Service Tax on Software Upheld

In 2005, the Supreme Court held that the transfer of branded software constitutes a sale and is exigible to sales tax, levied by State Governments under Entry 54, Schedule VII of the Constitution (Tata Consultancy Services v. State of AP). I have argued elsewhere that this decision may, with respect, require reconsideration on the question of whether the typical software transfer accompanied by a EULA is a “sale” or merely a limited licence. Controversy over the legal status of software and its taxation has continued despite the pronouncement of the Supreme Court. It is not only that software per se defy easy legal classification but also that significant differences between different types of software complicate the matter. We noted that an amendment to the Finance Act – s. 65(105)(zzzze) – proposed to levy service tax on certain transactions involving software, and discussed its implications. On 24 August, 2010, the Division Bench (Taxation) of the Madras High Court rejected a challenge to the constitutional validity of this provision. The decision, which makes for interesting reading, is available here.

The writ petition was filed by the Infotech Software Dealers Association [“ISODA”], a group comprising over 100 members engaged in software resale. The Court was careful to note that the “resale” was principally effected in three ways – through shrink-wrap software, multiple user software and internet downloads. The petitioner entered into a Master End User Licence Agreement with the developer of software, and in turn into End User Licence Agreement with its customers. Following the decision of the Supreme Court in Tata Consultancy Services, all such transactions were treated as exigible to sales tax and VAT. In the High Court, the petitioners assailed the constitutionality of the amendment for two reasons: first, that software always constitutes goods, and secondly, that all transactions in the categories mentioned above constitute a sale (or a deemed sale) – and therefore beyond the legislative competence of Parliament. The High Court accepted the first contention, but rejected the second. The second contention is by far the more significant, since most courts across common law jurisdictions have now taken the view that software does indeed constitute goods (whether a transaction in it constitutes a sale or not).

The High Court first referred to the decisions of the Supreme Court in Gannon Dunkerley, Tata Consultancy Services and BSNL. It then distinguished between “exclusive sales” and “composite sales” in the following terms:

However, in a transaction whereby the software is delivered to the customers, the question is as to whether it would amount to an exclusive sale. In the event if it is a case of sale, then the submission of Mr. Datar as to the legislative competency of the State Government under Entry 54 of List II must be accepted. There may be cases of exclusive sale or exclusive service or where the element of sales and service is involved. In cases where an element of service is alone involved, the Parliament has the legislative competency to enact law for levying service tax under Entry 93-C…

This is clearly correct. The Union of India argued that the typical software transfer agreement is not a sale, but a limited licence, since the copyright in the software is retained by the developer, who only transfers a limited right of use to the end-user. To answer this objection, one must, as the Court put it, look to the “nature of the transaction” and the “dominant intention of the parties”. Indeed, this formulation has been firmly entrenched in the line of cases following Gannon Dunkerley. However, the 46^th Constitutional Amendment, introducing Art. 366(29A) into the Constitution, made partial inroads into this principle by allowing States to levy a “tax on sale” on specific transactions that lack on one of the constitutive elements specified in Gannon Dunkerley. For example, it had been held following Gannon Dunkerley that the State is not competent to levy sales tax on food consumed in a restaurant on the theory that the food is “sold” to the consumer. Now States may do so by virtue of the specific provision in Art. 366(29A)(f). As a result, it is possible to take the view (although this is disputed) that the meaning of “sale” for the purpose of Entry 54, List II is broader today than at the date of the inception of the Constitution.

Naturally, therefore, the petitioners relied on Art. 366(29A)(d), which provides that a “transfer of the right to use goods” is a deemed sale, to suggest that software, which is undoubtedly goods, is covered by this provision even if the Union of India’s contention is correct. This issue – whether the limited nature of the End User Licence Agreement that accompanies typical off-the-shelf software converts what appears to be a sale into a licence – deserves the closest scrutiny, and has produced divergent results in England, and within America. The Madras High Court addresses this issue in paragraph 31 of its judgment, and the following observations are crucial:

31. From the above, the dominant intention of the parties would show that the developer or the creator keeps back the copyright of each software, be it canned, packaged or customised, and what is transferred to the network subscriber, namely, the members of the association, is only the right to use with copyright protection. By that agreement, even the developer does not sell the software as such. By that Master End-User License Agreement, the members of petitioner-association again enter into an End-User License Agreement for marketing the software as per the conditions stipulated therein. In common parlance, end user is a person who uses a product or utilises the service. An end user of a computer software is one who does not have any significant contact with the developer/creator/designer of the software … On a careful reading of the above, we are of the considered view that when a transaction takes place between the members of ISODA with its customers, it is not the sale of the software as such, but only the contents of the data stored in the software which would amount to only service. To bring the deemed sale under Article 366(29A)(d) of the Constitution of India, there must be a transfer of right to use any goods and when the goods as such is not transferred, the question of deeming sale of goods does not arise and in that sense, the transaction would be only a service and not a sale [emphasis mine].

From the above observations, it would appear that the Court has held Art. 366(29A)(d) inapplicable to a typical software transfer transaction. However, in paragraph 32 and subsequently, the Court clarifies that this depends “upon the individual transaction”.

The law on characterizing software is today at the crossroads: on the one hand, the Supreme Court held that a typical software transfer agreement constitutes a “sale” on the basis that it constitutes “goods”, without, however specifically considering whether such a transaction is only a limited licence. On this basis, sales tax was levied. On the other hand, the Madras High Court has held that service tax may be levied on these transactions because it is possible that individual transactions involving software may not constitute a “sale” although software is “goods”, because of the nature of the transaction. The Courts were not considering the same type of software, of course, and the two opinions are not inconsistent – but a clear enunciation of the importance Indian law attaches to the nature of the transaction will promote the interests of clarity.