‘manufacture’

CA Ghanshyam Joshi (CA, Dip IFR (ACCA UK)) (3229 Points)

19 January 2010

Duplication of computer software or processing of recordable media on blank CD amounts to ‘manufacture’

Jan 18, 2010 Income Tax Case Laws

Supreme Court (SC) [2010-TIOL-04- SC-IT] in the case of Oracle Software India Ltd. (Taxpayer) on the issue of whether the process of converting a blank compact disc (CD) into a recorded CD, by duplicating the master copy of software on it, constitutes ‘manufacture’ under the Indian Tax Law (ITL) for the purpose of claiming tax holiday. The SC held that the processing of recordable media on to a blank CD amounts to ‘manufacture’ under the ITL, as it involves the blank CD being dedicated to a specific use for which it otherwise was not fit. Hence, the Taxpayer was eligible to claim a deduction against its profits for carrying out the operations constituting ‘manufacture’ under the provisions of the ITL.

Background and facts of the case

The Taxpayer, a 100% subsidiary of Oracle Corporation, USA (OC), was incorporated in India for the purposes of developing, designing, improving, producing, marketing, distributing, buying, selling and importing of computer software.
The Taxpayer sub-licensed a software developed by OC for the purpose of making copies. In this regard, the Taxpayer imported Master Media (MM) of the software from OC which was duplicated on blank CDs. These blank CDs were packed and sold in the market along with the relevant brouchers. The Taxpayer paid a lump-sum amount to OC for the import of the MM and also royalty at the rate of 30% of the price of the licensed product. The only right which the Taxpayer had was to replicate/duplicate the software. It did not have any right to vary, amend or make value addition to the software embedded in the MM.
This process of commercial duplication of the MM involved a series of steps requiring specific commercial devices. After the import of the MM from OC, it was subjected to a validation and checking process with the help of separate software to satisfy its integrity. Thereafter, the MM was inserted in a machine called a CD Blaster and a virtual image of the software in the MM was created in an internal storage device. The virtual image was later utilized to replicate the software on the recordable media i.e. the blank CD.
The ITL, by way of a tax holiday, provided for a deduction of a specified percentage from profits and gains derived by an ‘industrial undertaking’ for a specified number of years. An ‘industrial undertaking’ is defined to mean an undertaking engaged in the ‘manufacture’ or processing of goods. However, the ITL, as applicable for the relevant tax year, did not provide for a definition of the term ‘manufacture’.
According to the Taxpayer, the process undertaken constituted ‘manufacture’, and hence, its profits were eligible for the tax holiday under the ITL. The Taxpayer’s claim was rejected by the Tax Authority. However, the Taxpayer’s position was upheld by the second appellate authority i.e. Income Tax Appellate Tribunal as well as the third appellate authority i.e. High Court. Aggrieved by the High Court’s ruling in favor of the Taxpayer, the Tax Authority preferred an appeal before the SC. The issue before the SC was whether the above stated process constituted ‘manufacture’ as per the provisions of the ITL.

Contentions of the Taxpayer

Specific machinery was used to convert blank CDs into recorded CDs which, going through various other processes, became a ‘Software Kit’. Such blank CDs constituted raw material for the purposes of the given processes.
The MM cannot be conveyed as it is. In order to sub-license, a copy thereof is required to be made and the process involved in making the said copy constitutes ‘manufacture’ under the provisions of the ITL.

Contentions of the Tax Authority

There exists no element of ‘manufacture’ or processing of goods in the process stated above, as it involves mere copying or duplication.
The software in the MM and the software after being copied into a blank CD remain unchanged, as the copy is a clone of the software in the MM. There is no change in the use, character or name of the CDs after the duplication process is undertaken by the Taxpayer.
The Taxpayer is not eligible to claim tax holiday since the duplication process does not amount to ‘manufacture’ under the ITL.

Ruling of the SC

It must be noted that technological advancement in computer science makes knowledge as of today obsolete tomorrow and therefore, things need to move with the time.
For the purpose of determination of an activity as ‘manufacture’ under the ITL, the Tax Authority should study the actual process undertaken by a taxpayer in each case.
Commercial duplication cannot be compared with duplication done at home. A pirated copy of a CD is also a duplication, but it is not a commercial duplication. Hence, the complex technical nuance should be kept in mind in determining whether a duplication is commercial or not.
The term ‘manufacture’ implies a change. But every change is not a ‘manufacture’, despite the fact that every change in an article is the treatment of labor and manipulation.

The SC rejected the Tax Authority’s contention that the end product is not different from the original product i.e. the software in the MM. The SC observed the following principles emerging from its earlier decisions in the cases of Tata Consultancy Service V. State of Andhra Pradesh [2004-TIOL-87-SC-CTLB], Gramophone Co. of India Ltd. V. Collector of Customs, Calcutta [2002- TIOL-552-SC-CX-L13] given under the indirect tax laws:

-A software program may consist of commands which enable the computer to perform a designated task. The copyright in the program may remain with the originator of the program, but, the moment copies are made and marketed, they become goods.

-There is no difference between a sale of a software program on a CD/floppy disk from a sale of music on a cassette/CD. A blank audio cassette is distinct and different from a pre-recorded audio cassette and the two have different uses and names.

-In all such cases, the intellectual property is incorporated on a media for the purpose of transfer and therefore, the software and the media cannot be split up.

Applying the above principles, it was held that the marketed copies are goods, and if they are goods, then the process by which they become goods would certainly fall within the ambit of ‘manufacture’ under the provisions of the ITL.
The SC observed a new test evolved by the courts in the USA in the case of United States V. International Paint Co. [35 C.C.P.A. 87, C.A.D. 76] for determining a process as ‘manufacture’ i.e. if an operation/ process render an article fit for use for which it is otherwise not fit, then such process would constitute ‘manufacture’.
Applying the above test in the present case, a blank CD is an input and the processes undertaken by the Taxpayer render the blank CD fit for use for which it otherwise was not and, by duplication, the recordable media, which was unfit for any specific purpose, gets converted into a program.
The processing of recordable media on to a blank CD amounts to ‘manufacture’ and the Taxpayer was eligible to claim the tax holiday for carrying out the operations constituting ‘manufacture’ under the ITL.

Ruling of the SC

It must be noted that technological advancement in computer science makes knowledge as of today obsolete tomorrow and therefore, things need to move with the time.
For the purpose of determination of an activity as ‘manufacture’ under the ITL, the Tax Authority should study the actual process undertaken by a taxpayer in each case.
Commercial duplication cannot be compared with duplication done at home. A pirated copy of a CD is also duplication, but it is not a commercial duplication. Hence, the complex technical nuance should be kept in mind in determining whether duplication is commercial or not.
The term ‘manufacture’ implies a change. But every change is not a ‘manufacture’, despite the fact that every change in an article is the treatment of labor and manipulation.