Service tax must operate as VAT

A recent decision of the indirect tax tribunal (CESTAT) in the case of Coca Cola India Private Ltd vs Commissioner of Central Excise, Pune, is of considerable interest since it lays down the manner of interpretation of the relevant rules pertaining to input service tax credit and hence the eligibility to such credit in relation to a manufacturer using such input service in the business.

In the above case, the issue that arose for consideration was whether the input service taxes paid by an assessee on advertising a final product not manufactured by itself, but by another manufacturer in relation to which the brand name and all other related rights were with the assessee was eligible for set-off against the excise liability in relation to an intermediate product manufactured by the said assessee.

In this case the assessee argued that the relevant credit rules for input service tax credit operated as follows:

""credits in relation to input services were eligible as an offset against taxable output services if the given input services qualified as per the definition of 'input services'.

""credits in relation to input services were eligible as an offset against taxable output goods, that is, final products, if the given input services qualified as per the definition of 'input services'.

Thus, as per the above rules these credits would only accrue if the test of input services was met in relation to both situations. Under the credit rules, the inclusive part of the definition of input services referred to certain specified services such as security services, audit services, advertisement services, and other similar services generally used by a business regardless of the relation to the final product.

It was therefore argued that the service taxes relating to advertising would be eligible as an offset regardless of the fact whether such advertising related to the manufactured final product or not. The argument was based on the fundamental concept of the value added tax which ensured that the final tax was paid on value addition and that there was no tax on tax. The idea was to provide a set-off mechanism for the input taxes borne in relation to business expenses as a whole against output excise/service tax liability of the business.

The CESTAT took note of the fact that the assessee did not at all manufacture the final product in relation to which the advertising expenditure was incurred. The business model was for the assessee to limit himself to manufacturing just the intermediate product,which was, the concentrate for bottled aerated waters. These aerated waters, being the final product in relation to which the advertising cost was incurred, was entirely manufactured by third party bottlers to whom the concentrate was sold outright.

The fact that the assessee incurred the advertising cost and hence had automatically included these in the assessable value of the intermediate product manufactured by it, in the absence of any deduction in relation to the expenses, was considered by the CESTAT but still came to the conclusion that this fact did not alter the situation in relation to eligibility of tax credits on the advertising expenses.

The CESTAT took note of the two Supreme Court decisions in the case of Parle International Ltd as well in the case of Pepsi Foods Ltd which had both held that the advertising expenses incurred by an assessee in relation to a product which was unrelated to the product manufactured by it was not to be included in the value of such manufactured product on the ground that there was no nexus between the advertising and the excisable product manufactured by the assessee. The CESTAT consequently disregarded the fact of actual inclusion of such expenses in the assessable value and held that the rationale of the two decisions of the Supreme Court was on the core point of lack of nexus between the expenditure, that is, advertising and the excisable product manufactured by the assessee. Consequently, in the case of Coca-Cola the CESTAT has held that the totality of the service tax provisions, read with the rationale of the two decisions of the Supreme Court will support the finding that such advertising expenses which are in relation to a brand and admittedly owned by the assessee are not eligible input services in relation to the manufactured product.

This decision of the CESTAT is a very significant one as it holds that the absence of a nexus with manufacturing, in relation to the numerous expenses such as audit services, advertisement services and other similar services as incorporated in the relevant definition of input services, as per explanation 2 to the rule 2(k) of the CENVAT Credit Rules, cannot lead to the conclusion that advertising expenses of any kind would, therefore, qualify as input services. The decision of the CESTAT would mean that the definition of the input services even in relation to the aforementioned expenses would need to be read in a manner as to extend only to those expenses which have a nexus with the activities performed by the assessee and in the absence of the nexus, no credits will be available.

It can be seen that all of the decisions referred to above, relate to the aerated water industry where the business model is predicated on the brand name owner limiting himself to the manufacture of only the technically complex intermediate product, the concentrate in relation to which , the aspect of secret formulae/proprietary ingredients was also present. The subsequent activity of the straight forward bottling of such concentrate, after dilution with water was typically performed by third party bottlers. In such a situation, the brand name owners run the risk of not being able to offset their input service taxes against the excise tax paid on the concentrate. This is a very important decision as it reduces the ability of the brand name owners of the aerated water/beverages to offset all of their input taxes. Indeed, the consequences of this decision would be that service taxes on advertising, which is perhaps one of the most significant costs incurred by the brand name owners of aerated waters/beverages, would be an absolute cost to the brand name owner since neither he nor the third party bottler would be able to offset such tax. Clearly therefore, the matter needs to be addressed on an urgent basis in terms of a possible change in the relevant definition or by issuance of an appropriate circular/clarification by the Central Board of Excise and Customs to ensure that the service tax operates as a pure value added tax, as intended, and that no input taxes of any kind which relate to the business as a whole are effectively costs and not offsets.

The writer is leader, indirect tax practice, PricewaterhouseCoopers