ISODA's writ petition demanding removal of Service tax on Packaged Software got dismissed by the Madras high court on 24th August 2010. The order said that government has right to levy Service tax on IT Software and is well within the rights conferred to it by the Indian Constitution. It further confirmed that software is 'goods' but transaction involving transfer of right to use - between ISODA member (software reseller) and End user could be 'sale' or 'service' depending upon what is written in the End User License Agreement (EULA) from the software developer / copyright owner.
Tax experts concurred that interpretation of order could pose serious difficulty to the business operations of the software resellers - as would be difficult to read EULA of each Packaged Software license and determine whether the transaction is a 'sale' or 'service' or combination of the two. Doing so would be subject to the interpretation of a legal agreement - which is not within capacity of an ordinary end user or a software reseller or a field level government officer. But order did anticipate such problems and said that ISODA member could resist the tax demand when made; and could approach the court for clarification.
I feel that it is almost impossible for an average person to find out whether the transaction is a 'sale' or 'service' by merely reading the text of the EULA due to its complicated legal language and its interpretation. Due to this difficulty, it is likely that each government officer would interpret the EULA in a way convenient to his department. So, one can foresee a slow but sure build-up of numerous disputes and litigations over sale v/s service interpretation all over India.
Supreme court had opined in the TCS case that EULA is only a mechanism to enforce copyright protection i.e., restrict usage with certain terms and conditions. So, to read and interpret EULA to determine nature of transaction may not turn out to be a practical solution.
Upon doing the fine reading of the order and slight reflection, I came to conclusion that only handful of people understand business model of IT software properly. And all tax confusion is because of lack of this perspective. If one understands nature and characteristics IT software with its different modes of delivery - it is easy for any one to come to the understanding that one may not have to read EULA to determine nature of transaction between the End User and the software developer.
When we say that business of Packaged Software is an industry worth billions of dollars, there has to be a common thread that makes it as one big industry. Currently there is an urgent need to identify such commonality of characteristics and quickly establish nature of IT software transactions. For example, it is established by courts well that sale of Electricity is 'goods', providing Telephony services is a 'service', sale of mobile SIM cards is a 'service' for first transaction and 'goods' subsequently. It is simply not practical to keep reading and interpreting EULA of each packaged product. But, million dollar question is who will do this for the IT software industry in India?
So, I set out to put down basic ground realities of IT software business on a piece of paper for the sake of better understanding. In the piece below I have tried to draw the picture and you may decide - if it adds to your understanding of the nature of software transactions.
Information Technology Software vis-a-vis other types of software
Electronics has brought revolution to the modern world beyond what a men could have ever imagined just 150 years back. Over last 40 years a new branch of Electronics emerged with general purpose or programmable electronic devices called Computers and Programmable Logic Controllers (PLCs). Computers were found useful in business and PLCs were found useful in Industries for automation. This general purpose Computers and its network became very popular and started being used widely all over the world. This branch of Electronics popularly came to be known as Information Technology. While PLCs and other special purpose Electronic items also progressed at a fast pace. But among them except for Smart Mobile Phones most of the electronic items remained an item performing one specific function for which it was designed.
So, Information Technology (IT) is a branch of Electronics with attendant Hardware device, Software and network of such devices using Telecommunication Networks. Other programmable electronic items are known as PLCs, CNC machines, Industrial Robots etc.; and special purpose electronic items like Television sets, Audio-Video Players and Recorders, Digital Cameras, Telephone Instruments including Mobile phones, Automobile electronics, Rail Electronics, Satellite Electronics, Home gadget Electronics for Washing Machines, Microwave Ovens, Cooking Stoves etc. All of these electronic devices are run by great piece of software inside it but it's not IT software. In fact, TV programs recorded in studios for telecast on TV channels is called TV software! And we are not talking about it either, here.
Technical Nitti-gritty
Each of this electronic item is made up of two parts - popularly known as hardware and software. Software is of two type - embedded and programmable. Generally speaking, embedded software is hard-coded i.e., non-changeable software and is integral and essential part for working of the electronic device; it is considered part and parcel of hardware. While programmable software is modifiable and replaceable in nature - although non-essential many a times - but could make important contribution to the usefulness of the electronic device. So, when IT software is referred to - we are referring to programmable software used by computers or network of computers.
Such IT software is developed by a Software Developer using certain type of software called Development tools which include various type of Software languages like C, Java, Cobol, Pascal, Assembly, Fortran etc. and development tools like Visual Studio, Eclipse; and Databases like Oracle, DB2, Informix, Sybase etc.
IT Software developer would develop a software using above mentioned development tools for a specific client based on his specific requirement - called Customized Software; or develop a general purpose software - designed and developed keeping in mind needs of many users having similar requirement - called Packaged Software.
Packaged Software Business
Development of Packaged software is a business with great risks and great rewards. Few outstanding examples of this business model are Microsoft, Symantec, Adobe, McAfee, Autodesk etc. Software development, Manufacturing and Distribution of Packaged software is internationally a big business running in to billions of Dollars. In India, this business size is estimated to be Rs.10,000 crore a year.
Diagram below depicts the licensing and distribution model of Packaged IT Software.
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| IT Software Licensing and Distribution Model |
Vendor provides his packaged software in the market to various types of customers like Replicators & Distribution companies, End users including companies/organizations, hardware vendors on OEM basis and other independent software vendors/developers - by packaging it differently through various license agreements. And Vendor receives money for the same from various customers depending upon terms of the license agreements.
Typically it's a two tier model - where an intermediate company is given license to replicate and distribute. It is essentially a license to do the "production" or "manufacturing"; and the resulting product is sold or distributed in the market to reach the end user via a traditional distribution channel or via eCommerce transaction.
Packaged Software delivered in many different forms
One important point to be noted here is that packaged software is delivered to end user in various forms of delivery viz., Media (CD/DVD/Storage device), Internet Download, Network Delivery, Backup Media/Storage Device etc. How packaged software is delivered to the end user does not matter or alter the nature of transaction. Even one of the explanatory notes released by Tax Research Unit said following:
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D.O. F. No.334/1/2008-TRU Date: 29-2-2008
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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.
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On this point of forms of delivery there has been lot of confusion in the mind of various people - so this point requires careful consideration while deciding on nature of transaction.
Resell of Packaged Services
In the above diagram, one more point to be noted is that in this model - "Subscription License" which involves some kind of service for 1 or 2 year period - is productized (or packaged - in other words). So here, a service (if any) is packaged and sold, resold and distributed like a product. It is important to recognize this unique distribution model of "service" - as its improper understanding may pose some difficulty with respect to taxation issues. I would like to call it as a "resell of a service".
So, in the context of IT software - government should recognize and accept that "resell and distribution of service" should be treated as trading transaction i.e., "sale" - as there is no element of "service" provided by the reseller. Also, the transaction should not be subjected to TDS (Tax Deducted at Source) because its only a "sale" or "trading" transaction. In all these transactions, actual service provider is the software developer and actual service recipient is end user. And reseller is only facilitating the transaction by trading/sale of a productized service.
Given below is the tabular depiction of the Business and Distribution Model of IT Software.
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| Business and Distribution Model of IT Software |
Current taxation structure for ISODA members is depicted below:
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| Various Taxes on IT Software distribution in India |
So, say when Sachin Tendulkar buys say Microsoft Office 2010 Home and Business Edition box pack with DVD by paying say Rs.10,000/- from a store he get a copy of software developed by Microsoft Corporation,USA, manufactured by Microsoft Operations Pte Ltd, Singapore (MO) and sold to Croma through an Indian distributor like Ingram Micro India Ltd (IMIL) via Microsoft Regional Sales Corporation, Singapore (MRSC). So, distribution path is MC --> MO --> MRSC --> IMIL --> Croma --> Sachin Tendulkar.
Similarly when Coal India Ltd (CIL) purchases say 10 licenses of Microsoft Office 2010 Std by paying Rs.15,000/- per license - they get a piece of paper authorising them to use Microsoft Office 2010 Std on 10 PCs. CIL can install the software on 10 PCs from a media pack (DVD) purchased from the reseller at Rs.1,500/- per piece - which could be one time purchase. For the sake of simplicity - we shall assume that CIL had this media pack from its earlier purchase. Note that this paper license also follows same distribution route as shrink wrap box purchased by Sachin Tendulkar.
But Sachin Tendulkar pays VAT @5% on Rs.10,000/- i.e., Rs.10,500/-; and CIL pays Service Tax @10% on Rs.1,50,000/- i.e., cost of paper license; and VAT at 5% on the total viz., 1,65,000/-, taking total payment to Rs.1,73,000/- (rounded off). And while making payment to the reseller - CIL deducts TDS at 10% and pays the balance amount viz., 1,55,700/- to the reseller.
Assuming reseller's purchase price of each Microsoft Office 2010 Std to be Rs.14,000/-; he would had paid (Rs.14,000/- x 10 no.s + 10% Service tax) x 5% VAT = Rs.1,61,700/- to the distributor IMIL. Of course, he would also deduct 10% TDS and pay only balance to the distributor. But he will have to deposit TDS amount with Income tax immediately. So, while reseller made a profit of Rs.10,000/- in books of accounts; he lost Rs.6,000/- from his cash flow. So, net effect of Service tax and TDS on reseller is that reseller keeps on depositing more than 60% of his gross margin to Income tax department.
As far as reseller is concerned he just takes an order from CIL at Rs.15,000/- per license, places it on IMIL at Rs.14,000/- per license, who in turn purchases it from MRSC at say USD 290/- (Rs.45/USD= Rs.13,000/-) per license. And MRSC procures it from MO at say USD 260/- per license. And MO pays say USD 200/- per license as royalty to Microsoft under its replication and distribution agreement.
Summary and Recommendation
So, following points are very clear from the business model described above:
1. Once Packaged software is manufactured by the replication and distribution licensee it assumes nature of a product i.e., goods.
2. In the hand of distributor and reseller the product is sold as it is - without any service addition from his side. So, there is no element of service provided by the distributor or a reseller to the end user. So, it may not be correct to levy 10% service tax on a packaged software product from the reseller/distributor.
3. Since distributor / reseller is not providing any service to the customer, it may not be correct to deduct 10% TDS on his payment.
I hope careful reading of above three diagrams will clear most of the misunderstanding that is prevalent among Government Officials, Judiciary and Politicians; and help them to devise, design and interpret IT Software taxation structure in proper context with reasonable clarity.
In summary, it is easy to understand for any one that transaction related to a Packaged IT Software is essentially a sale / trading activity as far as software reseller is concerned. So, sale and distribution of Packaged IT Software should be treated as trading i.e., sale/purchase of goods/services and should be liable to taxes under Excise/Customs duty, VAT and as Business Income under Income tax.
Bringing supply of Packaged IT Software products under Service tax / Royalty regime has brought unnecessary complexities to the sun-rise industry. If government decides to continue taxing this industry with complex taxation laws, Packaged Software industry will die a slow but certain death. It's time we all wake up and take corrective action.
