Transactions with Associated Enterprises — A new category of service tax payers ?

Service tax law is amended from 10-5-2008 for casting
liability on transactions of taxable services with associated enterprises to pay
service tax even before the actual payment is received by the service provider.
For this purpose, Explanation (c) to S. 67 of Chapter V of the Finance Act, 1994
is amended and an Explanation is inserted in Rule 6(1) of the Service Tax Rules,
1994.

An attempt is made in this article to highlight the effect of
these provisions and the onerous responsibility cast on the taxpayers to
identify the transactions of taxable services between the Associated
Enterprises, a new category of taxpayers being introduced under service tax.

Service tax was hitherto payable on receipt of the value of
taxable service by the service provider. Even in case when the liability to pay
service tax is cast on the recipient of service, the amount actually paid by
such recipient triggered the liability. This means that so far, the liability of
service tax crystallised on what is known as ‘cash basis’ as distinguished from
‘accrual basis’ in accounting parlance.

Now, from the day the Finance Bill received assent of the
President i.e., from 10-5-2008, the liability is cast on the associated
enterprises to pay service tax even if the actual payment of value of taxable
service is not received/paid, as the case may be. ‘Associate Enterprises’ are
defined to take meaning from the Income-tax Act, 1961. This is a major deviation
in case of transactions between specified persons called as ‘Associated
Enterprises’ (AE) under the law. This amendment is introduced as anti-avoidance
measure, as the Government thought that tax avoidance takes place in case of
transactions of taxable services between the associated enterprises as service
tax is not paid, though it is recognised in the books of account as revenue or
expenditure by the concerned parties. This is clear from the clarification
issued by the Tax Research Unit (TRU) of the Government of India, dated 29th
February 2008. For better understanding the relevant portion of the said TRU
Letter is reproduced as follows :

In this context, let us examine the actual amendments :

Explanation to S. 67 (as amended) :

‘Gross amount charged’ includes payment by cheque, credit
card, deduction from account and any form of payment by issue of credit notes or
debit notes and book adjustment and any amount credited or debited, as
the case may be, to any account, whether called suspense account
or by any other name in the books of account of person liable to pay
service tax, where the transaction of service is with any associated
enterprise.” (emphasis supplied).

Prior to the amendment, the explanation read as follows :

Further, an Explanation to Rule 6(1) is introduced to bring
in line with S. 67, as a machinery provision :

Explanation — For the removal of doubts, it is hereby
declared that where the transaction of taxable service is with any associated
enterprise, any payment received towards the value of taxable service, in such
case shall include any amount credited or debited, as the case may be, to any
account, whether called ‘Suspense Account’ or by any other name, in the books of
account of a person liable to pay service tax.”

It can be seen from above that the definition of ,gross amount charged’ u/ s.67 is expanded in case of transactions with AE to include debit or credit to any account including a suspense account, in the books of the person liable to pay service tax. Under the erstwhile provisions as amended by the Finance Act, 2006, the liability to service tax was attracted upon issue of debit note or credit note in the context of payment of consideration in relation to provision of taxable service. For example, if there already existed a deposit in the books of A in favour of B, and A renders a taxable service to B, the liability of payment of service tax would arise when a book entry of adjustment of deposit is passed to-wards the value of taxable services provided. However, if A and B are associated enterprises, then the liability to service tax arises the moment a bill is issued, irrespective of the fact that whether there existed any deposit or not. This is because issue of a bill would result into credit to an income head and the liability would trigger on accrual basis of accounting. Thus the concept of book adjustment in relation to transactions between AE is of much larger import than in case of unrelated parties. Thus an onerous responsibility is cast on an enterprise providing service to its associated enterprise. Further illustrations of such onerous responsibility of this amendment are given elsewhere in this article.

Let us now examine whether such amendment was absolutely necessary to curb the incidence of avoidance of tax as made out by the Government. Firstly, the Service Tax Law is designed to cast liability on receipt of payment. This only means that the liability not necessarily arises even as transaction is recognised as revenue/expenditure in the books of account. Secondly, the purported avoidance is already taken care of by introduction of Explanation to S. 67 and valuation rules by the Finance Act, 2006. As can be seen from the Explanation before the amendment, the gross amount charged included payment by way of issue of credit/debit note or accounting adjustments. Further, even supposing that someone tries to avoid the tax (not actually avoid but delay) by raising debit note to a sister concern’s account instead of the recipient of service (assuming that all three are AE), it will not only raise questions from audit and other compliances, but also service tax and penalty from 100% to 200% can be levied u/ s.78 for fraud, collusion, etc. with intent to evade payment of service tax and the limitation period extends to five years. Thus, enough provisions exist under service tax to take care of the situations envisaged by the Government to deal with tax avoidance.

The effect of the amendment is that in case of a transaction of taxable service with AE, all debits or credits or adjustments in the account shall be regarded as the payment received towards the value of taxable service. This means that the liability to service tax triggers immediately upon issue of a bill for taxable service in case of AE. The payability of service tax on such transaction then falls due on the immediately following due date. It can thus be said that the amendment results only into preponement of liability. The amendments can therefore be said to be not addressing the issue of tax avoidance, but effectively preponing the liability in case of transactions between the AE.

Issue  of identification of AE :

The taxpayer community in this country has heard of the concept of associated enterprises under Income Tax from 1-4-2002 when the special provisions relating to avoidance of tax were introduced to levy tax on international transactions on Arm’s-Length Price (ALP), in line with international practice by the Finance Act, 2001. Under Income Tax, the umbrella of coverage is confined to international transactions involving one or more non-resident parties amongst the parties to the transaction. However, in case of service tax, even the domestic transactions are covered and also there is no need of any non-resident person to be a party to the transaction of taxable service.

AE is very widely defined under S. 92A of the Income-tax Act. and takes into its ambit an enterprise which participates through one or more persons, directly or indirectly, or through one or more intermediatary in the management or control or capital of other enterprise and also one or a set of persons who commonly participate directly or indirectly or through one or more intermediaries in the management or control or capital of the other AE. In the following cases, one enterprise is deemed as Associated Enterprise in relation to other enterprise as it appears from S. 92A(2)

The word, ‘enterprise’ is defined under the Income-tax Act as a person including a permanent establishment of such person.

The word, ‘permanent establishment’ is defined u/s. 92F which includes a fixed place of business through which business of enterprise is wholly or partly carried out.

The term ‘relative’ is not defined under Service Tax or under Central Excise Act. However, the Income-tax Act defines ‘relative’ as ‘in relation to an individual, means the husband, wife, brother, or sister or any lineal ascendant or descendant of the individual’ [5. 2(41)].

From the above definition, it is clear that the coverage under these provisions is wide. However, under income-tax, only international transactions are relevant to capture the transactions between the AE and it is not difficult to establish such a relationship in the context of international transactions. Applying this principle in the context of domestic transactions, is a Herculean task. Had such transactions been confined to import or export of services, it would have been simpler to take recourse to transfer pricing regulations to determine who should be regarded as an AE in relation to the transactions of taxable service.

It therefore follows that the first issue would be to identify any enterprise being regarded as AE in relation to transaction of taxable service. In the context of domestic coverage, it may lead to absurd results, for example, a loan advanced by a bank, the amount of which exceeds 51% of the book value of the total assets of the borrower, such bank becomes AE of the borrower. We are all aware that normally the borrower’s margin is 30% while the bank borrowing can be to the extent of 70%. It is equally difficult to come out of the criteria under many other clauses and one is unknowingly and unintentionally roped in as AE of the other enterprise.

The provisions pertaining to AE are applicable to all kinds of entities i.e., not only companies but also to non-companies like individuals, HUF, partnership firms, AOP, Ba I, etc. In case of a partnership firm, BOI or AOP, in most of cases an individual or more than one individual holds more than 10% each. In case of an HUF, one or more individuals having control is very common. In such cases, all such entities will be covered as AE in relation to the other and will require payment of service tax on ‘accrual’ basis.

Let us take a case of a private or a public company, in which case also it is equally difficult to identify associated enterprise. Accounting Standard AS-IS issued by K’Al, requires every company to disclose their transactions with related parties. However, here we find that the persons covered under AS-IS are much more restricted than S. 92A of the Income-tax Act. This can be seen from the ‘relationship’ covered under AS-IS, a relevant portion of the Standard is given below:

“2. This Statement applies only to related-party relationships described in paragraph 3.

3.    This Statement deals only with related-party relationships described in (a) to (e) below:

(a)    enterprises that directly, or indirectly through one or more intermediaries, control, or are controlled by, or are under common control with, the reporting enterprise (this includes holding companies, subsidiaries and fellow subsidiaries);

(e)    enterprises over which any person described in (c) or (d) is able to exercise significant influence. This includes enterprises owned by directors or major shareholders of the reporting enterprise and enterprises that have a member of key management in common with the reporting enterprise.

4.    In the context of this Statement, the following are deemed not to be related parties:

(a)    two companies simply because they have a director in common, not with standing paragraph 3(d) or (e) above (unless the director is able to affect the policies of both companies in their mutual dealings);

(b)    a single customer, supplier, franchiser, distributor, or general agent with whom an enterprise transacts a significant volume of business merely by virtue of the resulting economic dependence; and

(c)    the parties listed below, in the course of their normal dealings with an enterprise by virtue only of those dealings (although they may circumscribe the freedom of action of the enterprise or participate in its decision-making process) :

(i)    providers  of finance;

(ii)    trade  unions;

(iii)    public  utilities;

(iv)    government departments and government agencies including government-sponsored bodies.”

The Accounting Standard defines control as a related party controlling more than half of the voting power in the other party. Significant influence is defined as one individual owning, directly or indirectly, 20% or more in voting power of any enterprise. It thus appears that the coverage is much more limited under the Accounting Standard than what is envisaged u/s.92A of the Income-tax Act. Therefore, the companies will have to devise a separate set of modalities to identify an AE for the purpose of payment of service tax.

Similarly, since the liability of service tax arises once the receipt of provision of taxable service crosses Rs.I0 lakhs, even small and medium enterprises shall have to formulate modalities to identify the AE in relation to the transactions of taxable services with them. Further, persons other than provider of output service, who are liable to pay service tax, like GTA service, also will have to formulate suitable modalities for identification of the AB.

As per one estimate, about 50% of the service tax payers have transactions of taxable service with AE. Such assessee may also have transaction of taxable services with other than AE. These assessees will have to make two kinds of computation in the same month or quarter, as the case may be, (i) for service tax payments in case of transactions of taxable service with AE, and (ii) in case of transactions of taxable service with other than AE.

The new provisions for carving out associated enterprises for such differential and harsh treatment have thrown up certain interesting questions for which no clarification is offered and no solution is in sight. Such issues are listed hereinbelow as brain-stormers.

(a) Export  of Service:

For the purpose of exemption under the Export of Service Rules, one of the conditions required to be satisfied is of receipt of the value of taxable service in convertible foreign exchange. In case of AE, the liability arises at the time of raising the bill and debit or credit to any account. In a case when the payment is received subsequently, though in convertible foreign exchange, it will be difficult for the person providing otherwise exempt service as export of service, to satisfy this condition. Urgent clarification for mitigating this genuine hardship is required.

(b) Cenvat    credit :
(i) In case of international  transactions:

A person liable to pay service tax on taxable service provided from outside India and received in India (import of service) from overseas AE, is required to pay service tax once he passes debit or credit or adjustment entry in the books of account. Such an assessee may not be required to pay for the value of import of service to his AE immediately upon provision of service (based on the terms of contract). However, mere payment of service tax without payment of value of service, may not entitle him claim of credit of input service tax paid, even though it is used for providing taxable output service or in manufacture of excisable goods, as the condition laid down in Rule 4(7) of the Cenvat Credit Rules 2004 is not satisfied.

(ii) In case of domestic  transactions:

ABC is having transaction of taxable  service with XYZ (AE) in July 2008 and pays service tax on that transaction. The amount of invoice issued to XYZ was adjusted in the running account of XYZ, as payment was not required to be made in view of credit balance lying in the account of XYZ.

In such circumstance, it will be difficult to claim Cenvat credit for XYZ in view of the fact that payment of taxable service is not made. For this purpose, ABC and XYZ may have to take extra precautions as follows:

(a)    ABC to inform XYZ about book adjustment in their account

(b)    XYZ to show corresponding adjustment in their books

(c)    XYZ will have to convince the CEO about this constructive payment.

May be for this purpose, it has to obtain ‘receipt’ from ABC or even a certificate of his Chartered Accountant.

(c) Memorandum entries for monthly closing of accounts:

In this fast-moving era, not only Indian subsidiaries of foreign companies but also internally related Indian companies are required to report their monthly results of profit or loss. In case of listed companies, quarterly results are required to be disclosed. In the process, such entities have to pass book entries of income/expenditure, whether called memorandum entries, suspense entries, etc. on the last day of the month. Such entries are reversed on the first day of the immediately following month. Whether such entries would also trigger the liability to pay service tax is a moot question.

(d) Invoices cancelled/amended on re-appraisal before payment:

An assessee provides taxable service to AE and issues an invoice for the value of taxable service. However, subsequently the value is re-appraised or negotiated and finally a lower amount bill is issued by the service provider. The whole exercise is over before making the payment of consideration. However, the payment of service tax is already made on the basis of invoice issued. Whether there is any recourse to adjust such excess payment of service tax in case of reduction in bill amount. It is a moot question, whether Rule 6(3) of the Service Tax Rules can be of any help in this regards.

(e) Amendment to the amount charged on the basis of change in Arm’s-Length Price (ALP) under the Transfer Pricing Regulations:

It may so happen that the amount charged for service provided is not accepted by the Transfer Pricing Officer for a similar service rendered in earlier year. On this account, it becomes necessary to change the current year’s pricing, and the invoice amount is altered (e.g., cost plus 15% model from cost plus 10% adopted earlier). Whether this kind of change will trigger service tax liability on additional amount charged and when service tax becomes payable on such additional amount.

Conclusion:

From the detailed analysis of the new provisions pertaining to the transactions between associated enterprises, it can be seen that they will add more complexities to the already controversial provisions of service tax. It will result in undue hardship for the taxpayers, particularly small companies, individuals, HUF, partnership firms, BOIs, AOPs, etc. On the other hand, the Department is ill-equipped to track such transactions, which is so difficult for even an honest taxpayer to do, so much so that a taxpayer may not mind paying service tax under the new provisions (on accrual basis), but may find it difficult to identify AEs in relation to the transactions of taxable service. So far, under the service tax, there were two types of assessees, one the provider of service and two, the recipient of service. Now, these provisions have introduced one more kind of person liable to pay tax, on what we call accrual basis.

Above all, the intended benefits appear to be far lesser as compared to the exercise the assessee and the Department have to undertake.

It appears that without realising the implications, the Government has in its overenthusiasm, imported the provisions from the Income-tax Act, which are of widest import and essentially framed for different purpose altogether. This only adds to the woes of the taxpayers under already overcomplicated service tax. Had the provisions been applied for international transactions, it would not have raised much dust. But by applying the same analogy to the domestic transactions, the Government has gone much overboard.