The Customs, Excise & Service Tax Appellate Tribunal (CESTAT), Allahabad Bench, has set aside a service tax demand of ₹16.67 crore imposed on HCL Infosystems Ltd. in relation to royalty paid to Microsoft for licences permitting pre-installation of Windows operating software on computers.
The bench of P. K. Choudhary (Judicial Member) and K. Anpazhakan (Technical Member) has observed that the activity could not be taxed under the category of “Intellectual Property Service” for the period prior to May 16, 2008, particularly because copyright was expressly excluded from the definition of “intellectual property right” under the Finance Act, 1994.
The bench noted that the Department had failed to identify the specific intellectual property right allegedly involved or establish that the alleged intangible property was protected, registered or recognised under Indian law. It also found that the extended period of limitation could not be invoked because the Department was already aware of the assessee’s activities through an audit and subsequent correspondence.
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The appeal arose from an Order-in-Original passed by the Commissioner, CGST & Central Excise, Noida. The adjudicating authority had confirmed service tax of ₹16,67,01,000, along with interest, under the proviso to Section 73 of the Finance Act, 1994. A penalty equivalent to the tax amount was imposed under Section 78, apart from penalties under Sections 76 and 77.
The dispute concerned the period from 2005-06 to 2008-09, up to May 15, 2008. HCL Infosystems had been paying royalty to Microsoft for licences relating to operating software that was pre-installed on computers manufactured by it.
The original adjudication order had dropped the demand for the period up to April 16, 2006, but confirmed the demand for the period from April 17, 2006 to May 16, 2008 by invoking the extended limitation period.
Under the Microsoft Desktop Operating System Licence Agreement for OEM customers, HCL was authorised to pre-install Microsoft operating systems on its computer systems, including Windows XP and Windows Vista. It could also install a backup copy on the computer hard disk and distribute or sub-license the pre-installed product to the end customer.
Microsoft supplied the OEM Pre-installation Kit, while copies of the permitted software, external media, manuals and Certificates of Authenticity were obtained from authorised replicators in India. The Certificate of Authenticity was affixed to the computer chassis as required under the licensing arrangement.
At the manufacturing facility, the operating system was loaded onto the hard disk, which was assembled with other components to make the computer. The computer was then sold with the software media and manuals. HCL also sub-licensed the pre-installed software to the buyer, who obtained a right to use the software rather than ownership of the software itself.
HCL’s position was that no taxable service was involved because there was no transfer, temporary transfer or permission to use or enjoy an intellectual property right falling within Section 65(55a) of the Finance Act, 1994. Consequently, it had not paid service tax on the royalty.
The dispute began after a CERA audit. According to the Department, the royalty paid to Microsoft attracted service tax under the reverse charge mechanism because the transaction involved use of Microsoft’s intellectual property, including its Windows product and associated trademark.
A show cause notice was issued on October 21, 2010. The notice alleged, among other things, that HCL had paid royalty for using Microsoft’s product and that the transaction was liable to service tax under the category of Intellectual Property Service on a reverse charge basis.
The Department also alleged that the assessee had failed to register, pay service tax and file ST-3 returns and had thereby suppressed the taxable value with an intention to evade payment of tax. On this basis, the extended limitation period under Section 73 was invoked.
The two-member Bench comprising P. K. Choudhary, Member (Judicial), and K. Anpazhakan, Member (Technical)examined the statutory framework applicable during the relevant period.
The Tribunal reproduced Section 65(55a) of the Finance Act, 1994, which defined “intellectual property right” as a right to intangible property such as trademarks, designs, patents or similar intangible property recognised under a law in force in India, while specifically excluding copyright. Section 65(55b) defined intellectual property service as the temporary transfer or permitting the use or enjoyment of an intellectual property right.
The Bench emphasised that every form of intangible property was not automatically covered by the statutory definition of intellectual property right. Only intangible property recognised under a law in force in India fell within the relevant service tax provision, while copyright was expressly kept outside the definition.
A key finding of the Tribunal was that the show cause notice and the adjudication order failed to establish what specific intellectual property right was involved.
The Bench observed that the Department had neither disclosed nor established how the alleged intangible property was protected, registered or recognised under Indian law. In the Tribunal’s view, this omission was fatal to the service tax demand under the IPR service category.
The Tribunal relied on its earlier decision in Fluent India Pvt. Ltd. v. CCE, Pune-I, where it was held that the Revenue could not simply describe an activity as an intellectual property service without specifying the precise intellectual property right involved.
The Bench also referred to Royal Western India Turf Club Ltd. v. Commissioner of Service Tax, Mumbai, which stressed that an order confirming service tax under the IPR category must clearly identify whether the transaction concerns a patent, copyright, trademark, design or another legally recognised category of intellectual property.
Consequently, CESTAT held that the impugned order did not provide cogent reasoning identifying an intellectual property right falling within Section 65(55a), and therefore the order was liable to be set aside on this ground itself.
The Tribunal then considered the substance of the Microsoft licence.
It noted that Microsoft was the owner of the copyright in the Windows software and had granted HCL a licence to pre-install the software on computers manufactured by it. HCL was not claiming ownership of the copyright or an absolute assignment of Microsoft’s copyright.
The Bench found that the Department’s own reasoning established that Microsoft retained the copyright and that HCL merely received a licence to use the software. Once that position was accepted, the Tribunal held that the transaction involved temporary enjoyment of a copyright, which was specifically excluded from the definition of “intellectual property right” under Section 65(55a).
The Tribunal found the facts comparable to the decision in Fluent India, where a non-exclusive software licence was held not to be subject to service tax under the IPR service category. In the present case too, the licence was non-exclusive and permitted HCL to pre-install the software and sub-license its use to computer purchasers.
On a combined reading of the relevant provisions of the Copyright Act, 1957, the Bench concluded that the relevant intellectual property was copyright and that copyright was specifically excluded from Section 65(55a). Therefore, the licence for exploitation of that copyright did not constitute a taxable IPR service during the relevant period.
The Tribunal also considered an important change in the service tax law effective May 16, 2008.
CESTAT noted that the Finance Act introduced the taxable category of Information Technology Software Services (ITSS) with effect from May 16, 2008. The right to use information technology software for commercial exploitation, including rights to reproduce, distribute and sell, was brought within the service tax framework through the new entry.
The Tribunal observed that the earlier IPR service entry had not been expanded; instead, a new taxable entry was introduced specifically covering information technology software services. Therefore, according to the Bench, the disputed activity could not retrospectively be brought under the earlier IPR service category for the period preceding May 16, 2008.
The Bench relied on decisions including Schlumberger Asia Services Ltd., Vikash Construction Company, Board of Control for Cricket in India and Suntec Business Solutions Pvt. Ltd. in arriving at this conclusion.
Accordingly, CESTAT held that although the activity fell within the Information Technology Software Service category introduced from May 16, 2008, it was not liable to service tax under that category for the period before May 16, 2008.
The Tribunal separately examined the Department’s invocation of the extended limitation period.
The demand had been confirmed for the period beginning May 16, 2006. However, the Department had conducted an audit of HCL on March 9 and 10, 2007. A letter dated March 29, 2007 had also raised the issue, followed by continuing correspondence between the parties.
CESTAT held that these circumstances demonstrated that the Department was already aware of the relevant activities during the normal limitation period. Once the information was within the Department’s knowledge, the Tribunal found it difficult to sustain an allegation that the assessee had suppressed the same information.
The Bench also noted that the assessee had been disputing its service tax liability bona fide and had disclosed the relevant information. Merely because the assessee did not obtain registration, pay service tax or file returns on account of its bona fide understanding of the legal position, suppression could not automatically be alleged.
CESTAT also found that the transaction involved a revenue-neutral situation.
The alleged service tax was demanded under the reverse charge mechanism. Had HCL paid the service tax, the Tribunal observed, the service was used in the manufacture of dutiable computers and the corresponding CENVAT credit would have been available for payment of Central Excise duty.
The Bench held that where a transaction is revenue neutral because the assessee would be entitled to CENVAT credit of the tax paid, the existence of an intention to evade tax may be absent. On this basis, the extended period of limitation was held to be legally unsustainable.
Once the underlying service tax demand was held unsustainable, the Tribunal held that there could be no separate basis for recovery of interest or imposition of penalties.
CESTAT therefore set aside the service tax demand as well as the associated interest and penalties.
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