Software Supply versus Software Service

In Puranas, There is one creature termed as 'Ardha Nari Nateshwar'. We do not know if such creature exists or not, but in 2008, a 'Purna Nari Nateshwar' in form of IT Softwarre has been created as it is both goods and service at one and the same time!


ntroduction of service tax on ‘Information Technology Software service’ has created many issues and problems, which will take years to sort out. A war has commenced on 16-5-2008, between ‘IT software supply’ and ‘IT software service’, between powers of Union to levy tax and powers of State to levy tax, between ‘goods’ and ‘services’, between CBE&C and assessee and between State Vat authorities and dealer.


Unfortunately, this is a one sided war and most obvious loser in the whole game is the hapless assessee/dealer. Other parties have nothing to lose in this game.


In this article, attempt has been made to discus various issues involved and to make sense out of ill conceived and poorly drafted legislation.


1. Statutory provisions
Services relating to information technology have been comprehensively covered vide Finance Act, 2008 w.e.f. 16-5-2008. Various services are covered under different heads of service Statutory provision relating to service tax on Information Technology Software are as follows.
As per section 65(105)(zzzze) to Finance Act, 1994, inserted vide Finance Act, 2008 w.e.f. 16-5-2008, any service provided or to be provided to any person, by any other person in relation to information technology software for use in the course, or furtherance, of business or commerce, including—
development of information technology software.
study, analysis, design and programming of information technology software.
adaptation, upgradation, enhancement, implementation and other similar services related to information technology software.
providing advice, consultancy and assistance on matters related to information technology software, including conducting feasibility studies on implementation of a system, specifications for a database design, guidance and assistance during the startup phase of a new system, specifications to secure a database, advice on proprietary information technology software.
providing the right to use information technology software for commercial exploitation including right to reproduce, distribute and sell information technology software and right to use software components for the creation of and inclusion in other information technology software products.
providing the right to use information technology software supplied electronically.
is a taxable service.


“Information technology software” means any representation of instructions, data, sound or image, including source code and object code, recorded in a machine readable form, and capable of being manipulated or providing interactivity to a user, by means of a computer or an automatic data processing machine or any other device or equipment [section 65(53a) inserted vide Finance Act, 2008 w.e.f. 16-5-2008]


1.1 Departmental clarification
Relevant extracts from CBE&C TRU letter F. No.334/1/2008-TRU dated 29-2-2008 clarifies as follows -
4.1.2 Software consists of carrier medium such as CD, Floppy and coded data. Softwares are categorized as “normal software” and “specific software”. Normalised software is mass market product generally available in packaged form off the shelf in retail outlets. Specific software is tailored to the specific requirement of the customer and is known as customized software.
4.1.3 Packaged software sold off the shelf, being treated as goods, is leviable to excise duty @ 8%. In this budget, it has been increased from 8% to 12% vide notification No. 12/2008-CE dated 01.03.2008.
4.1.4 IT software services provided for use in business or commerce are covered under the scope of the proposed service. Said services provided for use, other than in business or commerce, such as services provided to individuals for personal use, continue to be outside the scope of service tax levy. Service tax paid shall be available as input credit under Cenvat credit Scheme.
4.1.5 Software and upgrades of software are also supplied electronically, known as digital delivery. Taxation is to be neutral and should not depend on forms of delivery. Such supply of IT software electronically shall be covered within the scope of the proposed service.
4.1.6 With the proposed levy on IT software services, information technology related services will get covered comprehensively.


1.2 Basic dilemma in interpretation of the definition of IT Software service
The term used in definition of is ‘including’. It is well settled that the term ‘including’ expands the scope of definition. What is not covered in main part of the definition can get covered in inclusive part of the definition. As regards clauses (ii), (iii) and (iv) of aforesaid definition, there is no ambiguity that these are ‘services’. The ambiguity is in interpretation of clauses (i), (v) and (vi).
The issue is whether ‘development of information technology software’ is a taxable service or ‘service in relation to development of information technology software’ is a taxable service. If the first interpretation is taken as correct, development of all unbranded software will be liable to service tax. If the second interpretation is taken, only services in relation to development of software (like consultancy, code writing etc.) will be taxable.
Similarly, whether ‘providing the right to use information technology software supplied electronically’ itself is a taxable service or ‘service in relation to providing the right to use information technology software supplied electronically’ is a taxable service. If the first interpretation is taken, then even issuing ‘paper license’ would be a taxable service.
Admittedly, both the interpretations are possible, the first one is expansive while second one is restrictive. As explained later, if the first definition (i.e. expansive definition) is taken, it conflicts with various constitutional provisions. If second i.e. restrictive definition is taken, it does not conflict with any of the Constitutional provisions and hence should be adopted by applying principle of ‘reading down’.


2. Software is goods
In Tata Consultancy Services v. State of Andhra Pradesh (2005) 1 SCC 308 = 141 Taxman 132 = 271 ITR 401 = AIR 2005 SC 371 = 2004 AIR SCW 6583 = 137 STC 620 (SC 5 member Constitution bench), it has been held that canned software (i.e. computer software packages sold off the shelf) like Oracle, Lotus, Master-Key etc. are ‘goods’. The copyright in the programme may remain with originator of programme, but the moment copies are made and marketed, they become ‘goods’. It was held that test to determine whether a property is ‘goods’ for purpose of sales tax, is not whether the property is tangible or intangible or incorporal. The test is whether the concerned item is capable of abstraction, consumption and use, and whether it can be transmitted, transferred, delivered, stored, possessed etc. Even intellectual property, once it is put on a media, whether it be in form of books or canvas (in case of painting) or computer discs or cassettes and marketed would become goods. In all such cases, intellectual property has been incorporated on a media for purpose of transfer. The buyer is purchasing the intellectual property and not the media, i.e. the paper or cassette or discs or CD. - - There is no distinction between ‘branded’ and ‘unbranded’ software. In both cases, the software is capable of being abstracted, consumed and used. In both the cases, the software can be transmitted, transferred, delivered, stores, possessed etc. Unbranded software when marketed/sold may be goods.

However, Supreme Court did not express any opinion because in case of unbranded software, other questions like situs of contract of sale and/or whether the contract is a service contract may arise. Hence, in case of unbranded software, the issue is not yet fully settled. [SC upheld decision of AP High Court reported in Tata Consultancy Services v. State of AP (1997) 105 STC 421 (AP HC DB)].


In Bharat Sanchar Nigam Ltd. v. UOI (2006) 3 SCC 1 = 152 Taxman 135 = AIR 2006 SC 1383 = 3 STT 245 = 145 STC 91 = 282 ITR 273 (SC 3 member bench), following extract from decision in case of Tata Consultancy Services v. State of Andhra Pradesh was quoted with approval and adopted, ‘A ‘goods’ may be a tangible property or an intangible one. It would become goods provided it has the attributes thereof having regard to (a) its utility; (b) capable of being bought and sold and (c) capable of being transferred, delivered, stored and possessed. If a software, whether customised or non-customised satisfies these attributes, the same would be goods. - - It was observed that whether goods are incorporal or corporal, tangible or intangible, they must be deliverable’.


Earlier also, in Associated Cement Companies Ltd. v. CC 2001(4) SCC 593 = 2001 AIR SCW 559 = AIR 2001 SC 862 = 124 STC 59 (SC 3 member bench), it was held that computer software is ‘goods’ even if it is copyrightable as intellectual property.


2.1 Software is dutiable goods under customs, excise and Vat
Information Technology Software (branded as well as tailor made) is ‘excisable goods’ under headings 8523 80 20 [earlier 8524 91 11, 8524 91 12 and 8524 91 13]. The tariff rate of duty is 12% w.e.f. 1-3-2008 (earlier it was 8%). However, all software, except canned software i.e. software that can be sold off the shelf, is ‘exempt’ under Sr. No. 27 of notification No. 6/2006-CE dated 1-3-2006.


‘Packaged software or canned software’ means a software developed to meet the needs of variety of users, and which is intended for sale or capable of being sold, off the shelf [Explanation to Sr No. 27 of notification No. 6/2006-CE dated 1-3-2006].
Customs Duty on software - Information Technology Software falls under heading 8524 40 11 of Customs Tariff. Duty is ‘free’. Thus, on import of software (branded or tailor made) there is no customs duty. However, excise duty of 12% is payable on branded (packaged or canned) software. Hence, CVD will be payable if packaged or canned software is imported.


2.2 Paper license of software is ‘goods’
Documents of title conveying the right to use Information Technology Software (popularly termed as paper license of software) falls under 4907 00 30 of Customs Tariff with duty rate of 12.5%. However, it is exempt vide Sr No. 157 of Notification No. 21/2002-Cus dated 1-3-2002. It is also covered under Central Excise Tariff under same heading i.e. 4907 00 30 and excise duty rate is Nil. Thus, on paper license, basic customs duty or CVD is not applicable.
It may be noted that ‘transfer of right to use goods’ is a deemed sale of goods and taxable under sales tax/Vat.


2.3 Excise duty and service tax on software
Hamlet had said ‘To be or not to be, that is the question’. Indian assessees are saying ‘Software is goods or service (or both), that is the question’.
Software falls in heading 8523 80 20 of Central Excise Tariff. However, all software, except canned software i.e. software that can be sold off the shelf, is ‘exempt’. Duty on packaged software is 10% w.e.f. 27-2-2010, while there is no excise duty on tailor made i.e. customised software - Sr No. 27 of notification No. 6/2006-CE dated 1-3-2006 as amended w.e.f. 27-2-2010.


‘Packaged software or canned software’ means a software developed to meet the needs of variety of users, and which is intended for sale or capable of being sold, off the shelf [Explanation to Notification No. 17/2010-CE dated 27-2-2010 and Sr No. 27 to Notification No. 6/2006-CE dated 1-3-2006]


The issue is whether both service tax and CVD/excise duty are payable on software. I have tried my best to understand the statutory provisions and my views are as follows (though obviously ten people can have ten different views on the issue).


Single use packaged or canned software – Manufacturer/importer should pay excise duty/CVD on entire value of consideration received from buyer and then no service tax is will be payable (Notification No. 2/2010-ST dated 27-2-2010 in respect of excise duty and Notification No. 17/2010-ST dated 27-2-2010 in respect of CVD on imports.


The term ‘single use’ has not been defined. If the software is permitted to be used on more than one computers, it can be termed as ‘multi-use’ (as the term used is ‘single use’ and not ‘single user’).


SSI units can avail exemption from excise duty but then they will be liable to pay service tax as the exemption under Notification No. 2/2010-ST is subject to condition that ‘appropriate duties of excise’ should have been paid (Of course, they can argue that they can claim deduction of value of material under Notification No. 12/2003-ST dated 20-6-2003 and then ‘value’ for purpose of service tax is Nil).


In my view, traders of such software will not be liable (Indeed they are even otherwise not liable as sale and purchase of goods cannot be subjected to service tax, but I understand that in some Commissionerates, traders are being asked to pay service tax on sale of packaged software).
Other packaged or canned software – In case of other packaged software (i.e. multi-use), excise duty will be payable on consideration paid or payable for transfer of right to use such software [Notification No. 17/2010-CE dated 27-2-2010]. In case of imports, corresponding CVD will be payable [Notification No. 31/2010-Cus dated 27-2-2010].


CBE&C has clarified that value of software can be split into software media and right to use software (i.e. IPR relating to software) as the notification itself envisages such splitting – MF(DR) Instruction No. 354/189/2009-TRU dated 4-11-2009 in respect of imported software but will equally apply to packaged software manufactured in India.


It may be noted that in case of branded (tailor made) software, there is no ‘sale’ of software as such as entire property in software is never passed on to buyer.. Only right to use is transferred (some times for a limited period, which has to be renewed by paying further amount). There will be ‘sale’ of software only if source code and entire property in software is transferred to buyer.
If the manufacturer/service provider charges some amount over and above the consideration received for transfer of right to use (may be for installation, customisation etc.), service tax will be payable on such amount. Service tax cannot be demanded on amount on which excise duty has been paid, since assessee can claim deduction of value of material under Notification No. 12/2003-ST.


SSI units can avail exemption of excise duty but they will be exposed to liability of service tax, though they can argue that value of service is Nil.


Renewal of license of packaged software – Sometimes, the license to use packaged software is for limited period (usually one year). The license is renewed on payment of renewal fee by giving password. Thus, ‘packaged software ‘is not sold. In such cases, in my view, service tax will become payable, since packaged software ‘packed with document providing right to use’ is not given.


Customised software – Customised software is subject to service tax but assessee can claim deduction of value of material under Notification No. 12/2003-ST dated 20-6-2003.
Conclusion – The issue is still confusing and prone to litigation. Hence, whatever you decide to do, it is better to inform department in writing, to avoid charge of suppression of facts (I am sure department is as confused as you are).


Position prior to 27-2-2010 – Prior to 27-2-2010, there was no distinction between single use and multi use packed or canned software. However, in my view, even prior to 27-2-2010, manufacturer could claim deduction of value of material under Notification No. 12/2003-ST though factually, many large manufacturers were charging (may be still charging) both Vat/CST and service tax on entire amount of the Bill.


3. Legally, service tax on sale or purchase of goods or transfer of right to use goods cannot be levied
Service tax is imposed under entry 97 of List I which is a residual entry. Thus, if a transaction is covered in list II i.e. State List or in any other entry in List I, it cannot get covered in entry 97 of List I.
Entry No. 92A of List I (Union List) - Taxes on the Sale or purchase of goods other than newspapers, where such sale or purchase takes place in the course of Interstate trade or commerce.
Entry No. 54 of List II (State List) - Tax on sale or purchase of goods other than newspapers except tax on interstate sale or purchase.


In Imagic Creative Pvt. Ltd v. CCT (2008) 12 STT 392 = 12 VST 371 (SC), it has been held that service tax and Vat (sales tax) are mutually exclusive.
Service tax is not leviable on a transaction treated as sale of goods and subjected to levy of sales tax / VAT – Ref Code 036.03/23.8.07 of CBE&C Circular No. 96/7/2007-ST dated 23-8-2007. Though the clarification is in respect of services of authorized service station, the principle should apply to all transactions.
Thus, where transaction is subjected to Vat or sales tax, service tax cannot be imposed.


4. What is service
The term ‘service’ is not defined under the Finance Act, 1994. However, from aforesaid Constitutional provisions and judgments of Supreme Court, it can be safely stated that what is not ‘goods’ is ‘service’.
As per Webster’s Concise Dictionary, ‘service’ means ‘a useful result or product of labour, which is not a tangible commodity’. Wikipedia (www.answers.com) defines service as under – ‘In economics and marketing, a service is the non-material equivalent of a good. Service provision has been defined as an economic activity that does not result in ownership, and this is what differentiates it from providing physical goods.


Basically, service is ‘economic activity’ resulting in ‘value addition’, which can be perceived but cannot be seen as it is intangible. Another feature of ‘service’ is that it is perishable instantly, and it cannot be ‘stored’. For example, service of hotel room or seat in an aircraft, if not utilised today, perishes tomorrow. Today’s hotel room or seat in aircraft cannot be used tomorrow. Benefit of service may last longer (e.g. consultancy service, audit service), but the service itself perishes and cannot be stored. Service once availed cannot be ‘returned’ to service provider or transferred to another person, while goods can be returned or transferred.


Of course, use of some goods will not mean that there is no ‘service’. We have to see which is predominant factor.
‘Goods’ also do perish, but not so instantly.
In Bharat Sanchar Nigam Ltd. v. UOI (2006) 3 SCC 1 = 152 Taxman 135 = AIR 2006 SC 1383 = 3 STT 245 = 145 STC 91 = 282 ITR 273 (SC 3 member bench), it was observed that an article would become goods provided it has the attributes thereof having regard to (a) its utility; (b) capable of being bought and sold and (c) capable of being transferred, delivered, stored and possessed. Hence, conversely, it can be said that if the thing is not capable of being bought and sold or not capable of being transferred, delivered, stores or possessed, it will be ‘service’.


In sum, characteristics of ‘service’ are - (a) Economic Activity (b) Value addition (c) Intangible - can be perceived but not seen (d) Instantly perishable - cannot be stored (e) Service provided/availed cannot be ‘returned’ to service provider or ‘transferred’ to another.


4.1 Predominant nature of activity should be ‘service’
In sale or purchase of goods, some service is involved. However, it is incidental to the main contract which is sale of goods.
A composite contract cannot be vivisected and service portion cannot be subjected to tax – Widia GMBH v. CCE (2006) 5 STT 414 (CESTAT) * Blue Star v. CCE (2007) 7 STT 68 (CESTAT).


5. Rules of interpretation of Statute
In case of conflicts, rules of interpretation of Statute become relevant.
Reading down of a provision - If a provision in Act is too wide and seems unreasonable, Court may restrict its meaning by narrowing down its literal meaning i.e. by ‘reading down’ the provision. A statute can be declared valid even if per se it seems to be without jurisdiction, by ‘reading down’.


In Arun Kumar v. UOI (2006) 155 Taxman 659 (SC 3 member bench), it was observed, ‘Reading down puts into operation the principle that so far as it is reasonably possible to do so, legislation should be construed as being within legislative power. It has the practical effect that where an Act is expressed in language of a generality which makes it capable, if read literally, of applying to matters beyond the relevant legislative power, the Court will construe it in a more limited sense so as to keep it within power’.


In Pannalal Bansilal Pitti v. State of AP - (1996) 2 SCC 498 = AIR 1996 SC 1023, it was observed that reading down the provision of an Act is a settled principle of interpretation so as to sustain their constitutionality, as well as for effectuation of the purpose of the Statute.
Interpretation supporting constitutionality of a provision - In UP Avas Evam Vikas Parishad v. Jainul Islam 1998 AIR SCW 801 = 1998(2) SCC 467 = AIR 1998 SC 1028 (SC 3 member), it was held that if certain provision of law, construed in one way, would make them consistent with the Constitution and another interpretation would render them unconstitutional - Court would lean in favour of the former construction - same view in UOI v. Elphinstone Spinning & Wvg Mills AIR 2001 SC 724 = 2001 AIR SCW 364 = 105 Comp Cas 309 (SC 5 member constitution bench) * Danial Latifi v. UOI 2001 AIR SCW 3932 (SC 5 member bench).


6 Conclusion


Considering constitutional limitations and SC judgments, it can be said that service tax can be imposed only on ‘service’.


Thus, in my view, ‘development of information technology software’ itself is not a taxable service . ‘Service in relation to development of information technology software’ is a taxable service. Similarly, ‘acquiring the right to use information technology software supplied electronically’ itself is not a taxable service, but ‘service in relation to acquiring the right to use information technology software supplied electronically’ is a taxable service.
This interpretation can be adopted by applying principle of ‘reading down’ to make a provision constitutional.


In short, service tax is on ‘software service’ and not ‘software supply’.
If interpreted this way, then there remains no conflict between Constitutional provisions and the service tax on information technology software. Thus, mere sale or purchase of Information Technology Software cannot be subjected to service tax since the transaction is covered under Vat/sales tax. Only services in relation thereto can be subjected to service tax.


For example, if ‘A’ is undertaking activity of development of information technology software, he will not be liable to service tax. However, if ‘B’ provides some service to ‘A’ in relation to development of such software, ‘B’ will be liable to pay service tax.
Test of what is ‘service’ is already discussed above, i.e. it should be intangible, instantly perishable and should not be storable or transferable.
Even assuming service tax is payable, deduction of material cost can be claimed under Notification No. 12/2003-ST and hence 'value' for purpose of service tax will be Nil.
Of course, there is no chance that this view will be accepted by department. The department’s view is clear from CBE&C circular dated 29-2-2008, which reads as follows –
para 4.1.5 ‘Software and upgrades of software are also supplied electronically, known as digital delivery. Taxation is to be neutral and should not depend on forms of delivery. Such supply of IT software electronically shall be covered within the scope of the proposed service’.


I am sure there will be numerous show cause notices and demands at lower levels, followed by contrary views of Tribunal (as is happing today in case of interpretation of ‘input service’). There is no doubt that the issue will reach Supreme Court sooner or later.


Really, it is not the tax that is killing, but what is hurting more is uncertainty and possible huge demands. If the choice is between higher but certain taxes and lower taxes with higher uncertainty, I think industry will prefer higher taxes to higher uncertainty.