Karnataka High Court rules that implementation of customized software is a service and cannot be subject to VAT

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1 14 September 2015 EY Tax Alert Karnataka High Court rules that implementation of customized software is a service and cannot be subject to VAT Executive summary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor. This Tax Alert summarises the decision of the Karnataka High Court (HC) 1 regarding the taxability of consideration received for implementation of customized software by a software company (petitioner) for banks. The HC held that such an activity is a service and therefore, the consideration for the implementation of software should not be subject to Value Added Tax (VAT). It was observed that the implementation services are required to integrate the system to make the software functional or useable only after the supply of packaged and customized software. Thus, it is in the nature of post-sale activity. As there is no transfer of property in goods at the time of implementation of the project, there is no direct sale or deemed sale. It is in the nature of service simplicitor. The HC also noted that a separate service contract is entered into for provision of services and rendering training to employees, so that the installed software starts functioning. Moreover, it was open for the customers to procure implementation services from any other competent agency. On these grounds, it was held that implementation activity cannot be considered as a part of customization of software. Where copyright is held by the developer of the software and the copyrighted article alone is handed over to the customer as a transfer of right to use the goods, the software is goods and is liable to VAT TIOL-2106-HC-KAR-VAT

2 Background The petitioner company is engaged in the business of development and sale of information technology related services like customization of software, implementation of software, annual technical and support services, trading / support services of third-party software besides providing services and other related technical consultancy and engineering services. The petitioner developed a specialized universal banking software solution known as Finacle Universal Banking Solution (Finacle) consisting of various modules. Considering the specific business requirements of the client-banks, implementation of the software is required to ensure that the banks requirements were met. Implementation activity typically includes installation of the software on the bank s hardware, bank specific customization, setting up interfaces for data migration from the old system to the Finacle system, testing activity etc. Where the client-bank approaches the petitioner for the implementation of the software, the petitioner enters into separate agreements i.e. one for sale of Finacle and the other for provision of implementation services. Apart from the activity of development and sale of its own software and services, the petitioner also purchases and sells third-party software and provides implementation and other support services for such third party software. The petitioner also provided Annual Technical Support services (ATS services). The petitioner had been paying Sales tax / VAT on the activity of development and sale of software. In respect of provision of implementation, customization or other support services, the petitioner was paying only Service tax, and no Sales tax / VAT. With regard to ATS services, which involved transfer of property in goods, the petitioner was paying works contract tax. In the case of implementation of customized software, where the copyright of the customized software is with the software developer, the implementation process is a pure service rendition and did not involve any transfer of property. If any source coding or scripting is done during the process of implementation, the ownership or copyright or any proprietary right would not vest with the software developer. They worked purely as a hired labour. Further, the ownership vested at all point of time with the employer who had issued the assignment. In such circumstances, since there was no transfer of ownership or the licence to use the software (deemed sale), it was a pure service contract. There was no sale of goods and it was a case of rendering service and was liable to Service tax only. Points for consideration before HC In the absence of transfer of a right to use of a software under a contract, could it be said that the activity of implementation involves a deemed transfer of goods as contemplated under Article 366(29A)(d) of the Constitution? After supply of packaged and customized software, if any service was required to integrate the software into the system to make the software functional or usable, does it amount to pre-sale activity which was chargeable to VAT or was it a postsale activity, which was in the nature of a service simplicitor? Petitioner s contentions The implementation activity is a post-sale activity and commences only after the sale of software to the client-bank / customer. The customer had the option to engage anybody for the implementation of the software after buying it from the petitioner.

3 The sale of software and its implementation were two different and independent activities and could not be clubbed together. At the time of implementation of the contract, there is no transfer of goods. Even if any software emerges during that process, the ownership would vest with the customer. Therefore, there is no transfer of right to use as the customer owns the software. It is a pure service contract and no sale is aspect is involved therein. Moreover, the entire consideration received in the course of implementation of contract is subjected to Service tax. Therefore, levy of VAT on this part of the contract is unsustainable. Revenue contentions As per the agreement, it is clear that unless the software undergoes scripting, configuration, screen customisation and other processes, it is not ready to go live. Only when the goods are marketable and become functional, it can be said that the goods have come into existence and are capable of being transferred. Customization included implementation. Therefore it is contended that without customization without implementation, the software is not complete saleable, useable and functional. Unless the software is customized, it is not usable and therefore, such consideration paid for customization is subject to VAT. Revenue rejecting the petitioner s claim for exemption on implementation of software by observing a new ground (post the filing of objections stage), had contended that the said activity was nothing but a value addition of Finacle software and therefore there was a sale of customized software. Whether the activity is termed as implementation of the contract or customization or improved enhancement, is immaterial. It is the substance of the contract which has to be looked at. Thus, the contract is a neither a service contract nor a works contract, but a contract for sale. High Court s decision The Karnataka HC relied on the Apex Court decision in the case of Tata Consultancy Services v. State of A.P. 3 wherein it was held that a transaction involving sale of computer software is clearly a sale of goods. HC also referred to Circular no. 17/ dated 24 July 2006, which deals with the levy of tax on software under the Karnataka Sales Tax Act, 1957 and Karnataka VAT Act, Referring to the above Circular, HC observed that in case of customized software, where copyright is held by the developer of the software and the copyrighted article alone is handed over to the customer as a transfer of right to use goods, the software is goods and is liable to VAT. It was observed that the petitioner was entering into several types of contracts with its customers. One type of contract involves contract of supply of customized products, contract of implementation and contract of ATS services. Another type of contract is only for supply of customized software and ATS contract, without contract of implementation. On perusal of a sample contract with one of the client banks, it was observed that it comprised of supply of software as well as its implementation. The scope was enlisted in separate annexures to the contract. From the above contract, it was clear that there was no mention of any software coming into existence which will be made use of in the implementation process. On the contrary, it was specifically stated therein that before the implementation program commences, there should be installation of software (1) SCC 308

4 It was thus held that, in substance, implementation means the customized software is integrated into several other systems so that the bank can start using the licenced software. In the process, there is no transfer of goods or right to use any goods. It is a service contract and therefore, the consideration for the implementation of software should not be subject to VAT. It was also held that implementation phase starts after the installation of the software and hence, it is not a part of customization process. It is in the nature of a post-sale activity. Further, though there is one composite contract, it is in two parts one for contract of sale of customized software and another for services in relation to implementation of software. Comments This is an important ruling, as the High Court has observed that since the implementation activity is already a subject matter of tax under the Service tax law, the States will have no authority to levy VAT on the same. This would bring respite to the software industry already facing widespread litigation around this issue. Once implementation of software is covered under the Service tax law, the jurisdiction of the State to levy tax on such activity stands excluded. It was also observed that ATS services amounts to a works contract as it is a contract to permit right to use enhancements, upgrades, maintenance and releases as well as ATS services. The petitioner has rightly discharged VAT on the same.

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