FEBRUARY 18, 2010

Will FM handle these most contentious Service Tax issues?

By S Sivakumar, CA

AS some wise man said, we all live on hopes. We have one more opportunity to hope for, in terms of the Budget 2010-11. As contrasted to customs duty and central excise duty, service tax has managed to create a lot of contentious issues. I've attempted to highlight four of these most contentious issues for the FM's kind attention. Given the likelihood of the fact that we might have to live with service tax for another year, one hopes that the FM handles these contentious issues in the forthcoming Budget.

1. Realty Sector suffers from a total lack of clarity on applicability of service tax

There has been a lot of avoidable confusion, in terms of the very applicability of service tax on the Residential Realty Sector. Service tax was first levied on the residential realty sector on June 16, 2005 when the construction of residential complexes was subjected to the levy of service tax. Under the service tax law, a residential complex is, interalia, defined to include 12 or more flats or residential units having certain common facilities. Hence, construction of more than 12 flats is subjected to service tax. The issue involving the liability of a Developer who has employed a back to back contractor for undertaking the construction activity, has remained a mystery, till now. The Department itself was taking contradictory views, but, it was fairly certain that in cases where back to contractors had been employed, the Developers were not liable to service tax. These contentious issues notwithstanding, the Government brought a new taxable service titled ‘Works Contractor's services' with effect from June 1, 2007, while allowing the existing taxable service, viz. ‘Construction of Complex' services, to continue. With a composition scheme being extended to the Works Contract services involving a tax rate of just 2% and with Cenvat credit being extended to capital goods and services, most realty players were enthused to switch over to the new scheme. But, the Department came out with a caveat that existing contracts as of June 1, 2007 could not be brought under the works contractor's services.

To cap it all, on January 29, 2009, the Board came up with a highly controversial Circular bearing No. 108/02/2009, which seemed to take the entire realty sector out of the service tax net. The said Circular, interalia, states that, an agreement to sell a flat or a residential unit, is outside of the service tax net. The sad part remains that most Service Tax Commissioners have taken an open stand that service tax is applicable on joint development agreements and in cases, where agreements for construction are entered into, defying the Board Circular.

The Realty Developers and Builders are caught between the customers, who are not willing to pay service tax on the basis of the Circular, on the one hand and the Department on the other hand, which is refusing to extend the benefit of the Circular to the Developers/Builders. The last thing these players desire is to be burdened with a service tax liability after several years, when it would be impossible for these players to recover the service tax dues from their customers, who would already have got the flats registered in their names.

One would hope that the FM either withdraws Circular No. 108/2/2009 or issues a further clarification that no service tax is leviable on the transactions between the Developer/Builder and the flat buyers, irrespective of the manner in which these transactions are entered into.

2. Transfer of Software Licenses suffers from double levy

This is perhaps, the most contentious issue that has been really haunting India's most promising industry. Despite that service tax is leviable only services, the Union Government, by bringing in ‘Information Technology Software Services' as a taxable service with effect from May 16, 2008, has clearly poached into the territory reserved for the States, especially with regard to the selling of software licenses, which has been clearly recognized as a transaction involving sale of goods. As we know, under Notification No. 49/2006-CE dated 30.12.2006, which 8% excise duty was imposed on software in terms of the new entry viz., ‘8523 80 20 dealing with ‘Information Technology software'. The rate of duty which was fixed at 8% for the period January 1, 2007 to February 8, 2008 got enhanced to 12% effective from March 1, 2008. However, exemption was granted to ‘Customized Software' vide Notification No. 6/2006-CE dated 1.3.2006. Information Technology Software (branded as well as tailor made) is ‘excisable goods' under headings 8523 80 20 [earlier 8524 91 11, 8524 91 12 and 8524 91 13]. As stated above, the tariff rate of duty is 12% w.e.f. 1-3-2008 (earlier it was 8%). However, all software, except canned software i.e. software that can be sold off the shelf, is ‘exempt' under Sr. No. 27 of notification No. 6/2006-CE dated 1-3-2006. Not content with the confusion covering the levy of central excise duty on software, the Government introduced Section 65(105)(zzzze) in the Finance Act, 2008, bringing ‘Information Technology Software Services', into the service tax net with effect from May 16, 2008. The most obnoxious provision in the definition of ITSS is contained in clause (v) of Section 65(105)(zzzze) dealing with acquiring the right to use information technology software supplied electronically, which is a taxable service. Even before the dust created by the levy of service tax on software licenses could settle, the Government once again, created a huge confusion by issuing Notification No. 22/2009-CE dated dated July 7, 2009, as per which, an exemption was given in respect of central excise duty / CVD levy on Packaged/Canned software to the extent of value / consideration paid or payable for the right to use such packaged/canned software, provided the software was transferred for commercial exploitation.

The Government has brought about too many changes at too short a time with the result, that nobody, including the Department, is clear as to the levy of service tax on the sale of licenses, which is essentially a transaction in goods and not in services. Judgements of the Supreme Court in the TCS case and the decisions of the High Courts including the Madras High Court's decision in the Infosys case clearly point to the clear fact that, software is goods. Even the Income tax Act has recognized this fundamental principle. Both the Customs Tariff and the Central Excise Tariff treat documentary evidence as goods and prescribe rate of duty in the tariff. Moreover, under most VAT Acts, there is a specific tariff entry covering software licenses. This being the case, the levy of service tax on transfer of software licenses in any mode, is not justified and would not stand judicial scrutiny.

It is amazing to note that the Government treats software as services for levying service tax, while for all other purposes including for levy of central excise duty, software is treated as goods.

One hopes that the FM would finally remove the levy of service tax on transfer of software licenses by suitably amending Section 65(105)(zzzze).

3. Import of Services – Reverse Charge Mechanism cannot cover services rendered outside India

As we know, the reverse charge mechanism under Section 66A of the Finance Act, 1994, gets triggered when services are received from a service provider based outside India by a service recipient located in India. Certain criteria have been prescribed under the Taxation of Services (Provided from Outside India and Received in India) Rules, 2006 read with Section 66A. These rules essentially provide that, where a person who is based outside India provides taxable service to a person who is based in India, the service shall be treated as having been provided by the recipient in India and the recipient of the services is liable to pay service tax. These rules clearly specify that the services would have to be ‘received in India' to attract the reverse charge mechanism. Though the criteria prescribed talk of the place of belonging vis-à-vis the services provider being determined with reference to the place where he has established a business or a place where he has a fixed establishment from where the service is provided or a permanent address or a usual place of business, the fact remains that the service will have to be ‘received in India' for triggering the reverse charge mechanism.

Very fortunately, the Department has been seeking to bring all transactions involving forex payments by Indian companies, under the ambit of Section 66A including, services rendered by the non-residents outside India. While there is a logic for covering services rendered by non-residents while being in India, it would be unfair for services rendered by non-residents outside India to be brought under the reverse charge mechanism.

Under the income tax law, the distinction between services rendered by non-residents in India and outside India, is well recognized. Even the CBDT has recognized this principle of payments effected by residents to non-residents for services rendered outside India, to be out of the income tax net. Of course, we have had landmark decisions like the one from the Apex Court in the Ishikawajma Harima case 288 ITR 408 (SC), wherein, it has been held that for income tax to be levied, the non-resident should not only have rendered the services in India, but also that these services should have been utilized in India. This principle should apply equally for the reverse charge mechanism whereby, services rendered outside India are kept outside of the ambit of the service tax levy.

If a payment by a resident to a non-resident cannot constitute income in the hands of the recipient, the same transaction cannot also result in the levy of service tax under the reverse charge mechanism. The levy of service tax on import of services is assuming draconian proportions and there is an urgent need for the FM to trim down its coverage to cover only services rendered by the non-residents in India.

4. Government should stop meddling with SEZ scheme

In so far as the levy of service tax on services rendered to SEZ is concerned, Section 26(1)(e) of the SEZ Act clearly provides for exemption from service tax under Chapter-V of the Finance Act, 1994 on taxable services provided to a Developer or Unit to carry on the authorised operations in a Special Economic Zone. Despite that the SEZ Act provides a blanket exemption from service tax on taxable services provided to SEZ Developers and SEZ Units, the Government has gone ahead and levied service tax on services ‘not wholly consumed' within the SEZ, in terms of Notifications Nos 15/2009 and 9/2009 with effect from March 3, 2009. It is clear that there is a conflict between Section 26(1)(e) of the SEZ Act and Notifications Nos 15/2009 and 9/2009 issued by the Government under Section 93(1) of the Finance Act, 1994, in as much as the blanket exemption in respect of service tax given by the SEZ Act is sought to be restricted by the Notifications issued by the Government by laying down that the exemption is available only for services which are ‘wholly consumed within the SEZ'. This new requirement has brought about a lot of subjectivity in the overall scheme of taxation of service providers, in respect of services rendered to SEZ. No service provider can be sure that his output services would be ‘wholly consumed' within the SEZ, so as to be able to avail of the exemption.

Recently, in a landmark judgement in the Essar Steel case, the Gujarat High Court has reaffirmed the supremacy of the SEZ Act in case of conflicts with other Acts and consequently, the Notifications Nos 15/2009 and 9/2009 issued under the Finance Act, 1994 in respect of services rendered to SEZ Developers and SEZ Units would not stand judicial scrutiny, in my view.

Notwithstanding this, the FM should kindly ensure that his Ministry stops tinkering with the SEZ scheme and ensure that, the provisions of Section 26(1)(e) of the SEZ Act are implemented in letter and spirit, by completely exempting taxable services rendered to SEZ Developers and SEZ Units.

(The Author is Director, S3 Solutions Pvt Ltd, Bangalore)