How Point Of Taxation Rules Would Affect Information Technology Industry

[Mr. SUBRAMANI SIVAKUMAR]

S Sivakumar, Director, S3 Solutions Pvt Ltd

A lot is being written on the Point of Taxation Rules (‘POT Rules’), which is to be implemented with effect from April 1, 2011. Many are under the impression that this is an attempt to switch over from the cash basis to the accrual basis. The fact remains that the POT Rules would travel much beyond the accrual basis. This is an attempt to discuss the implications arising out of the proposed implementation of the POT Rules, from the IT sector point of view.

The details of the new dispensation is contained in Notification No 3/2001, which seeks to amend Rule 6 of Service Tax Rules 1994 and substitute the words” payments are received, towards the value of taxable services ”, with the words” service is deemed to be provided as per the rules framed in this regard ”.

The text of Rule 3 of the Point of Taxation Rules, as proposed, is reproduced below:

3. Determination of point of taxation - For the purposes of these rules, unless otherwise stated,” point of taxation” shall be determined in the following manner, namely:-

(a) a provision of service shall be treated as having taken place at the time when service is provided or to be provided; and

(b) if, before the time specified in clause (a), the person providing the service issues an invoice or receives a payment, the service shall, to the extent covered by the invoice or the payment made thereof, be deemed to have been provided at the time the invoice was issued or the payment was received, as the case may be, whichever is earlier.

Explanation 1.- For the purposes of this rule, wherever any advance, by whatever name known, is received by the service provider towards the provision of taxable service, the point of taxation shall be the date of receipt of each such advance.

Explanation 2.- For the purposes of this rule, in respect of services taxable under section 66A of the Act, the point of taxation under clause (b) shall be the date on which the invoice is received, or the payment is made, as the case may be, whichever is earlier.

As per Clause 3 (a) stated above, the provision of service shall be treated as having taken place at the time when service is provided or to be provided. As per this provision, as we can see, a service provider can be asked to pay service tax, even when he has not actually rendered the services, on the basis that he has contracted to render services at a future date.

Under the Point of Taxation Rules, the service tax liability would be calculated on the basis of the earliest of the following four dates, viz.

• Date on which service is provided
• Date on which service is to be provided
• Date of the invoice raised by the works contractor
• Date of receipt of the money

Let’s see some typical situations involving developers/works contractors and analyse how the Point of Taxation rules would operate….

Situation-1 : A software developer enters into an agreement to develop and deliver, a software project, with his prospective buyer/customer in India and agrees, as follows, for a project value of, let’s say, Rs 60 lakhs

25% of the amount to be paid on signing of the agreement on April 2, 2011

25% of the amount to be paid on July 1, 2011, on completion of the first phase of the project

25% to be amount to be paid on December 1, 2011, on completion of the second phase of the project

Final instalment of 25% to be paid on March 31, 2012, on completion of the final phase of the project

Under the current service tax law, the software developer will have no issues in discharging his service tax liability, as he will pay service tax on the receipt of the amounts from his customer, including, on the advance amount received. Assuming that, the software developer is not able to even start the activity, the developer will still pay service tax on the advance amount of Rs 15 lakhs received on April 1, 2011.

Let’s see how things would work out post April 1, 2011, under the new dispensation, on the same assumption that the software developer has not carried out any activity. The said software developer would be liable to pay service tax on July 1, 2011, December 1, 2011 and March 31, 2012, on the amounts of Rs 15 lakhs each, despite that the software developer has not even commenced the project and has not received any amounts from the customer, except for the initial advance of Rs 15 lakhs on April 2, 2011, on which, the software developer would, of course, be liable to pay service tax.

Situation-2 : Let’s discuss a slightly more complicated situation. Let’s assume that, the software developer does some initial coding work on the project, which, of course, is nowhere near what has been committed by him to his customer. Let’s also assume that the software developer raises invoices on his customer promptly, on June 1, 2011, November 1, 2011 and March 1, 2012, in respect of the three instalments, more as a matter of a reminder. Quite obviously, the customer would not pay the instalments, as the work that has been done falls short of the agreed milestones. What would happen to the service tax liability, under the POT rules? The software developer would be liable to pay service tax on June 1, 2011, November 1, 2001 and March 1, 2012, on Rs 15 lakhs each, on the basis that he has raised invoices, not-withstanding the fact that he has neither done the work nor has got paid.

Situation-3 :  Let’s now discuss the case of a software product player, who enters into an agreement on April 2, 2011 for the sale of his ten software licenses, for an individual value of Rs 1 crore, to his domestic customer, with the licenses to be delivered on June 30, 2011. Let’s assume that due to certain unavoidable circumstances, this software player is not able delivered these licenses on June 30, 2011. However, on August 31, 2011, this player is able deliver four licenses and goes for a cancellation of the contract, let’s further assume. Due to the delay in the delivery of the licenses, let’s further assume that his customer makes a payment of only Rs 3 crores on September 30, 2011 for the four licenses delivered. How will the POT Rules work?

Under the current service tax law, the software product player would have been liable to pay service tax on October 6, 2011, to the tune of Rs 30.9 lakhs, after recovering the same, from his customer.

However, under the POT rules, in the instant case, the software player would be deemed to have rendered a service under Information Technology Software Services on June 30, 2011 and would be liable to pay the service tax of Rs 1.03 crores, on July 6, 2011. However, when the issue is closed on September 30, 2011 with the customer making a payment of only Rs 3 crores plus the service tax of Rs 30.9 lakhs, the software player would have ended up with making an excess payment of Rs 72.1 lakhs, for which, he would have to apply for a refund, from the Department. Given the manner in which the Department treats refund applications from software exporters, the software players can assume the worst, vis-à-vis the refund.

Situation-4 : Take a typical situation, of a software services player, who enters into an agreement with a foreign customer for the supply of a software programme, on June 30, 2011, for an amount of US$ 100,000/-. Let’s assume that, due to certain issues, both the parties to settle the transaction for US$ 60,000/-. In a typical case, the Indian exporter would have written off the balance amount of US$ 40,000/- (subject to FEMA and RBI related provisions) and in any case, would not have been liable to pay service tax. However, under the POT Rules, the software exporter would be liable to pay service tax on the balance amount of US$ 40,000/-, as he would be deemed to have rendered services to this extent, which would not be covered by the provisions of the Export of Services Rules, 2005 as the services have not been realized in convertible foreign exchange.

Importers of services would need to keep track of dates of import of services

Yet another proposal which would affect Industry in general and the IT sector, in particular, would flow from Explanation 2 to Rule 3, as per which, in respect of services taxable under section 66A of the Finance Act, the point of taxation under clause shall be the date on which the invoice is received, or the payment is made, as the case may be, whichever is earlier. Thus, the importer of services would be liable to pay service tax on the earlier of, the date of receipt of the invoice or the date of the payment. Thus, all importers of services would now need to keep documents to prove the date of receipt of the invoices of their foreign service providers. Some of the documents that services importers would be advised to maintain are, originals of the courier/postal covers, fax copies of the invoices which would indicate the date of receipt, e-mail correspondences, etc.

Before parting with….

The Point of Taxation Rules, 2011 would  drastically affect all service providers, including the Indian Subsidiaries of MNCs, who export services to their parent companies/outfits. Read with the new provisions related to prosecution, the IT companies would need to ensure that they maintain all the requisite documentation and take extra care to ensure that they meet with the requirements of the service tax law, as their Directors can be prosecuted under the new provisions