LOST IN CREDIT LOSS!

‘16(1). Every registered person shall, subject to such conditions and restrictions as may be prescribed and in the manner specified in section 49, be entitled to take credit of input tax charged on any supply of goods or services or both to him which are used or intended to be used in the course of furtherance of his business and the said amount shall be credited to the electronic credit ledger of such person…..
17(5) Notwithstanding anything contained in sub-section (1) of section 16 and sub-section (1) of section 18, input tax credit shall not be available in respect of the following, namely: -….
(h) goods lost, stolen, destroyed, written off or disposed of by way of gift or free samples, and; ….’

GENERAL UNDERSTANDING OF IMPORTANT TERMS
The key terms under consideration in section 17(5)(h) and their respective meanings from the Law Lexicon (5th Edition) are given below:
Lost – A thing is said to be lost when it cannot be found or when ordinary vigilance will not regain it.
Stolen – ‘To steal’ means to take by theft and ‘Intent to steal’ refers to permanently deprive and defraud another of the use and benefit of property and permanently to appropriate the property to his own use or the use of any person other than the true owner.
Destroyed – ‘Destroyed’ occurring in section 32(1) of the Income-tax Act has a wider connotation than mere physical destruction. It would also cover loss arising on the theft of a vehicle. The term ‘destroyed’ in section 41(2) of the Income-tax Act would not cover items partly destroyed in fire and which have been retained by the assessee. In another context, the term destroyed means to ‘demolish’, i.e., to render a thing useless for the purpose for which it was intended.
Written off – ‘Write down’ means to reduce the book value of. ‘Write off’ means to carry or remove. ‘Write-off’ also means to delete an asset from the accounts because it has been depreciated (or been written-down) so far that it no longer has any book value. It can also mean to charge the whole of the value of an asset to expenses or loss (i.e., assign it zero value on the balance sheet).
Disposed of by way of gift or free sample – Dispose means to transfer to the control or ownership of another; or transfer or alienate. ‘Gift’ means to transfer by one person to another of any existing movable property voluntarily and without consideration in money or money’s worth. ‘Sample’, both in its legal and popular acceptance,  means that which is taken out of a large quantity and is a fair representation of the ‘whole’, a part shown as a specimen. The transfer ought to be by way of gift or free sample. The entire phrase can be interpreted as ‘to transfer the control or ownership over goods either by way of love / affection or by taking out a small quantity from a larger group and such transfer being without consideration’.

JUDICIAL INTERPRETATION
The phrase ‘lost’ can be understood in the sense that the taxpayer has lost possession over the goods on account of any external incident. It represents a total annihilation of the goods and does not appear to be encompassing situations where the goods are present but there is a loss (economic and / or physical loss) which is partial in nature. This expression should be understood in contradistinction to the phrase ‘loss’ which would be wider and include partial loss of goods concerned. Superior Court of Pennsylvania in Dluge vs. Robinson1, while considering an issue relating to ‘negotiable instruments destroyed, stolen or otherwise lost’, referred to the definition of the term ‘lost’ in the Black’s Law Dictionary (4th edition) which reads as follows:

‘An article is “lost” when the owner has lost the possession or custody of it, involuntarily and by any means, but more particularly by accident or his own negligence or forgetfulness, and when he is ignorant of its whereabouts or cannot recover it by an ordinarily diligent search.’

In Sialkot Industrial Corporation vs. UOI2 the phrase ‘lost or destroyed’ was examined and it means a complete deprivation of the property involved. This decision is important as it highlights the commonality in the phrases lost, destroyed, disposition as that in which there is loss of possession over the goods:

‘10. According to the Webster’s Third New International Dictionary, the word “Loss” means, the act or fact of losing, failure to keep possession, deprivation, theft of property. In the same dictionary, the word “lost” is defined as meaning “not made use of, ruined or destroyed physically or morally, parted with, no longer possessed, taken away or beyond reach of attainment”. According to the Law Lexicon, Vol. 2 page 44, the word “loss” has no precise hard and fast meaning. It is a generic and comprehensive term covering different situations. Loss results when a thing is destroyed. But it is also caused when the owner has been made to part with it although the thing remains intact. In this sense, loss means and implies “a deprivation”. It is synonymous with damage resulting either in consequence of destruction, deprivation or even depreciation and when a party is dispossessed of a thing, either when it can never be recovered or when it is withheld from him, he is deemed to suffer the loss.’

The said decision was distinguished in BEML vs. CC Madras3 in the context of the Customs Act which had distinct provisions for goods lost or destroyed and those that are pilfered. In that context the Court held that goods stolen cannot be included in the phrase lost or destroyed. But this distinction does not alter the interpretation in section 17(5)(h) since they are subject to similar implications under the GST law.

In CIT vs. Sirpur Paper Mills Ltd. [1978] 112 ITR 776 (SC) the word ‘destroy’ came up for consideration – Destroyed is a word in common usage, with well-defined non-technical meaning. As used in law, it does not in all cases necessarily mean complete annihilation or total destruction. But in the context and under particular circumstances the word many times has been defined as meaning totally obliterated and done away with as also made completely useless for the purpose intended – vide Corpus Juris Secundum, Volume 26, page 1246.

‘We are not concerned in this case with a situation where two independent machineries which are separable have to work combined for the purpose of business. We, therefore, need not answer as to what would happen in such a case. We are concerned in this case with the part of the machinery which admittedly was inseparable and had no independent existence as machinery. The context in which the words “sold”, “discarded”, “demolished” or “destroyed” are used and for the purpose for which they are used, to our mind, clearly suggest that it is to the whole machinery that they apply and not to any part of the machinery.’

OTHER LEGAL PROVISIONS
One may recollect the contextual use of the phrase lost and / or destroyed under the Central Excise Rules, 1944. The provision read as follows:

‘21. Remission of duty – (1) Where it is shown to the satisfaction of the Principal Commissioner or Commissioner, as the case may be that goods have been lost or destroyed by natural causes or by unavoidable accident or are claimed by the manufacturer as unfit for consumption or for marketing, at any time before removal, he may remit the duty payable on such goods, subject to such conditions as may be imposed by him by order in writing:’

Similar expressions were used in sections 22 and 23 of the Customs Act in the context of remission of Customs duty prior to clearance of goods for home consumption. The extract reads as follows:

‘SECTION 22. Abatement of duty on damaged or deteriorated goods. – (1) Where it is shown to the satisfaction of the Assistant Commissioner of Customs or Deputy Commissioner of Customs –
(a) that any imported goods had been damaged or had deteriorated at any time before or during the unloading of the goods in India; or
…..
(c) that any warehoused goods had been damaged at any time before clearance for home consumption on account of any accident not due to any wilful act, negligence or default of the owner, his employee or agent,
SECTION 23. Remission of duty on lost, destroyed or abandoned goods. – (1) Without prejudice to the provisions of section 13, where it is shown to the satisfaction of the Assistant Commissioner of Customs or Deputy Commissioner of Customs that any imported goods have been lost (otherwise than as a result of pilferage) or destroyed, at any time before clearance for home consumption, the Assistant Commissioner of Customs or Deputy Commissioner of Customs shall remit the duty on such goods.’

The specific use of the phrases ‘damage’ / ‘deterioration’ in company with ‘destroyed’ conveys that the Legislature has in the past assigned a distinct connotation to these phrases and the degree of damage or the condition of damage plays an important role in ascertaining whether there is destruction. It appears that only complete damage rendering the goods unusable would be considered as destruction and not otherwise.

RULE OF ‘NOSCITOR A SOCII’
While understanding the above phrase individually, the Noscitor rule of construction ought to be applied. According to the rule, where two or more words which are susceptible to analogous meaning are coupled together, they are understood to be used in their cognate sense. On application of this rule, it would be impermissible to extract a phrase and give it a meaning which is at divergence or wider in amplitude than the other phrases. They are to take colour from each other.

In the present context, the phrases ‘lost’, ‘stolen’, ‘destroyed’, ‘written off’ or ‘disposed of’ appear to have a common thread. The phrase lost and stolen is undoubtedly to be understood as a situation where the owner is deprived of the goods in its entirety. On the other end, the phrases ‘disposed of by gift or free sample’ also represents transfer of goods in its entirety to another person. Accordingly, the intermittent phrases ought to also be understood in the same sense. The phrases ‘destroyed’ and ‘written off’ should also be interpreted in the same sense. Destroyed ought to imply such destruction which completely extinguishes the goods. Partial damage or spoilage of goods which continue to have a physical existence and can be recovered or used partially should not be construed as destroyed. Moreover, write-off of goods represents a permanent write-off of goods which are not having any use to the business enterprise. Partial write-off due to technological obsolescence, etc., cannot be intended to have been included in the said enumeration.

Moreover, these are instances which are unforeseen or non-recurring in nature. If the business practice recognises foreseeable losses (such as evaporation, seasonal damage, etc.), such events may not fall within the strict construction of section 17(5)(h). Losses which arise out of business necessity, conscious efforts, budgeted / identified events, factored into product costs, etc., ought not to be considered as an unforeseen loss. Though there may be involvement of incidents of destruction of the goods, such destruction (being recognised and forecast) would not contextually adhere to the intent of the entire phrase. While one may contend that the phrases ‘disposed of by gift or free sample’ is a voluntary act, the fabric of the phrase evidently necessitates that the events have an unforeseen character inherent in them.

In Symphony Services Corp. India Pvt Ltd. vs. CC Bangalore4 the Court examined a situation where the goods have become entirely useless due to seepage of water, thereby concluding that they were destroyed goods, rejecting the contention of the Department that the said goods were ‘damaged goods’ and not ‘destroyed goods’. This decision is important for the proposition that only complete damage would fall within the expression destruction of goods and the physical condition of the same should be such that it renders them utterly unusable. It is only when such an interpretation is adopted that section 17(5)(h), in its entirety, would one be able to adhere to the Noscitor rule and ensure a consistent understanding of the phrase.

‘In respect of’
Before we move further, it is also important to study the phrase ‘in respect of’ standing at the preamble of section 17(5)(h). One understanding of this phrase is that it has a wide connotation and the Legislature intends to use this phrase in an expansive sense. The popular decision cited in this context is the case of Renusagar Power Co. Ltd. vs. General Electric Co., (1984) 4 SCC 679 where the Courts examined the scope of the arbitration clause in an agreement and held as follows:

‘(2) Expressions such as “arising out of” or “in respect of” or “in connection with” or “in relation to” or “in consequence of” or “concerning” or “relating to” the contract are of the widest amplitude and content and include even questions as to the existence, validity and effect (scope) of the arbitration agreement.’

The said interpretation was followed in a recent decision of the Supreme Court in the context of section 8 of the IBC (Macquarie Bank Limited vs. Shilpi Cable Technologies Limited5) which stated that the phrase ‘in relation to’ is of wide import and consequently interpreted in an expansive sense. In Doypack Systems Pvt. Ltd. vs. UOI (1988) 2 SCC 299, the Court was examining the expression ‘in relation to’ (so also ‘pertaining to’) and held that these expressions are intended to include matters of both direct and indirect significance depending on the context. The Court also stated that the expression ‘relate’ is to be understood as bringing into association or connection with and the said expression is synonymous with ‘concerning to’ and ‘pertaining to’. These are expressions of expansion and not of contraction. Similar views were echoed in other decisions in the context of Central Excise laws6. The above conclusions convey that section 17(5) should be read in its expansive sense with complete play being given to the scope of blocked credits. Accordingly, while interpreting the provisions in respect of goods which are lost, destroyed, etc., they must be applied in an expansive sense rather than a narrow sense.

But a more proximate context was considered in State of Madras vs. Swastik Tobacco Factory7 where the Court was examining the phrase ‘in respect of’ used while granting deduction of excise duty paid in respect of goods sold. While the Revenue argued that ‘in respect of’ here is synonymous with ‘on’ and narrows down the scope of the phrase to only those goods ‘on’ which excise duty was paid, the assessee argued the phrase was wide enough to cover even cases where excise duty paid on raw materials can be attributed to the finished goods. The Court rejected the argument of the assessee and held ‘in respect of’ in the context can only mean goods on which excise duty was paid and not on raw materials which are attributable to the final product. This decision narrowed down the ambit of the phrase and limited the scope of a ‘deduction provision’ to only cases having a direct significance with the subsequent events. Accordingly, the provisions of section 17(5) [more specifically clause (h)] should mandate that the ITC is denied only in respect of those goods which are lost, stolen, destroyed, etc., and not extend itself to goods contained in the finished goods after being put to use.

IDENTITY TEST OF GOODS
The above analysis takes us to the important juncture of whether there has to be a matching of the identity of goods on which credit is taken and the goods on which credit is being denied. In other words, whether a manufactured tyre which is lost, destroyed, stolen can be subjected to reversal ‘in respect of’ the ITC availed on the rubber used as raw material for manufacture of the tyre.

We should reflect back to the CENVAT Credit Rules, 2004 which contained certain provisions on reversal of ITC on removal, loss, destruction, etc.

The said rules captured the cases where the inputs were not put to the intended use of manufacture of goods. In rule 3(5), removal ‘as such’ was interpreted to apply only to cases where the goods were removed without putting them to any use. There have been multiple decisions on the specific point8 that ‘as such’ implies goods in their original condition without having been put to use. Courts have opined that alteration of the form, usage of goods into production process for a reasonably long period would not amount to removal of goods ‘as such’. This leads to the introduction of Rule 3(5A) which addresses the removal of capital goods after usage on a depreciated value. Such an interpretation appeared to be in harmony with the underlying basis for credit, i.e., use or intended for use. Importantly, the law refrained from introducing any reversal on removal of inputs contained in finished goods after the usage of such inputs. Rule 3(5B) was also introduced to address cases where goods, even though in non-usable condition, were retained in the premises and hence did not trigger removal of goods. The said rule therefore mandated reversal of credit where the write-off in the books of accounts was undertaken as a consequence of non-usage of goods. The proviso in the said rule entitled re-credit of this reversed amount the moment the same were again put back to use by the manufacturer.

Rule 3(5C) was introduced to address cases where goods were used and contained in the finished goods which were either lost or destroyed and the excise duty on the same was remitted under the Central Excise Rules. The crucial point worth noting is that these Rules distinctly provided for cases where goods on which credit was taken were ‘contained’ in the manufactured product. Until this Clause was inserted, courts have taken the view that CENVAT rules did not provide for reversal of goods used in the manufacturing process which were ultimately lost or destroyed and duty was remitted in terms of Rule 219. Even subsequent to the introduction of this Clause, Courts have held that the reversal of credit is not automatic and one has to establish remission of excise duty on such goods for reversal under 3(5C) to be triggered10.

The above interpretation rules out many cases of goods which are lost or destroyed or removed after use in production process. Even in cases where the identity of goods is altered / processed into finished products, the mere fact of inputs being contained in such lost / destroyed finished goods does not warrant a reversal unless there are specific provisions to perform the same. In summary, the identity test definitely played an important role in reversal of CENVAT credit.

In the context of GST law, the conclusion ought to remain constituted in view of legacy understanding of credit provisions and the literal wordings of section 17(5)(h). The preliminary conclusion derived on application of the Noscitor rule is further fortified when one reflects upon the background of legacy provisions.

Therefore, the wide interpretation of ‘in respect of’ may not be palatable to taxpayers and there may be an inclination to highlight the context in which this phrase is to be interpreted. They would claim that the expansive nature of section 16(1) should not be defeated by a wider interpretation of section 17(5). Goods lost, destroyed, etc., should be understood as an exception to the positive intent to allow tax credits in case of business use. Where business use has been met and the taxpayer is able to establish the necessity for use of the product in a particular manner (generally framed as commercial expediency), Revenue ought not to question the business acumen behind the use of such goods. And this is where Courts will have to also take cognizance of the ‘commercial expediency test’ while interpreting the said phrase.

The most profound appreciation of this test was stated in an Income-tax matter in S.A. Builders case11 which was examining a matter of allowability of interest for the purpose of business. The Court stated (in para 23-25 and 31) that expenses incurred out of business expediency do not limit themselves to earning profits or one’s own business. It would also include matters undertaken out of a business necessity or prudence even though it does not appear to render an immediate or a visible benefit to the said business. Most importantly, the A.O. cannot sit in judgement over the commercial expediency of a business decision [Hero Cycles (P) Limited vs. CIT12]. The said test was also expounded in J.K. Cotton Spg. & Wvg. Mills Co. Ltd. vs. Sales Tax Officer in the context of Cenvat / Modvat Credits under the erstwhile laws. The Supreme Court stated that credit ought to be extended to equipment in manufacture of goods if it aids any particular process and the said process is so integrally connected with the manufacturing that its absence would render the same commercially inexpedient.

The applicability of the above analysis under GST is visible with the decision of ARS Steel & Alloy International (P) Ltd. where the Madras High Court while addressing the Revenue’s contention that finished goods contained a substantially lower quantity of inputs in comparison with the raw material consumed, stated that loss of inputs which is inherent to the manufacturing process cannot be denied u/s 17(5)(h). The Court relied on the decision in Rupa & Co. Ltd. vs. CESTAT13 and observed that the phrase ‘Inputs of such finished product’ and ‘contained in finished products’ are distinct phrases and they cannot be viewed theoretically as mere semantics. It must be viewed in the context of the manufacturing process which necessarily entails loss of goods at various stages and such loss cannot be equated to loss of the inputs as such. Therefore, the legacy principle that the identity of the goods and the identity of the credit in respect of the goods for which reversal is being sought on the eventuality of being ‘lost’, ‘destroyed’, etc., u/s 17(5)(h) should be mapped and only on such identification would the reversal be permissible under law.

APPLICATION
The above analysis can now be applied to a set of cases where there has been a constant tug-of-war between the taxpayer and his Officer. The Table below has been divided into distinct instances based on events:

CONCLUSION
This is a topic where the Courts may have to draw a balance between the purported widespread application of section 17(5) and the business wisdom of taxpayers to treat their purchases in a particular manner while doing business. In the context of clause (h), one should be cognizant of the fact that the Government’s stake is limited to the tax component on such goods, whereas the taxpayer himself is committed to the base value of goods involved and if the taxpayer has made a decision to treat the goods in a particular way and recover their costs from the value chain, that decision ought to be respected by the Government while granting tax credits. Moreover, in mathematical terms where the taxpayer has factored in and loaded such losses onto the product pricing and the enhanced sale price, the loss is factored therein and tax revenue attributable to such loss has been passed on as a value addition down the value chain. Ultimately, in the legal sense the maxim ‘Ex praecedentibus et consequentibus optima fit interpretatio’ is apt here – the best interpretation is made from the context!