Kerala High Court: Customized Software Developed for Specific Users Are Taxable under the Category of ‘Goods’

Kerala High Court: Customized Software Developed for Specific Users Are Taxable under the Category of ‘Goods’

The Kerala High Court clarified that software developed and customized for a specific user fall under the category of ‘goods’ and not ‘service’ under Article 366(12) of the Indian Constitution for the purposes of levy of sales tax under the Kerala General Sales Tax Act (KGST Act).

The division bench consisting of Justices AK Jayasankaran Nambiar and Mohammed Nias CP explained that a customized software satisfies the definition of ‘goods’ under Article 366 (12) of the Indian Constitution since it has the attributes of utility, that is being capable of being bought and sold and of being capable of transfer, transmission, delivery, storage and possession.

In the present case, six Sales Tax Revisions were preferred by the State against the common order passed by the Kerala Sales Tax Appellate Tribunal, Ernakulam in six appeals.

Three of these appeals were related to assessments for the years 2002-03, 2003-04, and 2004-05, while the other three were regarding penalties imposed on the respondent/assessee.

The respondent, a software business, had not registered or paid sales tax assuming that the activity of developing and supplying customized software to clients would attract only service tax and not sales tax.

The Sales Tax Department initiated penalty proceedings against the respondent for not taking necessary registration and paying tax, which was confirmed by the First Appellate Authority. The Tribunal allowed the appeals and ordered in favor of the assessee, overturning both the assessment orders and the penalties.

Aggrieved by this decision, the State had approached the High Court. The revision petitions were allowed and remitted back to the Tribunal by the High Court. Following the remand, the Tribunal found in favor of the respondent/assessee denied the applicability of Tata Consultancy Services vs. State of Andhra Pradesh (2005) and held that customized software could not be taxed under the KGST Act. As such, the Tribunal allowed the appeals against assessment orders and penalties.

In Tata Consultancy Services (case), the Apex Court had observed that in the context of software, when copies of a software program are made and marketed, it becomes goods subject to sales tax, irrespective of whether it is customized or off-the-shelf. The Court emphasized that the focus should be on the software's marketability, utility, and capacity to be bought, sold, transferred, delivered, stored, and possessed.

Regarding the State’s challenge of the Tribunal’s order that set aside the assessment orders for the years 2002-03, 2003-04, and 2004-05, it was found that the Tribunal’s reasoning was that customized software developed and supplied by the assessee could not be taxed under the KGST Act, as per the Tata Consultancy Services case.

Upon reviewing the judgment, the High Court affirmed that the Supreme Court’s findings in the said case were applicable not only to ‘canned software’ but to uncanned/customized software as well.

The bench held that merely because the software was customized for particular user, it does not mean the software ceases to be goods for the purpose of levy of sales tax.

“Merely because the software developed by the respondent/assessee in the instant case was customized for a particular user and was not sold to other users, the charges collected from the customer cannot escape the levy of sales tax under the KGST Act. This is more so because the mere fact that it was customised for a particular user did not lead to the software ceasing to be goods for the purposes of levy of sales tax,” observed the Court.

Based on the aforesaid analysis, the Court concluded that even customized software satisfies the attributes of goods, and therefore, the charges collected from customers for customized software could not escape the levy of sales tax under the KGST Act.

However, the Court set aside the penalty sought to be imposed on the assessee for not paying sales tax earlier, considering that there was no deliberate or contemptuous attempt on the assessee’s part to evade the payment of any tax.

The Court reasoned that there was confusion earlier as to whether service tax or sales tax should be paid for the supply of customised software, leading to the assessee’s failure to pay the sales tax.

Therefore, the Court concluded that the penalty orders issued against the assessee should be set aside.

Special Government Pleader, Mohamad Rafique appeared on behalf of State.

The assessee was represented by Advocates CM Andrews, Boby M Sekhar and Syam Padman.