Software major Microsofts Indian arm has come under the tax scanner. The service tax department has confirmed a tax demand of Rs 128 crore and slapped a penalty of another Rs 128 crore on the company for alleged evasion.

It has been alleged that Microsoft Indias Gurgaon unit carried out certain marketing activities for the India operations and not for the Singapore arm of the US software major as it had claimed.

Sources in the department said the company had not paid tax on these services, claiming them to be exports. An email sent to Microsoft India for its comments did not elicit a response.

Sources said the service rendered by Microsoft India were not exports as per Rule 3(2) of the export of services rules of 2005. The marketing services provided by the company were covered under the business auxiliary services, they said.

The government had prescribed a separate set of rules for export of services in 2005, making it clear that any service consumed within India wont be treated as exports. Penalty has been imposed under Section 78 of the Finance Act, 1994.

Since the services rendered by the company were consumed in India, sources pointed out that Microsoft was liable to pay service tax. As per the service tax rules, export of services is defined as services being used outside India. These rules, however, do not match with the WTO rules of services export. The WTO categorises export services as those consumed abroad under Mode 2 category.

Many companies cutting across sectors get caught in the maze of these rules. In fact, the ambiguity in rules has been highlighted time and again by tax experts and some industry bodies. Earlier, Microsoft India had been issued a show cause notice by the department in April last.