Cover Story
The Great Indian Software Mess
 Because of complicated, cumbersome and contradictory tax laws, the software reseller community in the country is going through the most challenging times in its history
By Ramdas S
Since May 2008, hundreds of software resellers have been hurt by policies of the central government, the apathy of state governments, the lack of pro-activeness from vendors and confusing moves by distributors. Ever since software has been classified as a service, almost every software reseller is seeing depleting working capital.
A fluctuating dollar, an economy hit by the global slowdown, a business model that has seen receding margins for years and service tax department’s plans to collect taxes on the rebates passed on by vendors fill up the reseller community’s cup of woes. Moreover, the income tax department is eyeing the community’s business model and wants its pound of flesh—it has targeted many software importers with withholding taxes.
A CRN-ISODA (Infotech Software Dealers Association) survey conducted among the top 70 software resellers in the country has revealed some shockers. Just about everyone in the survey has reported negative growth over the past year or so, and one out of eight resellers is thinking of quitting the business if the status quo continues.
“It’s not an exaggeration to say that the packaged software industry and its channels in the country are dying. We have been hit from practically all sides, and we seek a quick solution to our problems,” says Rajesh Kothari, CEO of Blue Chip Computers, and Chairman and Founder of ISODA.
Timeline of troubles
The story started with budget 2008, when the then Finance Minister P Chidambaram said while presenting the Finance Bill, 2008, “I propose to increase the excise duty on packaged software from 8 percent to 12 percent to bring it on par with customized software, which will attract a service tax of 12 percent.”
Following this, on 16 May 2008, service tax was imposed on services provided in relation to information technology (IT) software for use in the course or furtherance of business or commerce, by inserting section 65 (105)(zzzze). The bill very specifically added a statement on acquiring the right to use IT software for commercial purposes, including the right to reproduce, distribute and sell IT software, and the right to use software components for the creation of and inclusion in other IT software products. A further statement was added to include all software acquired electronically.
By June 1, 2008 distributors woke up to the new reality, and quite a few of them started charging service tax on paper licenses. However, some distributors, especially prominent Microsoft distributors, managed to convince the customs and started paying countervailing duty (CVD) on software, classifying it as goods by taking advantage of the very ambiguous statement by the finance minister.
“We have had this situation since August 2008 where one set of distributors was paying CVD and another set was importing and then paying service tax to the service tax department,” says Harinder Salwan, Secretary, ISODA.
Channel partners, distributors and vendors have been running from pillar to post since August 2008, trying to get a clarification on the status of different types of software licensing available in the country.
There was more to come. In the budget tabled by the newly-elected government in May 2009, the ambiguity was further muddled with a statement replacing the word ‘acquiring’ by ‘providing.’ Then on 1 September 2009, the Finance Bill was further amended to clarify that all software—irrespective of whether it is shrink-wrapped, has a paper license or is electronically downloaded—is a service, and will therefore attract service tax.
“Ever since the nascent stages of this industry, software sold in the country were tabled as goods, and the VAT department continues to collect sales tax. Now, all of a sudden, excise (CVD), service tax and sales tax have been levied on software,” complains Salwan.
A letter by Gautam Bhattacharya, Joint Secretary (PRU-II), Ministry of Finance, which was issued to the Chief Commissioners of Customs and Central Excise at different ports, stated that software needed to be classified as two components: first, the media that would attract a CVD of 8 percent of its value; second, the software license or the right to use or the right to provide the use of software. This meant that paper licenses and electronic downloads were fully exempt from CVD, while the shrink-wrapped retail boxes attracted both CVD and service tax.
“There was further confusion about what the cost of the media should be, what the cost of the license should be, and what the right breakup should be, with different distributors offering different breakups,” recalls Salwan.
Cashflow problems
The complications became worse once customers started slashing TDS (tax deducted at source) on the invoices raised by channel partners on software that’s sold in the country. “At 10.3 percent TDS, our cashflows started getting affected. Theoretically, the TDS component is a credit we can encash when we file our returns. However, for an average reseller whose gross margins hover between 5 and 7 percent, it’s impossible to fully encash the TDS amounts cut by the customers,” says RK Singh, CEO of the Delhi-based Aditi Computers.
Since the bill used to carry both service tax and VAT levies, some customers refused to pay one of the tax components stating that their legal cells had advised them to pay only one of the taxes. “Unfortunately, that’s not an argument that any of the tax departments listen to when it comes to collecting their taxes. The customer not paying a tax component is not perceived as our liability by the tax department,” says Kothari.
With the service tax on software, the cashflows of the companies are the hardest hit. Almost 57 percent of those polled in the survey said that their cashflow is negative once the TDS has been cut by the customer.
“For a mid-sized reseller working at a low margin of 5 percent, it requires just about 10 decent-sized transactions to wipe off the entire working capital in the present scenario,” analyzes Salwan.
Take the case of Info Creations, Delhi. Says Hemant Handa, CEO of the company, “Recently I got a huge contract to supply software, but the TDS cut was somewhere close to Rs 50 lakh, which is a significant share of my working capital. Now this amount is blocked for several months. Another two transactions of this size and I can get wiped out.”
Typically, most resellers plan their purchases at the end of the month. When an entity buys a service, it is supposed to reduce the TDS amount on the value of the service (in this case, the software) and then remit the same amount to the income tax department. “While many of us enjoy up to a 30-day credit from distributors, by the seventh of the month we need to make the remittance of the TDS amount, failing which we attract penalties. This means that 10 percent (with the TDS amount being 10.3 percent) of our working capital is blocked,” explains Salwan. “Similarly, once the customer gives us the payment which could be at the fag end of a 30-day (or more) cycle, the customer reduces 10.3 percent TDS which would be roughly worth 13 percent of the original invoice value of the software.”
“The double taxation has increased costs. Moreover, the service categorization has added hardship since every customer is interpreting our trading invoices as service invoices and is deducting TDS at 10 percent plus, thereby badly affecting the working capital cycle, and this is throwing us out of business,” says G M Kamath of PC Technowledge Center, Mumbai.
Salwan says that for a software reseller to have a positive cashflow to sustain basic business, the reseller needs to work at 14 percent. “If you have to continue growing, pay salaries and take care of expenses, you need to have somewhere around 20 percent gross margins.”
In March 2009 ISODA filed a writ petition against the notification, challenging the interpretation of software being a service. “We are fighting the case on several grounds, the most important being that the entire law is draconian. The constitution clearly defines different lists of items to be taxed. List 1 contains the products and services which come under the central government’s prerogative, while List 2 contains those which come under the respective state government’s scanner. Software has long been and continues to be in List 2,” argues Kothari, “hence it’s extra-constitutional to bring software under service tax.”
The complex income tax laws in the country have become further complicated after the Karnataka High Court interpretation that software is an intellectual property, and can attract royalty. Ever since this verdict, the income tax department wants to tax income from the sale of software products, contending that it is a ‘royalty’ income. Importers of software have already been levied a ‘withholding tax,’ which is between 10 and 20 percent depending on the country of import. “Funnily, they ask us to pay tax even if we make a purchase over credit card. This is difficult for the suppliers to foot due to the laws in their own countries. The importers therefore need to pay the tax themselves,” adds Kothari, stating that the cost of software is likely to go up by another 20 percent.
Nasscom’s role suspect
Since, during the period between March 2008 and October 2009, many distributors were billing along with CVD to escape the TDS scanner, resellers buying from these distributors were collecting only the VAT component from their customers. The service tax department has already issued notices to prominent partners to cough up close to Rs 1.5 crore in tax arrears on business done since March 2008.
Another time-bomb which ISODA members are afraid might blow up any day is the service tax on backhand rebates issued ever since service tax laws were introduced in the country. “Already a few notices have been issued in Tamil Nadu, and it can spread across the country,” worries Kothari.
Almost 46 percent of those polled in the CRN-ISODA survey felt that as a result of the cascading effects of multiple taxation, the average selling prices of software have risen by 15-25 percent. According to Shyam Nagarajan, Director, Firstware Solutions, Chennai, “Double taxation has increased the costs, and with pressure on cashflow, everyone in the supply chain needs to work at higher margins. That’s why the prices of software to end-users have shot up by as much as 20-25 percent.”
Piracy levels are also known to have risen. “Partners are losing business every day, and the volumes of business are dropping. The hardware market has shown signs of recovery, but it cannot run without software. Piracy is definitely on the rise, and the government is responsible,” insists Asis Chaudhuri, COO, Duckback Information Systems, Kolkata.
While 97 percent blame the central government for the situation, a cross section of those polled do not spare state governments (55 percent), software vendors (47 percent), distributors (39 percent) and bodies such as Nasscom (43 percent).
Distributors and vendors are criticized for not being proactive and not acting in the interests of channel partners. There’s also suspicion about Nasscom’s role since the government is known to have consulted the trade body before implementing the service tax regime. “My personal observation is that Nasscom has also been a party to this, and has not taken any proactive step to help us,” says Singh of Aditi. “Indirectly, the large software exporters who also dabble in local business benefit because their profits and business models support a TDS of 10 percent.”
Seeking a way out
The solution software resellers are hoping for is a court interpretation/verdict or a resolution from the finance ministry. “Clearly, packaged software are goods. Most of these software products are published in US, and as per US laws packaged software are goods. We cannot have a different interpretation here, and we hope that the software is again reclassified as goods very soon,” comments Amarnath Shetty, Director, LDS Infotech, Mumbai.
The biggest demand is for the authorities to issue a clear definition of customized software in contrast to packaged IT software. Also, to recognize that IT software (customized or packaged) could be sold as a shrink-wrapped box, paper license or Internet download, and that this should be taxed uniformly under all Indian laws without any double taxation. “Please do not get us wrong,” says Kothari. “We do not mind paying taxes. However, there has to be some parity. Just because software has been a sunrise industry for long, you cannot kill it by treating it like the proverbial golden goose.”
Resellers want a clarification that service tax is not applicable on the sale of IT software when sold as a shrink-wrapped box, paper license or Internet download. Also, a clarification that providing the ‘transfer of right to use’ software by way of sale of license in any form does not involve any software service. There also needs to be a reduction or removal of excise and CVD on packaged software because packaged software is in no way a threat to the local IT industry. Resellers also feel that we need to stick to the guidelines of the commitment made by India to the World Trade Organization (WTO) in 1996.
“For a small partner, managing service tax is a huge pain. By the argument that packaged software is a service which gets traded between several resellers, any product manufactured is a service. Take for example a cupboard or any other furniture. Only 30-50 percent of the input cost is wood, the rest of the cost is because of services. So why do other products not come under service tax?” questions Manoj Kumar Agarwal, CEO, Ashram Computer Consultancy Services, Bengaluru.
Some resellers are hoping that a solution might come about automatically once the Goods and Services Tax (GST) regime gets implemented in India. “We hope that once the GST is implemented everything will get resolved,” says Agarwal.
Others feel that this could be just wishful thinking. “I don’t personally believe nor want any of our channel partners to bet on GST. No one knows for sure how GST will be implemented in the country,” opines Kothari.
Around 14 percent of the partners we polled have applied for lower TDS certification from the income tax authorities. “Section 197(2A) offers respite for an individual or business that can justify the deduction of TDS at a lower rate. We’ve managed to get a certificate from our assessing officer at a lower rate of 3.5 percent instead of 10 percent. This has definitely given us some breathing space,” reveals Prabhakar Kini, MD, Kinfotech, Bengaluru.
Adds Salwan, “We are also advising members of ISODA to seriously re-look at the margins they are working on. In the present circumstances you can’t do ‘legal’ business on software and continue to protect your working capital unless you have 14 percent. Till we manage to resolve this issue, we urge partners not to chase toplines but rather to be bottomline centric.”
While many software resellers live in the expectation that the issue will somehow get resolved, a few are rather pessimistic. Handa is one of the latter. “The government is filling its coffers, and it definitely sees us as a truly soft industry. We’ll require a miracle to solve this mess.”
A miracle is what ISODA and the resellers are hoping for. |