The ambiguous case of taxing intangibles

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Levy of service tax on provision of ‘services’ and value added tax (VAT) on sale of ‘goods’ is clearly demarcated and may look simple enough to the uninitiated.  However, this simplistic differentiation regarding the nature of levy becomes perplexing in the case of certain transactions. A perfect example of this puzzle is the applicability of VAT or service tax on intangibles. Intangibles, or incorporeal assets, in very basic terms, are assets like trademarks, copyrights, patents, computer software, etc that cannot be seen, touched or physically measured.

After a prolonged debate, fortunately, the characterisation of intangibles as ‘goods’ or ‘services’ has become more or less settled.  Both the central and state authorities are on the same page on the point that for indirect tax purposes, intangibles should qualify as goods.  However, there are certain borderline cases that continue to face challenges. For instance, whether supply of software qualifies to be a supply of ‘goods’ or supply of ‘service’. Interestingly, while there is clear view that supply of packaged software on tangible media is tantamount to sale of goods and attracts only VAT, issues repeatedly arise with respect to taxability of customised software. Despite customised software also being ‘goods’, disputes around levy of service tax continue to arise on such transactions, on account of the software development activities involved. As per the tests laid down by the courts regarding characteristics of goods (i.e utility, capable of being bought and sold, capable of being transferred, transferred, delivered, stored and possessed), customised software should also be treated as goods and therefore, subject to only levy of VAT. However, the transaction should be one of service where the software is developed at the behest of the client and the proprietary rights vest with the client from inception itself.

Characterisation of various electronic supplies (in the form of software, or digital content such as music, videos, books etc) for the purposes of levy of service tax and VAT also continues to be an area of debate.  This riddle is particularly difficult to crack as the process involves mere transmission of data from the world wide web and as such, there are no appropriated goods that are delivered at the doorstep of customers. Most VAT / GST implementing countries across the globe, characterise electronic supplies as services.  Taking cue from this international practice, the central government’s stated intent to levy service tax on electronic supplies appears logical.  Nonetheless, the VAT authorities continue to contend that intangibles, being goods, continue to be within their domain of taxation irrespective of the mode of their delivery.

Another area of ambiguity in the present context relates to transactions involving licensing of tangibles.  Licensing and/ or transfer of intellectual property rights such as trademarks, patents, copyrights or transfer of right to use software for commercial exploitation is common amongst business concerns these days.  Generally, VAT is applicable on permanent transfer or ‘transfer of right to use’ (transfer of effective control). Further, service tax is applicable on temporary licensing or permission to use intellectual property rights or licensing without transfer of right to use.  Courts, on several occasions, have held that ‘transfer of right to use’ would arise only in cases where the effective legal right to use the goods lies with the transferee.  Further, the transfer should be to the exclusion of the transferor as well as to any other users.

In reality, a transfer of intellectual property right and/ or licensing of software can never be to the exclusion of transferor and/ or other multiple users.  Grey area also exists regarding the scope of an ‘exclusive’ transfer, for instance, whether exclusive rights to use an intangible in a geography should also constitute as an ‘exclusive’ transfer. Similarly, the test of effective legal right to use also fails, as in almost all cases, the transfer of intellectual property rights is restricted with respect to the use and/ or disposal of such rights.  Since, it is almost impossible to satisfy these criteria for intangibles, a view can be taken that these tests should not apply in case of licensing of intangibles.  Thus, licensing of intangibles such as trademarks even on a non exclusive basis should be liable to VAT.  This view has also been affirmed by courts recently.  Further, as a corollary, service tax should not apply on such transactions. In light of this, the attempt to establish distinction between transfer of right to use and mere permission to use, is increasingly becoming superfluous and unnecessary for intangibles.

Having said the above, there is frequently an overlap between levy of VAT and service tax on licensing of intangibles. While strictly, only VAT should be logically applied on such transactions, service tax authorities often encroach upon these areas to contend levy of service tax as well.  The issue becomes aggravated in case of domestic transactions, wherein majority of the industry players have started taking a conservative position to levy both VAT and service tax on intangibles.  In case of offshore transactions, while VAT is not payable, service tax authorities continue to make a claim.  The confusion of taxpayers is made worse on account of different treatment of such activities under corporate tax laws, wherein typically such transactions are treated at a par with service transactions for withholding tax purposes.

The above is in sharp contrast to the judicial principles in this regard, wherein time and again, the courts (including the Supreme Court) have held that VAT and service tax are mutually exclusive to each other.  In other words, either VAT or service tax should apply on a particular transaction.  Despite taking this argument of dual taxation, in issues relating to taxation of intangibles, the courts restrict their comments to the levy under challenge instead of taking up a full scale analysis for ascertaining the correct tax levy.  As an outcome of this, exorbitant amount of taxes are being passed on to the ultimate consumers as part of price of goods or services.

In the wake of the impending Goods and Services tax (‘GST’) regime, it needs to be seen how the issue of multiple taxation on intangibles will be addressed to alleviate adverse impact on businesses. One recourse for resolution of the issue under GST may be to clearly provide for characterization of intangibles as ‘goods’ or ‘service’.  This may be particularly critical for the initial few years, wherein Government is contemplating imposing different rates of taxes on goods and services under GST.

Although GST is expected to be a much sought after reform that would effectively deal with the issues relating to taxation of intangibles amongst other issues, it may roll out its own set of complexities. The determination of place of supply of intangibles can be a challenging aspect of GST implementation in the country. Unlike the present origin-based VAT regime in India, GST is proposed to be a destination based tax, attracting levy in the state of consumption.  This could pose new difficulties in case of supply of intangibles, which may be consumed by the customers all across the country.  Another area of concern for businesses can be the rate of tax under GST which is speculated to be in the range of 20 to 22 percent.  This rate is even higher than the present combined rate of service tax and VAT of around 20 percent.  This may lead to potentially higher working capital requirements for all business concerns.

Transfer of intangibles is irrefutably one of the most disputed indirect tax subjects.  Even in the international arena, controversies persist around taxation of intangibles.  It may be too ambitious to expect that these controversies would get immediately resolved with the onset of GST regime. However, it may be hoped that with growing dependence of business world on digitisation, the courts start taking more conclusive views regarding applicability of taxes on intangibles.   In the meanwhile, the only recourse for the business community could be to structure their arrangements relating to intangibles in a fashion that clearly establishes the true nature of the transaction.  Further, to ensure optimized tax structure under GST regime, especially with respect to rates, it is advisable for businesses to take up advocacy with the government on a pro-active basis.

- By Rajeev Dimri, Leader, Indirect Tax, BMR & Associates LLP with inputs from Nimisha Chaudhary and Poonam Harjani.

The thoughts and opinions shared here are of the author.