‘SaaS’ – indirect tax issues in India

It seems there is still time before the Software as a service (SaaS) blooms well in the Indian domestic market. The biggest friction points are relatively low acceptability of online model, lack of quality internet penetration in country side and the unsupportive policy framework e.g. recurring billing, expensive payment gateway solutions and confusing indirect taxation in India. Owing to these bottlenecks, many SaaS companies relocated outside India or open a branch or foreign subsidiary.

iSPIRT has been pursuing a stay-in-India check list with Govt. of India, with following three top taxation issues embedded in it:

Removing confusion between ‘goods’ and ‘service’ tax on Software
Not treating software sales as royalty income and do away with TDS on sale of software
Start taxing online B2C sales by foreign companies

All three are relevant to the Software product Industry. However, the problem of ‘goods’ verses ‘service’ tax is intriguing to be solved and the subject of this article.

From tax perspective, many get carried away with the etymology of ‘Service’ in SaaS and believe service tax is the obvious classification. However, the classification under service alone, can’t be the most advantageous position for SaaS industry in a complex tax regime like India which is riddled with confusions.

This article attempts to explain this confusions of goods verses service tax effecting software product industry where SaaS is a special case in consideration.

Explaining the confusion between Goods V/s Service tax

The Indian tax system today classifies Software in following manner:

1. Treated as goods – has a tariff code associated (ITC HS Code)

Pre-packaged on media or paper license or PUK
Pre-packaged embedded with hardware

2. Treated a Service

Bespoke/Customized software development
Rest everything else that is not covered in a) above (SaaS falls here)

Those covered under a) above have a tariff code (ITC/HS Code) associated with them and hence fall under ‘goods’. The pre-packaged category (i.e. the Software products) have following tariff code assigned currently.

HS Code	Item Description
4907 00 30	Documents of title conveying the right to use Information Technology software
4911 99 10	Hard copy (printed) of computer software (PUK Card)
8523 80 20	Information technology software on Media

Same pre-packaged software downloaded ‘online’ is covered under service tax and is not treated as ‘goods’. Further, the tax system does not understand other models of SaaS, PaaS etc. All other categories of Software i.e. other than mentioned in a) above are covered under service tax by default under a logic of exclusion (not having covered under the tariff code list).

There is no guarantee that if the Service tax is applied there will not be a goods tax applied. VAT is applied in many cases based on interpretation in a way leading to double taxation. Even large players like Microsoft are not able to circumvent the double taxation. Their SaaS based offering (office365 bundled with exchange and storage on cloud[1]) are taxed differently at different point of times. Sometimes just the service tax and at other times service tax + VAT. You can hear a large number of use cases like this.

According to tax authorities in central government, the problem is solved simply by making goods and service tax rate one. They have solved the riddle by bringing in a notification for paying only one of the two at a given time excise duty/CVD or Service tax. But they have no remedy on states charging VAT. Whenever it is considered that the transaction implies ‘Transfer of right to use goods’ for any purpose (whether or not for a specified period) for cash, deferred payment or other valuable consideration, it is deemed to be a sale under Article 366(29A) of the Constitution of India. As a result Software even when defined as a services gets caught in 29A of (366) and VAT is applied based on how local authorities interpret a transaction.

The root cause of this confusion is that the tax regime has not given place to ‘intangibles’ at par with tangibles. As far as the tangibles trade is concerned, intangibles are treated as ‘goods’ as defined in 366(12) of the Constitution and their sale is covered by sale of goods act 1930. All that is defined as goods cannot be service by definition.

Does GST solve the puzzle?

Some people argue that these ‘good’ v/s ‘services’ tax problems will all vanish when GST is rolled out, based on the argument and assumption that the rate of tax in GST will be one.

GST is a ‘supply’ and ‘destination’ based tax system replacing the concept of manufacturing with concept supply of goods and supply of services. GST will also amalgamate most indirect taxes in existence at center and state. Both Center and state will have power to tax under GST for both goods and services. At present states do not have power to tax services.

One tax rate may be a necessary condition for attaining the neutrality and level playing field but not the sufficient condition.

Following are some reasons why even one rate GST is insufficient to solve the problem:

GST bill does not take cognizance of the root cause of absent definition of a ‘digital good’ i.e. including ‘intangibles’ at par with tangibles
The value chain of use and consumption of ‘goods’ and ‘services’ are quite different and hence will pose challenge in practice
The tax structuring is not done exclusively for the either software or the digital business. Also, Tax departments are prone to provide differential rates for new industry structures and business models for social needs under pressure of lobbying and differential tax rate may emerge for some segments of the Software Industry segments. The needs to tax new sectors of business and new models of business all arise in bits and pieces and then rules are overplayed above the basic tax structure, thus causing the confusion.
GST legislation is not clear on tax credit system in its completeness e.g. the inclusion of zero-rated supplies
The Clause (29A) of Article 366 has not been deleted in the proposed constitutional amendment and would need to be deleted as this would be redundant under the new concept where sales and deemed sales will be replaced by concept of supply or it may give rise to misuse under some pretext.
Any new statute has to be tested on ground it takes few years to evolve and align with ground reality. GST will be no exceptions.

GST bill has yet to be passed. After the GST bills is passed the rules will be framed under CBEC and it is expected that CBEC to be in its comfort zone will like to use existing frameworks and for Software product industry adoption of existing framework will not be helpful and it is imperative on us to suggest to government remedy for these long existing problems.

Proposed Solution – the need to define “Digital Goods” and “Digital Service”

To remove the root cause of the problem, a clear distinction between a “product” and “service” or “digital goods” and “digital service” is needed.

In the previous blog ‘SaaS’ – the product advantage and need we have argued that the product side in SaaS cannot be ignored. Even the service component in SaaS is about using this digital (intangible) product. Let us understand the product/goods properties that are commercially viable and legally tenable.

iSPIRT has been pursuing application of a frame work “COG-TRIP Test” that can be used to define Software Products as distinct from Software services. A SaaS product can be mapped to the complete COG-TRIP test. Given below is the framework of COG-TRIP.
1. Countability – no of licenses/users/subscribers
2. Ownership and Intellectual Property Rights
3. Qualification as an Intangible Good
4. Tradability: The Software Products (Goods) can be sold through different delivery modes.
5. Right of service/Right of Use
6. Identifiability
7. Production/Development Cost: All software production costs are capitalized and subsequently reported at the lower of unamortized cost or net realizable value

In the legal framework the above definition of “Product” has to be mapped to “Goods” as defined in 366(12) of the Constitution and hence there is need for the definition of “Digital Goods” at par with constitutional provision of “Goods” in article 366(12) which further is related to the Sale of Goods Act 1930. This will also cover the article 366(29A) aspects.

Gradually the world is also moving toward the above proposed scheme of overlaying the existing structure with a clear definition of ‘digital goods’ and ‘digital services’. US has a “digital goods and services fairness act” pending to be passed by congress. Australia has come up with a new digital GST.

The clear definition of ‘digital goods’ and ‘digital services’ definition not only provide the ease of doing business but also the level playing field against the foreign companies under new emerging business models every day.

Concluding notes – Looking for a long term solution

In a previous blog on ‘SaaS’ – the product advantage and need we have made a case for SaaS industry to be a formidable part of the Indian Software product industry (iSPI). For SaaS Industry, the advantage is in favour of getting defined under product (digital goods) category as an industry. This also infers that SaaS itself is a “Product” that provides a services to businesses or consumers who may actually fall in any industry verticals.

The tax is applicable on a transaction and does not get defined based on sector or industry. Once SaaS is recognized as Product (intangible goods) the next issue to be solved is asking for one single clear tax on a transaction be it “goods” or “services” based on the transaction.

Hence three basic requirements for SaaS segment to get a boost are:

SaaS is identified as a product or digital good
There is clear definition of digital goods v/s digital services in tax regime
There is one single and clear tax on one transaction

Tax and trade are much related in promotion of an industry and we hope these concerns will be addressed by Indian government in near future. SaaS can become a segment that can bring India pride and has possibility of emergence of next google from India.

Footnotes

[1] Consider a real life used case. I am running an office365 email service, procured through an Indian partner of Microsoft and I pay service tax on the subscription. I went ahead and placed order for a new office365 (same service) for a different domain directly from Microsoft online, the invoice charges me 14.5% service tax as well as 5% VAT. I tried to get a quote from other partner of Microsoft and again I get a quotation for 14.5% service tax and 5% VAT. In the first case I am buying from a partner of Microsoft who is a hosting provider. In second case the partner is a usual Microsoft partner selling their products or services.

Now consider buying office365 (office 2016 1 year subscription) for desk top licenses and there is CVD + VAT, even when it is a mix of offering both Product and Service for online storage and fully installed office pack.

The above used case mentioned above is of the office365 business essential plan has all the components built in the exchange online, access to MS Office products online only, online storage etc. It actually carries the many examples of the MS Office 2016 offered as SaaS model, Exchange offered as an email service and Storage offered as a service.

Disclaimer: The above example is based on real life personal experience of the writer and has nothing to do with iSPIRT.