Service tax credits on reverse charges

The CENVAT credit scheme, designed principally to avoid the cascading effect of taxes, by means of granting credits of duties paid on input goods and services for use towards payments of the output taxes on goods and services, in which such inputs are used, has been in vogue for more than two decades in respect of manufacturers. Even though service tax was introduced on certain specified services as early as in 1994, the mechanism of service tax credits was made available to service providers for the first time in 2002 under the Service Tax Credit Rules, which were thereafter replaced in the year 2004 by the CENVAT Credit Rules.

Given the fact that the mechanism of CENVAT credit is central to the concept of value-added taxation, it is critical to have an appropriately defined set of provisions in the rules governing their eligibility. Even more crucial is to have a sound administrative policy on the correct interpretation of these rules. This has, unfortunately, not happened. In the absence of clearly established principles and policies, there has been a great deal of difference in interpretation of credit rules by the assessees and the authorities.

Insofar as the availability of credits on input services is concerned, while it is true that several contentious issues such as admissibility of credits on usage of mobile phones, transportation charges and the like have been settled, significant challenges continue to remain in relation to several other tax costs.

This article aims at discussing a key issue relating to the admissibility of credits on the service taxes paid by a service recipient under the reverse charge mechanism on import of services. As is now well settled in law, it is legally permissible for the government to require recipients of services to self declare and pay taxes on such services (typically imports of services from abroad) and to thereafter avail credits on such payments.

A recent problem has come about in many excise/service tax commissionerates where the authorities have apparently taken a view that input credits are not available with regard to such payment of service taxes on imports of services. Show-cause notices have been issued for this to a number of assessees.

The argument that the authorities have taken to deny input credits on the above payments is that since the payments are made by the service recipients themselves, credits cannot be availed by such recipients for offsetting their output tax liability. The premise is that the import of services are chargeable to service tax under the recently introduced Section 66A of the Finance Act, 1994 (Act) whereas the credit rules allow credits for only such input services that are chargeable to tax under Section 66 of the Act.

In the above context, it is relevant to discuss the provisions related to the reverse charge mechanism for payment of taxes on imports of services and for availing credits thereon.

The reverse charge mechanism was first introduced under the Service Tax Rules in 2002 whereby it was provided that in case of provision of service by a non-resident not having an office in India, service tax would be payable by the service recipient.

Subsequently, an explanation to Section 65(105) brought in the concept of import of services and provided that the services provided by a person based outside India and received by a person based in India would be deemed to be taxable. Subsequently, the government deleted the explanation and inserted Section 66A in the Act in 2006 to define the incidence of import of service and to treat the recipient as a deemed service provider and hence liable to pay tax.

Thus, the reverse charge mechanism obligates the recipient of goods or services to pay tax in lieu of the real supplier of goods or services by treating the recipient, through legal fiction, as the provider of the service.

Now, the credit rules provide that the credit of taxes and duties paid on input services or inputs/capital goods is available to a service provider who provides the taxable service (output service). The rules further provide that the taxes paid on all eligible "input services" qualify for credit. Therefore, as long as a given set of services qualify as input services, service tax paid thereon would be eligible for set off against the output tax liability. This is quite clear from a reading of the provisions.

The government itself has taken a clear view in this regard "" in the case of services provided by a goods transport agency (GTA), the recipient of such a service is liable to pay service tax thereon, on a reverse charge basis. Circular No 97/2007 dated August 23, 2007, the master circular on procedural issues in service tax, while explaining the credit eligibility of service taxes paid on GTA services, states that the tax paid by the recipient of such services is eligible as input credit in the hands of the recipient.

Though this clarification is specifically in relation to GTA services, the situation in relation to services received from providers located outside India can be no different. Therefore, a different view in respect of import services, as apparently taken by the authorities, is inappropriate.

On the legal position itself, it is relevant to note that under the Service Tax Law, there is only one charging section, i.e., Section 66 of the Finance Act, 1994. This Section refers to all the services covered under the service tax net and provides that service tax is chargeable on all such services.

Thus, Section 66 is the charging section and Section 66A only defines the incidence of import of services. It is only where a service is chargeable to service tax under Section 66 that it could be covered under Section 66A, based on the criteria mentioned in the Taxation of Services (Provided from outside India & Received in India) Rules, 2006 (Import Rules) framed in this regard.

Therefore, the denial of input credit on import services on the grounds that they are not chargeable to tax under Section 66 of the Act is an incorrect legal proposition. All services chargeable to tax in the hands of the recipient under Section 66A are indeed taxable services under Section 66. If they are not, the reverse charge provisions will not apply.

The argument is all the more incomprehensible given the Central Board of Excise and Customs' (CBEC) clarification in Circular (F.No. B/1/4/2006-TRU) dated April 19, 2006, which clearly states that where import services are used as input for providing any taxable output services or goods, the service taxes paid on such services can be taken as input credits. It is relevant to note that the said circular has not been superseded by the recently issued master circular and is therefore still in force. It is now settled that beneficial circulars are binding on the authorities.

Given the clear position in law on the point, this recent initiation of litigation is unfortunate. The point is that the objective of a pure value-added tax becomes negative through such administrative responses, which indeed they are. A holistic, fair and even-handed administrative approach to such matters is critical so that assessees are not required to fight such seemingly frivolous and unproductive matters in the tax courts.