‘Manufacture’ in Income Tax

The decision of the Supreme Court in CIT v. Oracle Software is set to add another controversy to the many that already exist with respect to taxation. Involving the interpretation of the term ‘manufacture’, which has been a contentious issue in the excise law context, the decision gives rise to a couple of interesting issues.

The assessee was a wholly owned subsidiary of Oracle Corporation, USA, which imported the Master Media of software from Oracle, and duplicated it on blank discs, packed and sold in the Indian market. The assessee only had the right to replicate/duplicate the software, and not to vary, amend or make any value addition to the Master Media. Now, in order to claim a deduction under section 80IA of the Income Tax Act, it was required for the assessee to show that it was engaged in the process of ‘manufacturing’. It was in this context that the long-standing debate in excise law on the meaning of ‘manufacture’ surfaced in the income tax context, with the Court holding that this process of duplication was ‘manufacture’.

There are two parts of Justice Kapadia’s opinion that merit attention- the first is the possible dilution of the meaning the manufacture which the decision has effected, the second is the reason why he thought the dilution was justified. The learned judge observed that the real input for the process of duplication was the blank CD onto which the Master Media was replicated, as a result of which the CD became available for a specific use different from its original use. The Department rightly contended that the Master Media itself was not changed in any way as a result of the duplication. While the Court did not differ with the Department on this factual assertion, it held that the transformation of the CD was sufficient to render the process a manufacture. In the words of the Court,

If an operation/ process renders a commodity or article fit for use for which it is otherwise not fit, the operation/ process falls within the meaning of the word ‘manufacture’. Applying the above test to the facts of the present case, we are of the view that, in the present case, the assessee has undertaken an operation which renders a blank CD fit for use for which it was otherwise not fit. The blank CD is an input. By the duplicating process undertaken by the assessee, the recordable media which is unfit for any specific use gets converted into the programme which is embedded in the Master Media and, thus, blank CD gets converted into recorded CD by the afore-stated intricate process. The duplicating process changes the basic character of a blank CD, dedicating it to a specific use. Without such processing, blank CDs would be unfit for their intended purpose. Therefore, processing of blank CDs, dedicating them to a specific use, constitutes a manufacture

In arriving at this conclusion, the Court relied on its previous decision in Gramophone Co. v. The Collector of Customs, (2000) 1 SCC 549, where the Court had held that the process by which blank cassettes were converted into pre-recorded audio cassettes amounted to manufacture. The Court in Oracle opined that the facts in the two cases were nearly identical, and should result in the same conclusion. However, it is important to note that this decision in Gramophone was decided under the Customs Act, and is not necessarily reflective of the position of law under excise. While the evolution in the meaning of manufacture in excise is too long to document here, the broad test accepted by Courts has been whether the process has resulted in the creation of a commercially distinct product. However, this test has run into difficulties when it comes to processes like labelling or packing, which do not add to the product per se, but merely embellish it, or add to its marketability. There is no clear guidance available on whether and which forms of labelling/packing amount to manufacture, but Courts have been content with observing that if the labelling/packing play a significant role making the product excisable, or if the product was not marketable without the process, the labelling/packing will amount to a manufacture.

In my opinion, a similar issue arises on the facts of Oracle. There are two ways in which the process of duplication can be viewed. One way is to say that the CD is merely the medium through which the software is being made available to its customers, and there is nothing about the CD that changes/alters the Master Media. On this view, the process of replication cannot be considered manufacture. Another view, which the Court espoused, is that the CD forms an essential part of the marketability of the Master Media, and after replication, the CD and the software form a common integrated unit, with an independent commercial identity. It placed reliance for this purpose on the definition of ‘goods’ provided in Tata Consultancy Services, AIR 2005 SC 371. On this view, the Court seems to have elaborated on and explained the general meaning of ‘manufacture’, which could be relevant in the excise context too.

However, the Court took great pains to assert that the test put forth is inapplicable in any context other than the specific deduction under section 80IA. This is emphasised by the fact that a subsequent decision in CIT v. Emptee Poly-Yarn, again a decision of deductibility under section 80IA, cites Oracle for this limited proposition, and again insists that the meaning of manufacture put forth in the income tax context cannot be extended to excise. The Court observes that the decision in Oracle must be understood in light of the fact that at issue was ‘computer technology’; and that in modern times, it would be advisable to borrow from American jurisprudence, which applies a broader test of manufacture.

Thus, the decision in Oracle and its interpretation in Emptee Poly-Yarn has clarified the meaning of manufacture in the income tax context, while leaving its effect on excise laws undecided. There is nothing in the decisions which makes them necessarily inapplicable to the excise context- indeed many observations suggest that the reasoning adopted may be equally applicable in excise law too. However, by specifically disclaiming its applicability, the question that has surfaced is whether the scope of the decision was narrowed because the Court thought it prudent not to over-extend itself, or because it thought that the test in excise is different. If the reason in the former, the decisions are an admirable exercise of restraint by the judiciary; if it is the latter, the decisions may lead to renewed debates in excise law.

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