Tell me what is a “Packaged Software” license?

Is it a purchase of “Goods”, “Service” or a “Royalty Payment"?

The idea of “duality” has deep roots not only in Indian Philosophy - where God is supposed be ‘dvaita’ as well as ‘advaita’; but such duality is in modern science also.

In Science, debate over the nature of ‘light’ and ‘matter’ is dating 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. That is, 'light' has a dual nature i.e., 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 – which seems to have no equal any where in any other country – have discovered another duality – in fact a new ‘tri-ality’ (for want to better expression let’s say this) about ‘Packaged Software’. It has found that “Packaged Software” is three different things depending upon how you look at it. If you look at it from the view of State level taxes - it’s a ‘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 5500 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 that, once it is there, one need to make 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?

Let’s look closely to understand this.

If you look at it from State’s point of view (for the purpose of “Value Added Tax” or “Sales Tax”) - Packaged Software License is a “goods” – without any doubt. There are number of court cases and it’s a well settled legal view that “Packaged Software” license is a “goods” and it attracts 4% VAT. It is fine up to this point.

But, if you look at it from the Centre’s point of view (for the purpose of “Service Tax”) Packaged Software License is a “Information Technology Service” (IT Service). Government woke up to this reality as late as in February 2008 and introduced a new service in the list of taxable services during the 2008 budget. With effect from 15-5-2008 all IT Services became taxable under Service tax net.

So, all companies involved in the business of selling Packaged Software Licenses started charging “Service tax” at 12.36% (inclusive of 3% Education Cess). And then to give its due to the 'State' – they are charging “Value Added Tax” at 4% on the total of License Fee and Service tax.

Everybody thought - that’s it. We can manage it i.e., customer will understand somehow that if ‘duality’ is there in ‘Religion’ and ‘Science’ - so it’s not difficult to accept that it could be there in Government taxes also. More or less, most of the 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 would develop it in-house. After all they have all the resources!!!

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

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 cheque of only 89% of the Invoice amount from the Customer. Upon inquiry they found that customer had deducted 11.33% as TDS (Tax Deducted at Source 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 2 to 4% gross margin on the sale of the packaged software license. So, he purchases it at say Rs.96, sells it a say Rs.100 – considering the best margin case. He bills it to customer at Rs.117 (100 + 12.36%ST +4%VAT). And customer pays him Rs.104 after deducting Rs.13 towards TDS. Reseller pays Rs.17 to Government towards Service tax and VAT – so reseller is left with Rs.87 in his hand. So, net – net he has lost Rs.9 per 96 i.e., he lost 9% from his cash flow. So, tell me after how many such transactions he would be left with no cash flow? You need to be ‘panchvi pass’ to answer this simple question.

Hey boss - don’t be ‘संतुष्ट’ (यार, SRK overtakes me sometimes) with 2 to 4% margin – ask customer to pay 9+4 i.e., 13% margin. Hey, that’s an unlucky number. OK let’s earn 15% gross margin. After all – reseller also needs to make money sometimes. Isn’t it? So, overnight price of Packaged Software license went northwards by 15%. Of course, this increase was over and above the 13% extra that customer shelled out towards Service tax and VAT on Service tax. So, in July 2008 all Packaged Software licenses became dearer by 28%.

End of story? नही यार. Plot thickens now. Some software distributors figured that if they paid 12% CVD (aka Customs Duty) while importing the Packaged Software license then suddenly “IT Software” turned from “Service” to “Goods”. So, when 12% CVD is paid - only 4% VAT would be payable; and no service tax! Wow, it meant that no TDS also. Great solution! After all, Indians are good at finding solutions. We are giving software solutions to the whole of USA and many countries in the world then why not for India. Isn’t it?

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” it did not matter. And this was more-or-less in line with GOI ‘s commitment to WTO in 1996 that by 1st June 2000 India will reduce customs duty to zero for 94 IT related items; and other IT items would have zero duty by 1st January 2005. Of course, one anomaly existed viz., if you imported packaged software license in a ‘shrink-wrap’ box then you paid 12% Customs duty. But considering the yearly volume and value of import under category - which is about 2 to 3% of the total packaged software license import – most people ignored this anomaly.

So, at least for some time – software resellers thought that by payment of 12% CVD problem of Service tax and TDS got resolved. But no, our Service tax people are smart. They are not going to give up that easily. Text of the law is in their favour. They have every right to ask each reseller to pay up “Service tax” because they have already tasted the ‘blood’ in this few months. So, software reseller community is keeping it’s fingers (and blood vessels therein) crossed. They are hoping against all hope that Service tax people will be content with revenue they have raked in so far in this 2 months.

But matter is not over yet. In January 2008 news stories had appeared in press that Microsoft was asked to make payment of about 700 to 800 Crore rupees towards Income tax. Also, in July 2008 a Supreme court judgment - in a case involving software imported by Airport Authority of India from a US supplier – it was held that Income-tax was payable by the US supplier in India because payment to them towards software license purchase by AAI was in the nature of ‘royalty’ payment. 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 judgement – it also seems to say the same thing i.e., 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 i.e., lower TDS.

Also, it was heard that price of all ‘downloaded’ software went upwards by another 10 to 20% depending upon from which country the software was procured. Why this? This is to pay the ‘withholding tax’ (aka Income Tax or TDS) to be paid to the Government towards income tax on the profit made by the non-resident supplier in India. This income tax on the profits made by the non-resident supplier seems to be payable by the ‘importer’. Of course, if the non-resident supplier agrees and if India has DTAA (Double Tax Avoidance Agreement) with that supplier’s country then importer may deduct TDS from the payment. But if importer is unlucky – which most likely the case – then importer will have to pay this tax from his own pocket.

Can it become more complex than this? We bet it can – but only in India. We still have our friendly politicians and bureaucrats who can make it still complex. They are capable of inventing ‘fourth’ nature of “Computer Software” licenses - apart from ‘goods’, ‘service’ and ‘royalty’!!!!

But those who are engaged in the business of software license reselling in India have got fad up of all this tax non-sense. Although they are merely 200 to 250 in number (all over India) they have got together and formed an association called "ISODA" - Indian Software Dealers Association. They have already initiated many steps to protect their interest. More on it can be found at http://www.isoda.in

p.s., one question is still unanswered. When a customer purchases ‘Computer Software License’ – how will this payment be classified as? Will it be a revenue expense, royality 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 2% 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.

Long live India and it’s harried citizens.