Understanding IT Software Business Model in view of tax confusion

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.


IT Software Licensing and Distribution Model

First and foremost point to be noted to understand this business model is that packaged software is licensed to the end user by an End User License Agreement. It is an agreement between Software Developer (or Vendor - who is also a copyright owner, say Microsoft) - who is also a copyright owner and End User (say Coal India Ltd or Sachin Tendulkar).

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.

Business and Distribution Model of IT Software

I know, above diagram is difficult at first glance; and would interest you only if you are really interested in understanding business and distribution model of IT software. Any way, give it a try.
 

Current taxation structure for ISODA members is depicted below:

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.

Cost of outsourced work

For last few years outsourcing work is routinely adopted by companies to reduce costs. Now a days we see various non-core activities like after sales service, salary payments, marketing activities, claim processing, event management, house-keeping, physical security of premises and so on - are routinely handled by outside agencies. While cost reduction may be true in short run - there is a cost that a company pays for outsourcing its activities.

For example, look at the quality of service provided by outsourced agencies for After Sales Service. Is there any credible proof that outsourced agencies can offer to its customers that their customer's are served well and are happy with their service? I doubt.

Take this instance of a leading software product vendor who routinely outsources its Dealer Incentive scheme management to third parties.  Yesterday we learnt about a dealer scheme from this vendor's newsletter and clicked on the link to register for the same. And we got a Google advisory saying:

Site is listed as suspicious - visiting this web site may harm your computer.
Part of this site was listed for suspicious activity 1 time(s) over the past 90 days.

What happened when Google visited this site?

Of the 2 pages we tested on the site over the past 90 days, 2 page(s) resulted in malicious software being downloaded and installed without user consent. The last time Google visited this site was on 2010-03-13, and the last time suspicious content was found on this site was on 2010-03-13.
Malicious software is hosted on 2 domain(s), including waimaighaiphahxi.in/ , weedshop.org/ . 

I brought this to the notice of the Agency who was administering this scheme with copy to Partner Account Manager of the software vendor. In about 1 hour I got a telephone call from the Agency - a girl told me not worry - as we were pre-registered for the scheme!! When I asked her about Free Malware given out to the dealers upon registration - she feigned ignorance and said she will check up. There is no response from software vendor yet.

Few days back I had written to the same vendor's Senior Manager asking him if any quality checks are in place to ensure that all dealers are informed about the "schemes" launched by them and agency informs and distributes the incentives in time? After a reminder I got a email saying all distributors are advised to include my email id in all their communications to dealers! I asked him why have I not received the Incentive after 10 weeks of scheme closure - I've yet to receive any reply. Of course, I did not ask him about the schemes - which we did not know about - and lost out on incentives in this period of  4 to 5 months.

Take another example, recently we got cheque of more than Rs.1,00,000/- from one of customer through their outsourced agency - a bank - who makes payment to vendors on behalf of this party. Can you believe that this payment was already made to us few months back - as an advance payment after deducting TDS? When we pointed this out to the customer they asked for the cheque back by courier. Not a word of appreciation or complaint! Is this a routine? I believe so. Else how can you explain customer behaviour as noticed by us?

Believe me, this incident is not an isolated incident. We see about 1 or 2 incidents every year like this and return the cheques.

Why pay Service Tax on Packaged Software - to be on the safer side?

In India, the taxation and legal system is very complicated, extremely slow and quite expensive in terms of money and time.

So, whenever there is an ambiguity on the applicability of a particular tax or law - usual advise given by Tax Consultants is - "we feel this - this and this ... - but to be on safer side pay tax" i.e., collect from the customer and pay to the government. After all - it's the poor customer who pays!!!

And bigger the company seeking the advice - bigger is the consultant i.e., all MNC's seek advice from one of the big four management consultants. Never mind what their track record is. We have seen fate of number of global consulting organizations and their customers in the last 7-8 years. Not only consultancy organizations but even their top notch MNC customers have gone out of businesses. So, much about the big consultants and their advice!!

So, it's time that we start using our brain and innate wisdom to understand the tax/legal issues on hand and devise ways to tackle the issues. Times are tough and going forward - it's going to be tougher. So, it's time that we get out of our cosy comforts and forget about being safe and start learning to take stand, devise a strategy to fight the outcome of the stand and fight out - when required.

Take the issue of double taxation that has shaken the entire Software Industry in India. It has applied a 'brake' and changed the 'gear' from 5th to the 1st gear - without pressing the clutch. Any one who knows how to drive a four wheeler would understand what's fate of such an action.

Some people think that Indian Government has done this intentionally. It's done with a intention of milking docile IT customers and IT Software Houses of their hard earned money. And Government is not in a mood to offer quick corrective action. They want as much money as possible in the government coffers - so that they can pay the farmers and arrears to government employees as per 6th Pay Commission recommendation. And you know very well why all this is done - of course, to get votes in the next election and stay in power for another five years. All this in the name of democracy. It's a shame on us that we take all this lying down.

Consider this case a little deeper to examine - what's implication of both taxes applied simultaneously on the sale of a packaged software product?

It leads a question - whether 'Service tax' and 'VAT' is to be paid on 'basic price' simultaneously or one after another. If applied simultaneously - we are thrown back by 25 years to age old system of manual book keeping because modern Accounting Packages can not handle it. If you are using modern ERP packages then you will need to hire services of costly and time-consuming ERP consultants to modify your billing system. And they will take couple of months to carry out the necessary changes to your billing and accounting system.

If you apply it one after after then question arises - which comes first? VAT or Service tax. Fortunately, there is a consensus among tax authorities that Service tax comes first because it's a Central Government tax (like Excise) and VAT comes next. So, you pay Service tax @ 12.36% on basic price and then charge VAT on the total of basic price and service tax.

So far so good. But, bigger issue to be discussed and settled is whether Service Tax is applicable on the sale of packaged software or not. This is because as per Finance Minister's budget speech and a letter written by the Service Tax Commissioner - Service Tax is applicable on tailor made software and Excise/CVD is payable on the packaged software.

So, it is time to decide whether software resellers are selling tailor-made software or packaged software. Once they are clear about this point they will be able to convince all parties viz., government, distributors and vendors - that Service tax is NOT payable on the packaged software.

In this context, if any one is having any doubt, please read clarification given by Tax Research Unit (TRU) vide D.O. F. No.334/1/2008-TRU dt.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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4.1.7 Following consequential amendments in other taxable services are also being made: To clarify as removal of doubts that ‘Management, maintenance or repair of properties’ includes Management, maintenance or repair of IT software [section 65(105)(zzg)]. Maintenance of packaged software (being goods) is also leviable to service tax under the said service.

Notice "taxation is to be neutral and should not depend on forms of delivery" and "packaged software (being goods)". So, when we sell packaged software supplied vide different forms of delivery viz. Shrink-wrap, OEM, Paper license or Internet download, it's all same viz. packaged software. Packaged software (being goods) - attract VAT. So, there is no Service tax.

Once we all (dealers, distributors and vendors) are clear and are all united on this issue we could take a stand as an industry and we all should collectively refuse to pay Service tax to government. If government wants Service tax then let them demand it.

Currently we all are assuming that government wants Service tax on packaged software and we are paying it. But indication is otherwise i.e., government's original intention was to levy Service tax on the Tailor-made or Customised software only. Same thing was said in the Finance Minister's speech also.

While presenting the Finance Bill 2008 he said: “I propose to increase the excise duty on packaged software from 8 per cent to 12 per cent to bring it on par with customized software which will attract a Service tax of 12 per cent.”

I've learnt from a customer that he had some verbal discussion with the Commissioner of Service tax. In that Service Tax Commissioner confirmed that Service tax is payable only on the tailor made software. He even said that his field staff does not have mandate for the collection of service tax on packaged software products.

BUT WE ALL ARE PAYING SERVICE TAX ON PACKAGED SOFTWARE - RATHER FOOLISHLY - TO BE ON SAFER SIDE.

WHOSE FAULT IS IT? It is time we start thinking like Legal Experts and Court Judges viz., what is the intention of government in bringing IT Software Services in Service tax net? And whether it is correct to charge two taxes on same item viz., Packaged IT Software .

Believe me, in case of doubts, even our constitution rules in favour of the tax payer and not government.

“Service tax is imposed under entry 97 of List I (in Constitution of India) which is a residual entry. Thus, if a transaction is covered in list II, it cannot get covered in entry 97 of List I. Since sales tax is covered in list II, it is doubtful if service tax can be imposed on a transaction which is entirely getting covered under List II.” - V S Datey - Tax consultant.

Then - it's time that we take a stand as a IT Software Industry and decide not to pay Service tax on packaged software.