Taxing times for the software industry

ET reports that the software industry has witnessed a 40 % drop in sales as a result of recently introduced taxation provisions. After the decision of the Supreme Court in Tata Consultancy Services v. State of Andhra Pradesh, (2005) 1 SCC 308, the sale of ‘branded’ software like Microsoft products has been subject to the sales tax/VAT regime, on the theory that when software is stored on a physical medium such as a CD, it satisfies the definition of ‘goods’ found in various sales tax laws. The other major form of software is ‘bespoke’ or ‘unbranded’ software, which is software specifically designed for one customer or corporation. In Tata Consultancy Services, the Supreme Court declined to determine this issue, and left it open, observing that although bespoke software is also goods, a transaction involving its use may well be a composite service contract and therefore outside the sales tax regime.

Over the last five years or so, the complex tax regime has resulted in several questions as to the overlapping of sales and service tax. Traditionally, sales tax was levied only on a transaction that satisfied three conditions – objective existence of ‘goods’, intention to transfer title in those goods, and actual transfer of title (State of Madras v. Gannon Dunkerley, AIR 1958 SC 560). This meant that State Governments could not levy sales tax on several ‘composite’ transactions, such as a works contract or a hire-purchase contract. Dissatisfied with this state of affairs, the 46th constitutional amendment was passed, which altered the definition of “tax on goods”, and specifically listed seven composite transactions as subject to sales tax. One of these is the “transfer of right to use goods”. This greatly expanded the range of transactions to which sales tax applied, and started to overlap with service tax and other legislations. Concomitantly, the Central Government expanded the range of transactions to which service tax applied, with each Finance Act adding a host of transactions to the list of taxable items.

Software is one area where there has been a head on collision. In the 2008 Budget, the Finance Minister added s. 65(105)(zzzze) to the Finance Act, which states that a service provided to any person in relation to information technology software for use in the course or in furtherance of business or commerce is a taxable service. The provision goes on to list specific items such as the acquisition of the right to use information technology which satisfy this definition and are consequently subject to the sales tax regime.

ET reports that the result is so-called ‘double’ taxation of branded software products – service tax when there is a download, and VAT when it is sold on a CD. This has evidently caused software prices to rise by 16 %. It is reported that CBEC is examining this issue, but that an amendment will not be possible until elections are completed.

This issue has not been settled in India, except for the decision in Tata Consultancy Services, which does not directly address the point. In England, the Court of Appeal held that a transaction where software is supplied on a physical medium such as a computer disk is a sale (St Albans City and District Council v. International Computers, [1997] FSR 251). In America, the position is not as clear, and there has been disagreement on whether it is subject to even sales tax. Some Circuit Courts have held that it is, while others have held that it is not, and no decision of the Supreme Court has addressed this point. A comprehensive account of this conflict is found in Yeh, 22 Berkeley Tech. L.J. 355 (2007).

With no clarity on the Indian position, it appears that the software industry will have to pay both service tax and VAT for the foreseeable future, with adverse consequences for consumers, developers. There is also the likelihood, as ET reports, of another increase in piracy rates as a result of the rise in costs.

About the author

V. Niranjan


  • yes confusion like this is happening and bound to occur forever.
    Radical steps such as bringing in integrated taxing through “Goods and service tax ” could be the best option.
    let india inc. work on these radical steps.

  • The Revenue is making merry of the confusion… They levy all kinds of taxes on everything, irrespective of whether the transaction is a sale or a service. In income tax we have the real income principle at least; anything similar in sales and services?

  • @ Kodur_Sathya,

    That does seem to be an attractive option. But with elections round the corner, it looks like there is going to be no relief for the foreseeable future.


    I am not aware of any decision which has applied something similar to the real income principle. It is significant to note that even the real income principle is subject to a statutory provision to the contrary. Moreover, in AIR 1979 SC 1550 and in (2002) 5 SCC 203, the Supreme Court held that a legislation may be justified with reference to more than one legislative entry, and particularly with reference to the residuary entry. So the Central Government may simply argue that even if it is not a “service”, it is entitled to levy “service” tax under the residuary entry – Entry 97 of List I. Legislative intervention is perhaps the best solution.

  • @ V Niranjan:
    “the Central Government may simply argue that even if it is not a “service”, it is entitled to levy “service” tax under the residuary entry – Entry 97 of List I”

    It is arguable that such an exercise will be ultra vires; on scope of residuary see the observations in 13J Bench Kesavananda – majority opens the door for an argument which would not allow the residuary entry to be used in such cases… The observations may well be wrong, but they are by a 13J bench…

  • Niranjan – “So the Central Government may simply argue that even if it is not a service, it is entitled to levy service tax under the residuary entry”

    Note that this argument will not work under the present legislation on service tax, i.e. the Finance Act 1994. The charging section says that tax is levied on “taxable service”.

    S. 65 defines a “taxable service” as ANY SERVICE PROVIDED TO (detailed description in the sub-clauses)

    Note that this does NOT expand the definition of service – taxable service presumes the prior existence of “service” – no “deemed service” is created…

  • The point about Kesavananda is a very interesting one. It is the only decision which reads the residuary entry narrowly, and although it was delivered by a 13-judge Bench, subsequent decisions seem to have read it differently. For example, in Ujagar Prints and in Sat Pal, the Supreme Court expressly held that a “rag-bag” legislation is valid i.e. a law which refers to both the residuary entry and to other entries. More to the point, the Court held in Hoechst Pharma and other decisions that the residuary entry automatically applies wherever List II does not.

    The point on taxable service is also very interesting. It does seem to imply that there must be actual service. However, sub-clause zzzze specifically lists certain items which the legislature has said constitutes service, and the Court in Kalyana Mandapam held that the definition of service in the Act does not have to conform to the common understanding of service.

    It will be interesting to see how this dispute is finally resolved.

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