Indirect Tax Treatment in India of Embbeded/Pre-Loaded Software supplied alongwith Telecom Hardware

Dated 13th May 2011

India by now is the fastest growing cellular telephony market in the world with the second largest subscriber-base. Very recently (December, 2010) Telecommunication Regulatory Authority of India (TRAI) has issued a consultation paper on ‘Encouraging Telecom Equipment Manufacturing in India’. This consultation paper was preceded by report of KPMG titled ‘Indian Telecom 2010′ and Report by a Task force suggesting measures to stimulate the growth of IT, ITES and Electronics hardware manufacturing industry in India (2009). The consultation paper issued by TRAI mentions that in 2008-09 alone as per Directorate General of Commercial Intelligence and Statistics (DGCIS) data, equipment worth Rs. 461.58 billion was imported by Indian telecom operators. The KPMG Report also estimates the Indian Telecom Equipment Market in India to be in the range of Rs 450 billions and growing 20-25% per annum. In this background the issue of inclusion or exclusion of the pre-loaded/embedded* software value in/from the value of telecom hardware, which would lead to a very significant increase or decrease in the Central Excise or Customs duty liability, assumes tremendous significance.
Prior to 01.01.2007 Chapter 85 of the Custom & Central Excise Tariff had a chapter note No. 06, (post 01-01-2007, chapter note: 06 stands deleted and software now is required to be classified under CTH/ CETH:8523) which implied that software even when presented with the apparatus/equipment for which it was intended, will be classified as software vide tariff entry 8524.
INITIAL DEVELOPMENTS The attempts by the Revenue in the period prior to 01.01.2007, especially the earlier part of the past decade, to include the value of software which was supplied in a preloaded/embedded form, in the value of hardware across a broad spectrum of industry viz., manufactures/importers of personal computers, telecommunication hardware, etc., did not eventually succeed at the appellate level as a result of chapter note 06 of Chapter 85. A view was consistently taken by CESTAT that software under every circumstances is required to be classified under CETH:8524.Thus, the value of software escaped levy of Central Excise duty and Customs Duty, as software were chargeable to ‘NIL’ rate of duty vide exemption notification/tariff entry during the material time. These rulings essentially followed the judgment of the Supreme Court in the case of PSI Data System Ltd. vs. CCE (2002-TIOL-46-SC-CX), wherein it was held that value of software sold along with the Computer is not includible in the assessable value of Computer, since Computer & its Software are distinct & separate as a matter of commercial parlance.
In most of the matters, the departmental proceedings and the appellate orders did not focus or analysed in detail the type and nature of software being debated and the circumstances of its supply along with the hardware in sufficient technical details, for including its value, in the value of the hardware.
CLARIFICATION ISSUED BY CBEC in context to Central Excise:
Thereafter, vide Circular No. 664/35/2002-CE dated 12.07.2002, CBEC sought to address the issue of “Valuation of Computer Systems”.
While analysing the case of PSI Data System Ltd. vs. CCE (2002-TIOL-46-SC-CX). The Circular clarified that;
As per Central Excise Law, valuation of goods is to be done in the form in which it is cleared. It, therefore, emerges that for the period prior to 1.7.2000 computer systems will be valued by including the value of the software already etched or burnt or loaded on the hard disc of the system. No distinction should be made between an operating software’ or an ‘application software’ in this regard. If the computer is sold loaded with a software, the value of the software will be included in the value of the computer. Any floppy, disc or tape containing any software supplied along with the computer system will, however, be assessed separately. The introduction of the “transaction value” concept w.e.f. 1.7.2000 does not effect this basic principle. In other words, for the period 1.7.2000 onwards also the same system of valuation of computer system is to be adopted so far as inclusion (or exclusion) of software is concerned.
CLARIFICATION ISSUED BY CBEC in context to Customs: Circular No. 51/2002-CUS dated 12.08.2002, of CBEC sought to address the issue of “Classification of Computes Systems”, in context to Customs Clearance. The Circular clarified that in cases where the software presented along with the main equipment or apparatus is not intended for use with such equipment or apparatus, the classification would still remain under heading 85.24 except in situations where the software accompanying the imported article or articles make up a set put up for retail sale. In such cases, the set taken as a whole will be classified by application of GIR3 (b). Where the software accompanying the imported article does not constitute a set put up for retail sale under GIR 3(b), they will have to be necessarily classified separately under their own appropriate heading, namely, heading 85.24.
THE ACER INDIA JUDGMENT: In 2004, in a very significant ruling, in the case of M/s ACER India (CCE Vs. ACER India Ltd.- (2004-TIOL-81-SC-CX-LB), it was held that value of operating software is not includible in assessable value of computer, even if loaded on computer. Although computer may not be capable of effectively functioning unless loaded with computer, same would not tantamount to bringing them within the purview of part of computer. Computer is complete without software . This judgment emerged as a consequence of an earlier Division Bench ruling of Supreme Court in the case of ACER which held the value of software supplied along with hardware includible thus diametrically differing from the judgment of Supreme Court in the case of PSI Data System Ltd.
Significantly, the judgments of M/s PSI & Acer by the Supreme Court, were in context to personal computers & its operating/application software which are individually/ separately available in the market. These judgments made no pronouncement on pre-loaded and embedded software, which are predominantly not separately marketed, as is the case in the Telecom Hardware Sector. These pre-loaded/ embedded software applications in the case of telecom hardware are specifically developed to be operated with a particular type and variant of telecom machinery. Apparently the debate on inclusion of software in hardware was far from over in spite of the ACER judgment.
RELATED DISPUTE ON THE ISSUE OF SOFTWARE: A fresh set of objections were raised by the Revenue on the alleged issue of artificially splitting of the value of hardware and software especially by telecomm equipment manufacturers/ importers, in order to reduce the duty liability on the telecom hardware. Particularly, in the case of embedded software given the inseparable nature of the embedded software vis-à-vis the equipment. Ideally there should have been no cogent reason for not including their value in the assessable/taxable value of the equipment. However, given a substantial duty outgo on this account and the trend to give an all inclusive quotation while bidding for telecom equipment tenders; the practice of artificially splitting the value of software and hardware by some manufacturers/importers, found widespread acceptability in this sector, which is evident from the number of cases booked against them.
In the case of Anjaleem enterprises it was held by the Supreme Court [Anjaleem Enterprises Pvt. Ltd. Vs. Commissioner of Central Excise (2006-TIOL-06-SC-CX)] that:
“The software embedded in the programmed EPROM, which is an IC chip, constitutes the “brain” of the system. The programmed EPROM is an integral part of the system. The levy is on the unit. The levy is not on the programmed EPROM. The programme embedded is not easily removable. Hence, it will not fall in the category of recorded media under tariff item 85.24 and remains an IC under tariff item 85.42”.
THE HEWLETT PACKARD RULING: In another very important ruling, the S. C. in the case of [Commissioner of Customs, Chennai, vs. M/s Hewlett Packard India Sales (P) Ltd (2007-TIOL-154-SC-CUS] , stated in para 9 that………
“In the present case, the respondent imported laptops containing preloaded HDD. The said drives were preloaded with Operating System (software) which, as stated above, controls the working of the computer. The value of the Laptop depends on the Operating System, which is preloaded; the computer cannot open without the Operating System. The Laptop without an operating System is like an empty building. Such preloaded Operating System on the HDD forms an integral part of the Laptop”.
Eventually ruling that the laptop along with software has to be classified as laptop and valued as one unit.
DEVELOPMENTS POST- ACER, ANJALEEM AND H.P.: The CESTAT continued to rely on the Supreme Court judgment in ACER in very many instances, ignoring the Anjaleem and H.P. judgment all together. This is evident from the ruling of CESTAT in the following matters.
(i) MIC Electronics Ltd. Vs. Commissioner of Central Excise, Visakhapatnam (2009-TIOL-1662-CESTAT-BANG)
(ii) Bharti Airtel Ltd. Vs. Commissioner of Customs, Bangalore (2009-TIOL-654-CESTAT-BANG)
(iii) ITI Ltd Vs The Commissioner of Central Excise & Customs, Calicut (2009-TIOL-302-CESTAT-BANG)
(iv) United Telecoms Ltd Vs the Commissioner of Central Excise (2008-TIOL-663-CESTAT-BANG)
In all of the said referred rulings, either the Anjaleem or H.P. judgment were not referred to, and if referred no attempt was made to discuss or distinguish them to come to a positive conclusion about their non applicability.
However, CESTAT in the case of,
++ Avaya Global Connect Ltd. Vs. CCE, Ahmedabad-III (2007-TIOL-1833-CESTAT-AHM)
++ NCR Corporation India Pvt Ltd vs. CCE Pondicherry (2009-TIOL-1703-CESTAT-MAD) and,
++ Bhagyanagar Metals Ltd vs. Commissioner of Customs and Central Excise (2008-TIOL-2171-CESTAT-BANG);
On the issue of inclusion of the value of preloaded/ embedded software has ruled in favour of Revenue.
These recent rulings of CESTAT, suggests that the issue of inclusion of the value of pre-loaded/ embedded software other than in instances of personal computers is now coming to a full circle, with CESTAT and Supreme Court clearly distinguishing the ACER in a catena of judgments.
THE FRICK INDIA RULING and THE BOUGHT OUT PLEA : Another argument used by domestic telecomm equipment manufacturers is that the embedded software was not manufactured by them rather they are supplied as bought out item and hence are not liable to be included in the value of the equipment. This argument is on weak moorings, as these preloaded and embedded software are more often than not of the nature of essential bought out items .
In quite a few rulings Supreme Court and CESTAT have held that value of essential bought out items are to be included in the discharge of Central Excise duty of the main item viz.,
– Siddhartha Tubes vs. CCE (2005-TIOL-162-SC-CX) etc.,
Supreme Court in a landmark judgment- Frick India Ltd (2007-TIOL-164-SC-CX), has held that the concept of classification is different from valuation ( A key charge of the SCN & subsequent findings of Commissioner & CESTAT was the non payment of duty on the value of bought out items). Supreme Court held the General Interpretative Rules (GIR) along with the section and chapter notes do not provide any guidelines for valuation of excisable goods and that the concept of valuation is entirely different from classification; Eventually, ruling that the value of essential bought out items despite being classified under different heads as against the machinery manufactured and cleared, would be includible in the assessable value of the main machine/equipment.
In an somewhat analogous situation, in case of imported goods where the Software is supplied along with the machine, classification interpretative Rule GIR 3 (b) would come into play, whereby, the set has to be classified and in effect valued with the machine.
In the case of Commissioner of Income Tax vs. ORACLE SOFTWARE INDIA (2010-TIOL-04-SC-IT) Supreme Court has held that transforming blank CD into software loaded disc is ‘manufacture’. The Supreme Court in this ruling has accepted and gone by the test that if a process renders a commodity or article fit for use which otherwise is not fit, the operation would fall within the ambit of manufacture (Para 9).This ruling though delivered in context to Income Tax Act,1961, is also of a very crucial importance to Central Excise provisions related to manufacture.
UNFOLDING LEGAL SCENARIO: At present when chapter note:06 is no longer there, post 01.01.2007, there are absolutely no legal circumstances for not including the value of software along with that of the hardware when supplied in pre-loaded or embedded form. Further, it is apparent that the exemption to customized software,( there is also in existence Central Excise duty exemption granted to customized software other than packaged or canned software vide Notification No:6/2006 dt:01.03.2006(C.E.) ,as amended from time to time) would be available only when sold in a stand alone manner. Notwithstanding, the changes in the chapter notes, tariff and the Supreme Court rulings, these developments do not eliminate the possibility of;
++ Artificial value shifting between software and hardware. This apprehension has been expressed by Mumbai Air Cargo Customs vide its P.N.39/2007 dated: 03.12.2007.
++ The continued practice of not including the value of software in the value of hardware by the tax payer , due to lack of appreciation of the role and function of the software and the method and manner in which it is being supplied with the hardware especially in the case of telecom hardware, changes in the chapter notes, as well as judicial principles involved.
POST-SCRIPT:In context to packaged software: CBEC has issued Circular No. 15/2011-Customs, dated 18.03.2011, addressing the issue of assessment to Customs duty of, documents of title i.e. paper licence or PUK (Personal unlocking Key ) for IT software; to which it has essentially clarified that:-

A. Paper licenses or PUKs merit classification as per their individual character, i.e. under heading 4907 in case of paper license and heading 4911 in case of PUK card, ; vide chapter notes of Chapter 85 read with Rule 1 of the Rules for the Interpretation of the tariff schedule.
B. In the case of import of packaged software:-

CVD would be charged on RSP and such software would be exempted from payment of Service-Tax under the category of ITSS. However, in case of packaged/canned software on which affixation of retail sale price is not required, CVD will be charged excluding the value representing consideration for transfer of right to use such packaged/canned software and that Service-Tax under the category ITSS would be levied on such portion subsequently.
While the classification issue gets addressed in the case of paper licence and PUK’s. The valuation conundrum, in the peculiar circumstances sought to be addressed in the circular or even otherwise persists, in the case of paper licence ,PUK’s as well as Packaged Software not subject to RSP based assessment, and continues to be a nightmare for the Department as well as Trade .The issue of “Title” as well as “Licence” has in-built element of intangibility. The joint forum of WCO/OECD has sought to address the issue of valuation of intangibles as well. It is time that Board dwells on the subject and issues detailed guidelines on the issue of “valuation of intangibles” at the earliest possible.
(The views expressed by the author are his own and in no manner whatsoever reflects the Department’s view on the issue)
Footnote: * Embedded software is defined as software which plays an integral role in the electronics it is supplied with. Embedded software’s principal role is not Information technology, but rather the interaction with the physical world. Embedded software is usually written for special purpose hardware: that is computer chips that are different from general purpose CPUs. Edward A. Lee, “Embedded Software”, Advances in Computers (M. Zelkowitz, editor) 56, Academic Press, London, 2002.
Note:This aritcle was first published on the web-site on 08/04/2011.


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