Taxation of software is one of the most debated issues of indirect taxation. With the rapid digitalization and the constant quest of the central and state governments to get a bigger slice of the tax pie, software and software-related services have faced multiplicity of taxes and are a hotbed for tax litigation. The problem is compounded by the fact that a supply of software involves a host of incidental activities including implementation, upgrading and maintenance of the software.
The taxability of software was analysed for the first time in great detail in the Supreme Court’s decision in TCS (2004), which held that software, whether packaged or customized, qualifies as “goods” when put on a physical medium and accordingly is liable to value-added tax (VAT), levied by a state government. However, the court did not delve into various aspects of taxation of activities incidental or connected to software.
Waking up to the potential to realize revenue from taxation of software, in the latter part of the last decade both the central and state governments have enacted provisions to tax software and related services. While most of the states provided a broad entry in their VAT laws to tax information technology software, the central government in 2008 introduced a specific entry of “information technology software service” to levy service tax on software-related services. Under the negative list regime (effective from 1 July 2012), software-related services have been specifically enumerated as “declared services” and subjected to service tax. This approach by the central and state governments on software and related activities led to duality of taxation.
Madras High Court in ISODA (2010) repelled a challenge to the constitutionality of service tax on software-related service, while holding that whether a contract is a sale or service would depend on terms of the contract reflecting the intention of the parties.
The position became clearer with the subsequent ruling of Karnataka High Court in Sasken (2011), where the court held that a sale of software cannot arise where the contract provides that the copyright and other rights in the software developed for the client remains the property of the client since its inception. This principle may be seen to be endorsed, though to the opposite effect, by the Maharashtra Sales Tax Tribunal in Mastek and Atos, where the transaction was held to qualify as a sale of goods in a case where the copyright vested with the seller.
Further clarity has been brought by rulings of Karnataka High Court this year in Infosys (February) and IBM (September), where, based on the Sasken principles, the taxability of the transactions below has been analysed.
For packaged/customized software, where copyright is held by the software developer and the copyrighted article alone is handed over to the customer as a transfer of right to use goods, the software is goods and liable to VAT alone.
Where an entity works on a hired contract basis delivering fully developed software for a specified customer with future contracts for upgrading and enhancement, and the copyright in such software belongs to the customer, as it is developed, the transaction is a pure service, and not liable to VAT.
Where an agreement for annual technical support involves both service and issuing upgraded or enhanced software, the contract is a combination of both goods and service, i.e. a “works contract”. VAT is liable to be paid on the goods, and service tax is to be paid on the labour aspect. In upgrading and enhancement, the copyright is owned by the software developer and what is transferred to the customer is the right to use.
In the case of customized software, if any source coding or scripting is done during the process of implementation, the ownership or copyright or any proprietary right would vest not with the software developer, but at all times with the employer who issued the assignment. Since there is no transfer of ownership or the licence to use the software, it is a pure service contract, not liable to VAT.
The above decisions of the Karnataka High Court clarify the position to a large extent as regards taxation of software-related services.
In cases where the contractual terms are silent or unclear on who owns the copyright in the software, it may additionally be noted that section 17(dd) of the Copyright Act, 1957, stipulates that in case of a work made under the direction or control of a body corporate, such entity, in the absence of any agreement to the contrary, would be the first owner of the copyright in the work. In any case, to achieve clarity as regards taxation, it is prudent to clearly specify in the contract in which party the copyright in the software will vest.
Under the goods and services tax (GST) regime, proposed to be introduced in India from 1 April 2016, most of these issues should be resolved since GST would be a unified tax on the single event of supply (whether of goods or services). However, classification may continue to be relevant for the purpose of levying additional tax (which is proposed to be levied only on goods) or if different rates are suggested for goods and services under the GST regime.
Kumar Visalaksh is an associate partner and Stella Joseph is an associate manager at Economic Laws Practice. This article is intended for informational purposes and does not constitute a legal opinion or advice.
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Kumar Visalaksh is an associate partn