Valuation of Taxable Services – Rule for Taxing Reimbursements Held ultra vires

Subsequent to the introduction of Negative List based Taxation of Services wef 1/7/12, no amendments were made in Section 67 of the Finance Act, 1994 (Act) and Rule 5 of Service Tax (Determination of Value) Rules, 2006 [Valuation Rules] framed thereunder relating to the taxability of reimbursements. However, significant amendments were made, in regard to valuation relating to Works Contract Services (Rule 2A) and Valuation relating to Supply of Food/Outdoor Catering Services (Rule 2C).

In the meantime, in a significant recent judicial development, Rule 5 of Valuation Rules has been held to be ultra vires. Hence, considering its significant repercussions, the same is analysed and discussed in detail here. Provisions of Rules 2A and 2C of the Valuation Rules will be discussed in this feature in due course.

Delhi high court ruling in Inter Continental Consultants and Technocrats Pvt Ltd. (2012 TIOL – 966 HC – Del – ST)

In this case, the Delhi High Court was concerned with the question of law wherein it was decisively ruled that Rule 5(1) of the Valuation Rules providing inclusion of the expenditure or costs incurred by the service provider during the course of providing taxable service, to be part of the value for the purpose of charging Service tax is ultra vires Sections 66 and 67 of the Act, as the said rule travels beyond the scope and mandate of the said section 67.

Background:

In the case of Intercontinental Consultants and Technocrats Pvt. Ltd. (2012-TIOL-966-HC-DEL-ST), writ petition was filed. The petitioner company was providing consulting engineering services to National Highway Authority of India (NHAI) and charged service tax thereon and paid the same. However, during the course of providing the said service, the petitioner had incurred certain out of pocket expense like traveling, boarding and lodging, office rent, office supplies and utilities testing charges etc. These expenses were separately indicated in the invoice for recovering the same. This according to the revenue were essential expenses for providing taxable services of consulting engineers and therefore they directed the company to pay service tax on the same. While proposing the demand of service tax, the Show Cause Notice made Rule 5(1) of the Valuation Rules as its basis. Challenging the Show Cause Notice and the said Rule 5(1) of the Valuation Rules, the petitioner filed writ petition in 2008 with three prayers viz.

• quashing Rule 5 of Valuation Rules to the extent that it included reimbursable expenses in the taxable value for charging service tax;

• declaring the said rule to be unconstitutional and ultra vires section 66 and 67 of the Act;

• quashing the Show cause Notice holding it illegal, without jurisdiction and unconstitutional. In the interim order, the High Court had directed not to take coercive steps against the petitioner [reported at 2008 (12) STR 689 (Del)]. The final order dated 30th November, 2012 is reported at the above citation.

Discussion: Provisions of law:

Section 94 of the Act empowers the Central Government to make rules by issuing notifications. The rules are framed to carry out the provisions of Chapter V of the Act providing for the levy and collection of service tax. Valuation Rules were accordingly notified to come into effect from 19th April, 2006. Almost simultaneously, i.e. w.e.f. 18th April, 2006 section 67 dealing with ‘valuation’ of any taxable service also was amended to read as follows:

Section 67 (as introduced from 18/04/2006):

1. Subject to the provisions of this Chapter, where service tax is chargeable on any taxable service with reference to its value, then such value shall, –

2 Where the gross amount charged by a service provider, for the service provided or to be provided is inclusive of service tax payable, the value of such taxable service shall be such amount as, with the addition of tax payable, is equal to the gross amount charged.

3 The gross amount charged for the taxable service shall include any amount received towards the taxable service before, during or after provision of such service.

4 Subject to the provisions of sub-sections (1), (2) and (3), the value shall be determined in such manner as may be prescribed.

It is interesting to note that the above section 67 as amended and as it stood prior to 18/04/2006 authorised determination of the value of taxable service as, the gross amount charged by the service provider for such service provided or to be provided by him in a case where the consideration is in money. The highlighted words, “for such service” are key words in the above section read with the charging section 66 which reads as “there shall be levied a tax (hereinafter referred to as the service tax) @ 12% of the value of taxable services referred to in sub-clauses …………. of section 65 and collected in such manner as may be prescribed”. Thus, the charge of the service tax as per section 66 is on the value of taxable services. In turn, the taxable services are listed in section 65(105) and the relevant sub-clause under which the consulting engineering service is covered is sub-clause (g). Therefore, the only value which can be subjected to service tax is the value of the service provided by the petitioner to NHAI which is that of consulting engineer and nothing more. In other words, the quantified value can never exceed the gross amount charged by the service provider for such service provided by him. The petitioner thus contended that though section 94 of the Act enables the Central Government to prescribe rules, such rules can only be made to carry out the provisions of Chapter V of the Act. The power conferred cannot exceed or go beyond the section providing for them the charge or collection of the levy.

In the scenario, it is necessary to understand the subject matter of the controversy i.e. what does the said Rule 5 intend to include in the value of any taxable service. Rule 5 of the Valuation Rules reads as follows:

“(1) Where any expenditure or costs are incurred by the service provider in the course of providing taxable service, all such expenditure or costs shall be treated as consideration for the taxable service provided or to be provided and shall be included in the value for the purpose of charging service tax on the said service.”

Sub-clause (2) of the said section contains an exception to the above rule, that the expenditure or costs incurred shall be excluded from the value of taxable value when the service provider acts as a pure agent of the recipient of service subject to the conditions contained in the said sub-section. These conditions are required to be satisfied cumulatively and it is extremely hard to do so.

Further, Explanation 2 to the said Rule 5 reads as follows, followed by four illustrations:

“Explanation 2. – For the removal of doubts, it is clarified that the value of the taxable service is the total amount of consideration consisting of all components of the taxable service and it is immaterial that the details of individual components of the total consideration is indicated separately in the invoice.

Illustration 1. – X contracts with Y, a real estate agent to sell his house and thereupon Y gives an advertisement in television. Y billed X including charges for Television advertisement and paid service tax on the total consideration billed. In such a case, consideration for the service provided is what X pays to Y. Y does not act as an agent on behalf of X when obtaining the television advertisement, even if the cost of television advertisement is mentioned separately in the invoice issued by X. Advertising service is an input service for the estate agent in order to enable or facilitate him to perform his services as an estate agent.

Illustration 2. – In the course of providing a taxable service, a service provider incurs costs such as traveling expenses, postage, telephone, etc., and may indicate these items separately on the invoice issued to the recipient of service. In such a case, the service provider is not acting as an agent of the recipient of service, but procures such inputs or input service on his own account for providing the taxable service. Such expenses do not become reimbursable expenditure merely because they are indicated separately in the invoice issued by the service provider to the recipient of service.

Illustration 3. – A contracts with B, an architect for building a house. During the course of providing the taxable service, B incurs expenses such as telephone charges, air travel tickets, hotel accommodation, etc., to enable him to effectively perform the provision of services to A. In such a case, in whatever form B recovers such expenditure from A, whether as a separately itemised expense or as part of an inclusive overall fee, service tax is payable on the total amount charged by B. Value of the taxable service for charging service tax is what A pays to B.

Illustration 4. – Company X provides a taxable service of rent-a-cab by providing chauffeur-driven cars for overseas visitors. The chauffeur is given a lump sum amount to cover his food and overnight accommodation and any other incidental expenses such as park-ing fees by the Company X during the tour. At the end of the tour, the chauffeur returns the balance of the amount with a statement of his expenses and the relevant bills. Company X charges these amounts from the recipients of service. The cost incurred by the chauffeur and billed to the recipient of service constitutes part of gross amount charged for the provision of services by the Company X.”

Perusing the above, the Court observed that the above illustration 3 amplifies what is meant by sub-rule
(1). In the illustration given, the architect who renders the service incurs expenses such as telephone charges, air travel tickets, hotel accommodation etc. to enable him to effectively perform his services. Through the illustration, the Rule clearly breaches the boundaries of section 67. In addition to traveling beyond the mandate and the scope of the section, it may also result in double taxation. For instance, air travel attracts service tax and by including it in the value of the invoice and to charge service tax thereon would be certainly paying tax twice. In this frame of reference, the Court recognised that there could be double taxation provided it is clearly intended and cannot be enforced by implication. Citing Supreme Court in Jain Brothers vs. UOI (1970) 77 ITR 107, a part of the extract of the Court’s observation reads as follows:

“It is not disputed that there can be double taxation if the legislature has distinctly enacted it. It is only when there are general words of taxation and they have to be interpreted, they cannot be so interpreted as to tax the subject twice over to the same tax (vide Channell J. in Stevens v. Durban-Roodepoort Gold Mining Co. Ltd.). The Constitution does not contain any prohibition against double taxation even if it be assumed that such a taxation is involved in the case of a firm and its partners after the amendment of section 23(5) by the Act of 1956. Nor is there any other enactment which interdicts such taxation. If any double taxation is involved the legislature itself has, in express words, sanctioned it. It is not open to any one thereafter to invoke the general principles that the subject cannot be taxed twice over.”

While the Hon. Court found adequate authority for the contention that the rules cannot overreach the provisions of the main enactment, it cited the following:

“In Central Bank of India vs. Their Workmen, AIR 1960 SC 12 the observation was, “We do not say that a statutory rule can enlarge the meaning of Section 10; if a rule goes beyond what the Section contemplates, the rule must yield to the statute. We have, however, pointed out earlier that Section 10 itself uses the word “remuneration” in the widest sense, and R.5 and Form-I are to that extent in consonance with the Section.”

Similarly, In Babaji Kondaji Garad vs. Nasik Merchants Co-operative Bank Ltd., (1984) 2 SCC 50, the Supreme Court observed “Now if there is any conflict between a statute and the subordinate legislation, it does not require elaborate reasoning to firmly state that the statute prevails over subordinate legislation and the bye-law, if not in conformity with the statute in order to give effect to the statutory provision, the Rule or bye-law has to be ignored. The statutory provision has precedence and must be complied with.”

In the light of the above observations, the Court found that the expressions “consideration in money” or “the gross amount charged” used in section 67 in widest sense are not suggestive of including the amount collected for travel, hotel stay, transportation and other out of pocket expenses, but these words are defined in the Explanation below the section. Significantly, out of pocket expenses such as travel, hotel stay, transportation etc. are not included in those expressions.

The Court also relied on the observation in Devi Datt vs. Union of India, AIR 1985 Delhi 195 “but obviously the said rule has to be construed in the light of the parent section and it cannot be construed as enlarging the scope of Section 19 itself. It is a well settled canon of construction that the Rules made under a statute must be treated exactly as if they were in the Act and are of the same effect as if contained in the Act. There is another principle equally fundamental to the rules of construction, namely, that the Rules shall be consistent with the provisions of the Act. Hence, Rule 102 has to be construed in conformity with the scope and ambit of Section 19 and it must be ignored to the extent it appears to be inconsistent with provisions of Section 19”. Similarly in CIT vs. S. Chenniappa Mudaliar, (1969) 74 ITR 41 it was held that “if a rule clearly comes into conflict with the main enactment or if there is any repugnancy between the substantive provisions of the Act and the Rules made therein, it is the rule which must give way to the provisions of the Act.” Also in Bimal Chandra Banerjee vs. State of M.P. and Ors. (1971) 81 ITR 105, the Court observed:

“No tax can be imposed by any bye-law or rule or regulation unless the statute under which the sub-ordinate legislation is made specially authorises the imposition even if it is assumed that the power to tax can be delegated to the executive. The basis of the statutory power conferred by the statute cannot be transgressed by the rule making authority. A rule making authority has no plenary power. It has to act within the limits of the power granted to it”.

The Court further relied on CIT, Andhra Pradesh vs. Taj Mahal Hotel, (1971) 82 ITR 44 and Commissioners of Customs and Excise vs. Cure and Deeley Ltd., (1961) 3 WLR 788 (QB) and made similar observation as to the canon that a rule has to be framed remaining within the scope and ambit of the Act.

For the case under examination, the Court observed that reading section 66 and section 67(I)(i) of the Act together and harmoniously, it seems clear that while valuing a taxable service, nothing more and nothing less than the consideration paid as quid pro quo for the service can be brought to charge. Sub-section (4) of the said section 67 enabling the determination of value of taxable service “in such manner as may be prescribed” is expressly made subject to the provisions of sub-section (1). The Court decisively ruled that sections 66, 67 and 94, which empower the Central Government to prescribe rules to carry out the provisions of Chapter V of the Act mean that only the service actually provided by the service provider can be valued and assessed to service tax and Rule 5(1) of the Valuation Rules runs counter and is repugnant to sections 66 and 67 of the Act and to that extent it is ultra vires. By including the expenditure and costs, it goes far beyond the charging provisions and cannot be upheld. Citing Hukam Chand vs. Union of India, AIR 1972 SC 2427, the Court concluded that simply because every rule framed by the Central Government is laid before both the Houses of the Parliament, does not confer validity on a rule if it is not made in conformity with the Act as it is a specie of a subordinate legislation.

Whether all reimbursable expenses would not attract service tax any more?

While the ruling of the Delhi High Court indeed is extremely welcome, little can be commented about its finality at this stage. A lot will depend whether the revenue chooses to file appeal against the above ruling in the Supreme Court and this is most likely to happen. The possibility of the Government bringing about retrospective amendment in section 67 itself cannot also be ruled out, considering the fact that a large number of assessees have already paid service tax on the reimbursable expenses and again a large number of them may have paid after recovering the same and of which, CENVAT credit is availed by the recipients of such services. Precedents of retrospective amendment have already been experienced in the service tax administration itself in case of renting of immovable property service and broadcasting service, besides the fact that Supreme Court struck down provisions relating to reverse charge made via subordinate legislation as ultra vires vis-à-vis services of clearing and forwarding agents and goods transport agencies. (Refer Laghu Udyog Bharti Anr. vs. UOI 1999 (112) ELT 365 (SC) and subsequent retrospective amendment made in section 68 of the Act by the Central Government to overcome the directives of the Court in the said case). Therefore, the relief or even the sense of ‘fairness’ felt on account of the above judgment may remain short-lived and plan of action on the basis of the above ruling may not be an act of prudence, as felt by many at this point in time. However, and not withstanding the outcome or the finality in the above context, it is relevant to analyse the rationale laid down by the Larger Bench of the Bangalore Tribunal in Shri Bhagawathy Traders vs. CCE, Cochin 2011 (24) STR 290 (Tri.-LB) which dealt with the issue of taxability of reimbursable expenses under the service tax law in the scenario when Rule 5(1) did not exist. In this case, issues relating to reimbursement of various expenses incurred by C. & F. Agents were discussed in detail, by the Larger Bench including various conflicting judicial views in the matter. Relevant extracts of the observations made by the Larger Bench are under.

Having analysed the various decisions cited on behalf of the assessee and on behalf of the department, it would be appropriate to consider the scope of the term “reimbursements” in the context of money realised by a service provider. ……The concept of reimbursement will arise only when the person actually paying was under no obligation to pay the amount and he pays the amount on behalf of the buyer of the goods and recovers the said amount from the buyer of the goods.

Similar is the situation in the transaction between a service provider and the service recipient. Only when the service recipient has an obligation, legal or contractual, to pay certain amount to any third party and the said amount is paid by the service provider on behalf of the service recipient, the question of reimbursing the expenses incurred on behalf of the recipient shall arise. For example, when rent for premises is sought to be claimed as reimbursement, it has to be seen whether there is an agreement between the landlord of the premises and the service recipient and, therefore, the service recipient is under obligation for paying the rent to the landlord and that the service provider has paid the said amount on behalf of the recipient. The claim for reimbursement of salary to staff, similarly has to be considered as to whether the staff were actually employed by the service recipient at agreed wages and the service recipient was under obligation to pay the salary and it was out of expediency, the provider paid the same and sought reimbursement from the service recipient.

Various Circulars of the Board relied upon by the Learned Advocate for the assessee clearly referred to amounts payable on behalf of the service recipient. For example, the Customs House Agent (CHA) paying the Customs duty to the Customs Department, paying the charges levied by the Port Trust to the Port Trust, paying the fee for testing to the Testing Organisation are clearly on behalf of the importer/exporter and the same are recoverable by the CHA as reimbursement, that too on actual basis. These Circulars cannot be held to be in support of the claim of the assessee that they can split part of the amount as reimbursable expenses and the rest as towards service charges.

The claim for reimbursement towards rent for premises, telephone charges, stationery charges, etc. amounts to a claim by the service provider that they can render such services in vacuum. What are costs for inputs services and inputs used in rendering services cannot be treated as reimbursable costs. There is no justification or legal authority to artificially split the cost towards providing services partly as cost of services and the rest as reimbursable expenses.

Keeping in view this rationale, if a simple example of architect, consulting engineer or a chartered accountant is examined wherein when an architect visits site of the client outside his home city/town and so do the engineers of a consulting engineering firm or audit team of a CA firm, the travel expenses, lodging and boarding expenses incurred and reimbursed cannot certainly form part of the ‘value’ of taxable service as the service provider has incurred such expenses only to carry out the assignment of the recipient of service and such cost does not represent its own “professional fee” that is charged for using its proficiency expertise and/or knowledge of the subject. Yet in some cases for the sake of simplicity, sometimes allowances are fixed on a daily basis for employees to avoid cumbersome paper work or to overcome practical difficulties and this many a times acts as a deterrent to prove that the ‘reimbursement’ of the expense incurred is on “actual basis” in terms of the controversial Rule 5(2) of the Valuation Rules which provides that cost incurred as “pure agent” can be excluded from the value of taxable service, subject to satisfaction of all the conditions laid down in this respect. Taking another example of a CHA or a logistics service provider, it is found that when an expense like courier charge is specifically incurred for and on behalf of the recipient and under his specific instructions or a place is acquired on rental basis on behalf of client and is client-specific and for their limited purpose, it may not form part of the cost of providing such service and therefore, service tax may not be attracted in such cases. Nevertheless, the issue is subjective as observed by the Larger Bench in Shri Bhagawathy Traders (supra) wherein admittedly the subject is dealt with a well-balanced approach. The issue therefore may be debatable and therefore litigative in many complex situations as precise parameters are not available in law for the same otherwise than Rule 5 of the Valuation Rules.

Conclusion:

Nevertheless, the draconian Rule 5(1) of the Valuation Rules and the concept of “pure agent” as enshrined in the Rule sub-clause (2) of the said Rule 5 with rigidity certainly do not deserve to exist on the statute.

In the current scenario, when all services are brought within the sweep of the service tax except the Negative List and certain exempt services, if pragmatism is applied by the Government and Rule 5 is allowed to remain struck down, to a large extent dual taxation would be avoided and guidelines by revenue may be provided on the lines ruled by the Larger Bench in the case of Shri Bhagawathy Traders (supra). Service tax administration then would not be lopsided in favour of revenue on this aspect and may extend fairness to assessees at large on the issue of levying service tax on reimbursable costs and this may also possibly cover genuine concern of many business enterprises on the open issue of leviability or otherwise of service tax on shared costs among associate/group concerns.