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Taxation of Software

Written by: Romit Agrawal
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State tax laws are generally old and the state taxation is governed by the laws which were enacted at that time. Those laws are unchanged till date. Therefore, many states don't have the tax or revenue codes for the manufacturing and the sale of tangible property. Moving toward a developing economy, the information based service economy has merged under the service sector. The old methods of taxation have become rusty and, in some cases, unworkable when applied to developing economy. This is particularly true when this old law is applied to industries that were not even anticipated at the time of the statutes enactment.
Over the past fifteen years, the software industry has exploded into a high growth and extremely productive business. Traditionally, sales/use tax has applied only to the sale of tangible personal property . Thus, the sale of services is a transaction exempt from sales/use taxation . Similarly, sales of non-tangible goods are also exempt from taxation. In the software realm, programs written for a client's specific needs are not taxed since what is sold is treated as a service . Programs which are otherwise goods but are sold intangibly (e.g., over a modem) also are not taxed because they do not conform to the tangibility requirement

This essay will review three issues of current interest to software companies in focusing on how these issues can and should be analyzed:
1. Taxation of sales of computer software for sales and use tax purposes.
2. Taxation of software for ad valorem tax purposes.

Background on Software
Although computer software has no specific definition but it is generally referred to as the predetermined set of instructions or programs that the computer carries out . Software, which is of course inherently intangible, is physically manifested by electronic pulses arranged on a magnetic disk or magnetic tape or, in some cases, on a computer chip. Generally speaking, there are three distinct varieties of software: (1) operating systems, (2) application programs, and (3) files.
i. Operating Systems:- Operating systems, as the name implies, are programs that actually instruct the computer on how to operate. These systems are written under various codes such as MS DOS.

ii. Application Programs:- Application programs are the instructions which are actually manipulated by the computer and tell it how to perform various tasks. These include the word processing software with which all attorneys are familiar as well as the Lotus and Excel spreadsheet type software.
iii. Files:- Finally, there are files which are maintained. Files are not instructions but are simply compilations of data. For instance, for a lawyer these would include stored documents which have been prepared. Software can be "canned", i.e. pre-written or standardized, "custom", i.e. specifically coded for a specific user for a specific purpose, or a modified form of pre-existing software. It can be stored and delivered in many forms (i.e. on disk, by telephone line, via modems, within the memory of a computer, through computer punch cards). Perhaps it is because of the multiplicity of forms which can embody software that much of the difficulty arises in the tax area. Software can assume at various times aspects of a service transaction, tangible personal property or intangible property. Because tax statutes often tax each of these differently, this often results in confusion under the tax regimes.

Taxation of Software For Sales Tax Purposes

There is some uncertainty in taxation of software for sales tax purpose because of lack of rules and regulations for treating software as tangible property. By this, the question arises that whether the software is to be treated as a tangible property for application of the rules regarding sales tax.

(A) "Tangible personal property" means personal property which may be seen, weighed, measured, felt, or touched or is in any other manner perceptible to the senses. "Tangible personal property" does not mean stocks, bonds, notes, insurance, or other obligations or securities.

Historically, the statutory difference between "tangible" and "intangible" has been relatively easy to apply in the sales tax arena. Advances in technology, however, have done much to blur this line between tangible and intangible property.

Computer software ranks as perhaps the leading technology which defies easy classification. One problem is that the industry itself does not clearly define the term software. Moreover, information contained in "software" can be transmitted through several media. For example, the information can be delivered on a computer through disc, digital transmission over telephone lines, through direct input by an individual, through a magnetic tape transfer or, in some old fashioned cases, punched cards. The law in this area became confused early in its development. Initially, taxpayers sought to characterize software as tangible personal property in order to claim an investment tax credit for expenditures on software for federal income tax purposes.

In the early years, taxpayers contesting sales tax liability utilized precedent to argue successfully that software was not subject to sales tax because the intangible information, not the tangible media, was actually what was being sold . As the technology developed and software was more frequently sold to the general public in shrink-wrapped packages, the courts began to view software as tangible personal property in a manner more analogous to books, records, photographs and video cassettes . One court has held that the arrangement of instructions on a tangible medium constitutes a "corporeal body", and hence, tangible property . Another case found that computer software is ordinary common tangible property, at least where delivered on disks.

(B) Sales Tax Planning for the Software Industry.
What can the well advised software company do with this information

Determine Whether the Purchaser is Exempt:
In all cases a taxpayer should make an initial determination as to whether a purchaser of software is exempt from sales tax. For example, sales to certain non-profit organizations, governmental institutions and schools are exempt from tax.

Differentiate between various softwares:

Some general guidelines may also be of assistance in determining whether writing of software fits within the personal service exemption. First, computer consultants who write software for a specific customer clearly provide personal services which are not subject to the tax. In such cases, the purchaser often acquires title to the copyright for the specific application written by the consultant.
A closer case arises if a computer consultant retains the copyright to the software. In such a case, the services for the first customer may be exempt as a personal service transaction, but the license of the software to a second customer with slight modifications on the original software may be subject to sales tax.

Electronic transmission of Software:

With some customers, it may be possible to transmit the software electronically without the use of tangible media. The Department of Revenue does not appear to address the issue of whether electronic transmission is exempt from sales tax as not involving a transfer of "tangible personal property".

Differentiation of charges between Software and Consulting Services

The sale of software often involves uniform prewritten software which is transferred to the customer. Substantial consulting services are generally involved in applications which may exempt from sales tax. In fact, it is not uncommon that the cost of the standardized software is less than the charges for overall services provided to the customer. In these circumstances, it will be important to document and allocate the costs between the software and the consulting services.

Even assuming the transfer of the software may be subject to sales tax, the consulting services should be exempt from tax as personal service transactions. Of course, the Department of Revenue may attempt to reallocate costs if it appears the taxpayer is making an unreasonable allocation to services.

Taxation of Computer Software For Ad Valorem Tax Purposes

Another issue of great current interest and concern to the high tech community is the taxation of the capitalized cost of computer software for ad valorem tax purposes.

A. The Taxability Issue.
Taxation for ad valorem taxes varies. In some states, all tangible personal property is subject to ad valorem tax but intangible property is not. In other states, both tangible and intangible personal property are subject to tax. Thus, the question arises whether the software is tangible or intangible property. If the software is utilized in the state where only tangible personal property is taxable but intangibles are not taxable, the question arises as to whether software will be categorized as a taxable tangible personal property or a nontaxable intangible personal property. In states where both tangible and intangible personal property are taxable, the classification nonetheless remains important because in many states intangible property is taxed at a lower or different rate base than tangible personal property.

B. Taxation of Off -The Shelf-Software.
There is an argument that since the software can (and does) exist separately from the physical media, that it is not tangible personal property . Alternatively, taxpayers may contend that such inventories should only be valued based upon the value of the actual media on which embodied. The analogy of such off-the-shelf software to inventories of books, cassettes, compact discs, or videos is difficult to avoid, however. If such software is tangible personal property, under appropriate circumstances such software inventory may qualify for a Freeport exemption.

C. Taxation of Software as an Intangible.
As noted by at least one commentator, there are at least three different schemes for ad valorem taxation:
(1) the taxation of all property, both tangible and intangible,
(2) the taxation of all tangible personal property, and
(3) taxation of only selected classes of tangible personal property.

In several states that issue remains opens and, certainly, it does not take a vast extension of existing case law to argue that the physical embodiment of software in a tangible form, such as in a diskette, should no more make the underlying software taxable as tangible personal property than embodiment of the copyright words of Gone With the Wind in the covers of the book or in the form of a videotape makes the copyright of Gone With the Wind separately taxable as tangible personal property.

D. Taxation of Capitalized Software Costs.
Even assuming that inventories of off the shelf canned software may be taxable, this does not address the taxability of other software, particularly capitalized development costs. Historically, the capitalized development costs of software has generally not been assessed or taxed as tangible personal property. The majority of states which have addressed the issue and have concluded that software (at least unbundled software) is not tangible personal property for ad valorem tax purposes and therefore is generally not taxable . However, in states where intangible property is separately taxable, the issue will remain.

E. Legislative Responses.
As noted previously, most of the problems of ad valorem taxation of software are solved. Steps have been taken by some of the states either by explicit exemption or classification of software as non-taxable intangible property. In some states, there were essentially three alternatives that were available to a state to address the taxation of software. States which do tax intangible property has to define software as an intangible, and subject to its intangible tax which generally is lower than the personal property tax rate. Other alternative is to define software as taxable (either as tangible personal property or intangible personal property) but only to tax it on the valuation of the physical embodiment.

F. Issues.
In addition to the threshold question of whether software is tangible personal property or intangible personal property, the whole issue raises other interesting questions. Most basic, if software is taxable, where is such software taxable?
Broadly stated the question of wherever software is "sit used" for ad valorem tax purposes is the real one.

For instance, under the applicable state statute
# Where is software located?
# Where is it used?
# What if software is used in more than one office?
# What if the taxpayer is a multistate corporation and uses the software throughout the country?
# Can taxpayers avoid taxation by the expedient of transmitting software out of the state or by delivering a hard copy on the assessment date?
# What about setting an affiliated non-resident entity to own and license software to a resident user? Does this avoid ad valorem taxes?

The present tax system focuses on tangibility, an antiquated framework which has been stretched to fit new technology. Although it is desirable to have a universal system for assessing sales tax on all goods and products, a time must come in which the costs--in terms of confusion, inefficiency, and inequity-- outweigh the benefits, and exceptions to universal treatment must be made. Simplicity, certainty, efficiency, equity, and growth are the goals of any tax structure, while universality is but a corollary to these goals. These goals are clearly not met when attempting to apply the tangibility/intangibility distinction to software.

system which is based upon the applications/operational distinction of software promotes most of the goals of an ideal tax system: efficiency, certainty, equity, and economic growth. A functional distinction also creates vertical categories of taxable items rather than the horizontal categories created by the tangible/intangible standard. Using these concepts accepted in the industry, legislatures may easily identify the broad categories of software which it desires to tax. Accordingly, all the industry participants-- programmers, distributors, retailers, and consumers--may accurately and reliably assess the tax treatment which a transaction will incur. Parties will no longer be able to evade taxes by restructuring their transactions. The sales/use tax system will be equitably and consistently applied. Thus, this system presents the best alternative to the current sales/use taxation of software.

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