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Software and taxing issues
September, 07th 2009

Information Technology (IT) Software services was brought into the ambit of taxable services with effect from May 16, 2008. Inclusion of certain transactions under the service category IT Software Services has created confusion among software firms in India.

After the introduction of IT Software Services, the Finance Minister did make an attempt to clarify that for the levy of service tax on a software transaction, distinction needs to be made between Packaged software and Customised software and it is only the latter that he intends to bring under the levy of service tax.

However, confusion still prevails over the issue. Here, we take a look at the various aspects involved and a possible solution.

IT Software Services includes, amongst other items, acquiring the right to use:

IT software for commercial exploitation, including right to reproduce, distribute and sell

Software components for the creation of and inclusion in other IT software products

IT software supplied electronically

It is the inclusion of the above mentioned categories of transactions under the ambit of IT software services that has created the confusion.

Typically, these are licence transactions, more in the nature of transfer of goods than services. A packaged software could be licensed to a distributor, who may get the copyright rights to make copies of the software with the intent of selling them. Similarly, one could subscribe to a licence of a packaged software electronically for internal consumption.

Even these transactions that involve packaged software would fall under the current definition of IT software services.

In fact, under Income Tax laws, income derived from a transaction involving right to use of software is characterised under the head Royalty and not Technical services.

Historically, licence of software attracted Value Added Tax (VAT) of 4 per cent and 12 per cent excise duty. With its inclusion under the category IT Software services, it also attracts service tax.

Fundamentally, Service tax is payable when the transaction is in the nature of a service, whereas, VAT becomes applicable for a transaction of the nature of transfer of goods.

The scope for levy of these taxes is different and mutually exclusive.

Software providers, distributors, vendors and customers are all in a state of confusion and are waiting for some sort of clarification from the government. In abundant caution, most of the suppliers levy both service tax and VAT, thereby burdening the buyers with additional cost.

The anomaly and hardship can be avoided, if the government excludes the above mentioned categories of licence transaction from the definition of IT software service.

Relaxation in SEZ rules during recession

Units set up under SEZ scheme enjoy tax holiday without any sun-set clause. SEZ units enjoy tax holiday under Section 10AA of the Income tax Act.

A unit set up in the SEZ has to manufacture or produce specified articles or specified services and export such articles or services. Under such a situation, 100 per cent of profits and gains derived from export are exempted from tax for a period of five consecutive years; 50 per cent exemption for the next five years and; further 50 per cent exemption for five more years, subject to creation of Re-investment reserve account and utilisation of such reserve for the purpose of acquiring plant or machinery within a specified period.

Considering the fact that the SEZs are intended to promote new industry and new investment and not to facilitate migration of existing industries to avail of tax concessions, the tax exemption is granted to a new unit only if the following conditions are fulfilled, namely:

It has begun or begins to manufacture specified articles or specified services during the year relevant to assessment year commencing on or after April 1, 2006, in any SEZ;

It is not formed by splitting up, or the reconstruction, of a business already in existence;

It is not formed by the transfer of plant or machinery, previously used for any purpose

While the above conditions are desirable and essential to avoid abuse of tax concessions, an attempt is made to re-visit these conditions in a given context and quantify their possible impact.

The given context is that of an SME IT service provider operating in an economic environment where its customers downsizing their projects is quite common.

It is possible that this IT service provider may get a new business opportunity, which it may want to execute in an SEZ, in order to optimise its tax costs.

The entity may already have resources in the form of assets and manpower, at its disposal.

Now, were it to engage this new business in an SEZ unit and fulfil all the stipulated conditions, it would have to invest in new assets and recruit manpower. Doing that would result in under-utilisation of the resources already available.

Either way, in the given scenario, the under-utilisation of resources or not operating out of SEZ would translate into increased cost and make SME players less attractive to the customer.

The need of the hour is for the government to examine these conditions and possibly extend certain relaxations that are specific and time-bound. For instance, transfer of existing idle manpower into a new SEZ unit may not be construed as reconstruction of business.

Similarly, used assets that are already available with the entity can be put to use in the SEZ unit over and above the 20 per cent exemption already given for used assets.

The government may put in place additional checks and balances to prevent any abuse of these concessions.

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