SOFTWARE DEVELOPMENT IS A 'MANUFACTURING PROCESS' AND FIRMS INVOLVED IN CREATING COMPUTER SOFTWARE ARE 'FACTORIES' UNDER THE EMPLOYEES' STATE INSURANCE ACT, 1948
Pursuant to Section 1 of the Employees' State Insurance Act, 1948 (ESI Act), the ESI Act is applicable to all factories in the first instance. The appropriate government however is empowered to extend the provisions of the ESI Act to other class of establishments with appropriate notice. In a recent ruling, while determining the applicability of the ESI Act to a software company, the Bombay High Court took a view that software development is a manufacturing process and the premises where computers are involved in such a manufacturing process is a factory for the purposes of the ESI Act.
The Assistant Director, ESIC v. M/s Western Outdoor Interactive Pvt. Ltd. & Others
The two appellants in this case were computer units involved in software development and related activities. A circular dated 22 November, 2002 was issued under Section 1 of the ESI Act extending the applicability of the act to certain commercial activities. The Employees' State Insurance Corporation (ESIC) however issued notices to the appellants requiring payment of ESI contributions in respect of the period between January 2001 and September 2002, on the contention that a software development unit was a 'factory' under the ESI Act.
A factory, under the ESI Act includes any premises (i) wherein ten or more persons are employed for wages and in any part of which a manufacturing process is being carried on with the aid of power, or (ii) wherein twenty or more persons are employed for wages and in any part of which a manufacturing process is being carried on without the aid of power. The definition of manufacturing process refers back to the Factories Act, 1948 (Factories Act) and inter alia includes "making, altering, repairing, ornamenting, finishing, packing, oiling, washing, cleaning, breaking up, demolishing, or otherwise treating or adapting any article or substance with a view to its use sale, transport, delivery or disposal." The Bombay High Court held that the terms 'making, altering, treating, adapting' etc. used in the definition above were to be interpreted widely to cover activities such as software development and application.
A single judge of the Bombay High Court while deciding the matter analyzed the definition of factory under both the Factories Act and the ESI Act. It was noted that the definition of factory under the Factories Act, (unlike the definition of a 'factory' under the ESI Act), provides for 'Explanation II' which was introduced in 1987 and states that "the mere fact that an electronic data processing unit or a computer unit is installed in any premises or part thereof, shall not be construed to make it a factory if no manufacturing process is being carried on in such premises or part thereof." The advocate for the companies relied on the decision of the division bench of the Madras High Court in Cholamandalam Software Ltd. in which Explanation II was interpreted. The Madras High Court, while interpreting the applicability of Chapter VB of the Industrial Disputes Act, 1947 to the establishment, held that by virtue of Explanation II, any use of computer or any work carried out with the help of computer is taken out of the definition of factory. The Division Bench observed that the phrase 'if no manufacturing process is being carried on' in the explanation, means 'if no other manufacturing process is carried on'. Thus, even if software development or software application is a manufacturing process, it would be excluded from the definition of factory under the Factories Act if no other manufacturing process was carried on at the establishment.
Dismissing the contention to rely on Explanation II in the context of the definition of 'factory' under the ESI Act (where this Explanation is missing), the Bombay High Court further observed that Explanation II must be read literally and that the phrase "if no manufacturing process is being carried on" must not be read as "if no other manufacturing process is being carried on". The Court held that Explanation II was merely intended to clarify that installation of electronic data processing units or computer units would not constitute a 'manufacturing process' in itself and not act as an exemption to a data processing unit.
Further, while analyzing the definition of manufacturing process the court held that though computer related activity like development, programming, application are not expressly mentioned, the terms 'making, altering, treating, adapting' etc. should be interpreted to include software development and the premises where such manufacturing process is carried on should be considered a factory. While justifying the decision, it was stated that "application of the ESI Act is not a regressive but a progressive step and to think that if the ESI Act is made applicable then it will affect IT industry adversely is a futile fear."
From the context of the applicability of the ESI Act by itself, this judgment is unlikely to change the position in relation to coverage of software establishments significantly. This is because most State governments have already issued notifications covering various 'shops' and/or 'commercial establishments' within the scope of the ESI Act, and most IT/ITeS establishments are therefore already covered. However, despite this decision being in the context of the ESI Act, the Bombay High Court has also rendered an interpretation of Explanation II in the definition of 'factory' under the Factories Act, and differed in its view from the Madras High Court in the case of Cholamandalam Software Ltd. It must be noted that the decision of the Madras High Court was appealed and referred by the Supreme Court to a larger bench for decision in 2001, but so far there has been no ruling on this subject by the Supreme Court despite over a decade having passed since. Unless the Supreme Court takes a view on this important issue, there would be instances of conflicting judgments such as these and the ensuing uncertainty will not be beneficial to the industry, which has settled on the view that IT activities such as software development, etc. are not manufacturing processes. An immediate consequence could be that labour authorities will use this judgment to proceed against IT companies on the basis that they are factories and demand compliance with various additional laws. These additional compliances could be manifold – not only would compliance with the Factories Act prove tedious (which could significantly impact the start-up time of such businesses), various other labour laws (such as Standing Orders Act, etc), as well as provisions of the Industrial Disputes Act, 1947 (relating to retrenchments, closure, need for government approvals for the same, etc.) would also apply that would make overall compliance more onerous and adversely impact the comparative flexibility IT companies today enjoy in managing employee relations.