross margin. After all-resellers
also need to make money sometimes. So, overnight the price of packaged software
license went northwards by
15 percent. Of course, this increase was over and above the 13 percent extra
that customers shelled out towards ST and VAT. So, in July 2008 all packaged
software licenses became dearer by 28 percent.

End of story? The plot thickens now. Some software distributors figured that
if they paid 12 percent CVD (aka customs duty) while importing packaged software
license then suddenly 'IT software' turns from 'service' to 'goods'. So, when 12
percent CVD is paid only four percent VAT would be payable; and no service tax!
Wow, it meant no TDS also. Great solution!

So far, before this happened, packaged software license was imported in to
India by payment of 'nil' customs duty. Whether software was imported as a paper
license or software download from Internet did not matter. And this was
more-or-less in line with GOI 's commitment to WTO in 1996 that by June 1, 2000,
India will reduce customs duty to zero percent for 94 IT related items; and
other IT items would have zero duty by January 1, 2005.

So, at least for some time-software resellers thought that by payment of 12
percent CVD the problem of ST and TDS was resolved. But no, our service tax
people are smart. They are not going to give up that easily. They have every
right to ask each reseller to pay up ST because they have already tasted the
'blood' in this few months. So, software reseller community is keeping its
fingers crossed. They are hoping against all odds that service tax people will
be content with the revenue they have raked in so far in this two months.

But the matter is not over yet. In January 2008 stories had appeared in press
that Microsoft was asked to make payment of about Rs 700 to 800 crore towards
income tax. Also, in July 2008 there was a Supreme Court judgment in a case
involving software imported by Airport Authority of India (AAI) from a US
supplier. This was in spite of the wordings of the license agreement, which
stated categorically that it was 'a grant of license to use the software'. If
one reads the Microsoft case judgment-it also seems to say the same thing ie,
payment received by Microsoft-although it was through a well-laid distribution
network-was in fact an income towards 'royalty' payment; and not a 'business
profit'.

So, what does this view from income tax mean to software resellers? It means
that customers will keep deducting TDS from their invoices because customers are
making payment towards royalty. So last I have heard is that all software
resellers are queuing up outside the income tax (TDS) department to apply for
the certificate under Section 197(1) (See Rule 28AA) relating to deduction of
tax ie, lower TDS.

One question is still unanswered. When a customer purchases computer software
license, what will this payment be classified as? Will it be a revenue expense,
royalty payment or a fee towards a professional service?

Don't break your head. Just put this question in the next year's Chartered
Accountant's (CA) exam. We have heard that only two percent candidates pass the
final CA exam. But if this question is included in the exam then no one will
pass next year's CA exam. You bet.

(The author is Director of Blue Chip Computers, Mumbai)