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Two States – Himachal Pradesh and Uttarakhand – in their attempts to generate additional sources of revenue have run into constitutional hurdles. Both States attempted to levy a ‘water cess’, a tax on use of water by power generation companies but the Courts declared the same as unconstitutional. Both the Himachal Pradesh High Court and the Uttarakhand High Court have declared the respective levies of both States as unconstitutional. The High Courts of both States held that while the States are terming the levy as a water cess/tax, it was in effect a tax on electricity and States do not have the power to levy tax on electricity. In this article, I focus on the nature of tax, State’s competence, and the possible ramifications of the judgments on State’s efforts to generate additional sources of revenue.

Cess on ‘Drawl of Water’ or ‘Generation of Electricity’

Both the legislations – of Himachal Pradesh and Uttarakhand – levied tax on drawl of water of generation of electricity. The Himachal Pradesh Water Cess on Hydropower Generation Act, 2023 (‘Act of 2023’)in the Statement of Objects and Reasons stated that the water cess on hydropower generation will be imposed on consumption of water and head available in the project, which is the difference in levy at entry and exit of water conductor system. The Himachal Pradesh High Court referred to the relevant provisions of the Act of 2023 and observed that it was clear that water cess was not on ‘water’ but on ‘water drawn for hydropower generation’. And since there is no generation of electricity without drawl of water, in the absence of generation of electricity no water cess is imposed.

The Himachal Pradesh High Court also referred to the Notification issued under the Act of 2023 wherein the tax rates were determined by considering the head-height and not the quantum of water. The greater the height from which water falls on the turbine, greater the momentum resulting in electromagnetic field causing generation of electricity meant, as per the High Court, that the tax was on user of water, but user of water for generation of electricity. The High Court added that it was clear that if tax was on quantum of water, then height from which the water fell would be irrelevant and that:

The “use of water” in fact does not go by the text of the impugned Act. It is “generation of electricity” that is the “bone” and “water drawn” is only the “flesh”. The taxable event is “hydropower generation” and not the “usage of water” because if there is no generation, there is no “tax”. Moreover, if the cess was on “usage of water”, then how could the height, at which the water falls on the turbine, be made the taxable event? (para 41)

The Himachal Pradesh High Court was clear that the nature and character of water cess was such that it was inextricable with electricity generation, and it was a misnomer that the tax was levied on water and not on generation of electricity. (para 42)

The Uttarakhand High Court made similar observations vis-à-vis the Uttarakhand Water Tax on Electricity Generation Act, 2012 and observed that the user for the purpose of water tax was not a person who draws water, but a person who draws water for the purpose of generation of electricity. And further the measure of tax was not the volume of water used, but the units of electricity generated which was evident from the fact that for different heights different tax rates were prescribed. The High Court observed:

The measure of tax definitely is as per cubic meter water used but it depends on the height available for power generation. Higher the height, more is the tax per cubic meter water. Had it been tax on mere drawal of water, there would have been no necessity to correspond the use of water with the height available for power generation. (para 178)

The measure of the tax, the Uttarakhand High Court concluded was on generation of electricity, thus the tax was in pith and substance a tax on generation of electricity and not on use of water. (para 179)

The Himachal Pradesh High Court and the Uttarakhand High Court, correctly understood the nature of tax. Both the High Courts correctly adopted the approach of looking at the substance of the levy, and were not guided by its nomenclature alone. In doing so, they were able to correctly identify the nature of levy and concluded that it was not on use of water, as claimed by States, but on its use for generation of electricity.

State’s Competence

States tried to justify their competence to levy the impugned water cess/water tax by relying on and referring to various legislative entries of the Seventh Schedule. Some of the legislative entries of List II, that were referred to were: Entry 49 which provides for ‘Taxes on lands and buildings’, Entry 50 which provides for ‘Taxes on mineral rights subject to any limitations imposed by Parliament by law relating to mineral development’, Entry 45 which provides ‘Land revenue, including the assessment and collection of revenue, the maintenance of land records, survey for revenue purposes and records of rights and alienation of revenues’, Entry 17 which states ‘Water, that is to say, water supplies, irrigation and canals, drainage and embankments, water storage and water power subject to the provisions of entry 56 of List I as well as Entry 18 which provides for ‘Land, that is to say, right in or over land, ..’

While the High Court spend considerable space in interpreting each of the legislative entries, there are three broad points worth mentioning: first, water cess/ tax could not be justified by States by relying on Entry 17 or entry 18 since these are general legislative entries and taxes can be levied by States or the Union only by referring to tax legislative entries; second, water cess/tax could not justified as a tax on minerals, because while States argued that water is a mineral as held in Ichapur case, the Court’s observation in Ichapur was in the specific context of Petroleum & Mineral Pipelines (Acquisition of Right of User in Land) Act, 1962 and could not be applied in the impugned case; and third, the High Courts refused to interpret the water cess/tax as a tax on land despite State’s assertion that water flows on land, and land includes water and air because the High Courts refused to give an unusually wide interpretation to the term land and also High Courts were not convinced that there is a proximate relation between the water cess/tax and the land. The Uttarakhand High Court summarized its observations on the issues as:

Now, this Court has held that in the instant case, the water drawn from the source though falls on generator attached to land, but it is not use of water on land and it is also not land revenue for the simple reason because it is not only fall of water on land, but it is use of water for electricity generation that makes a taxable event. The pith and substance of the Act is water tax for generation of electricity. Therefore, the State Legislature is not competent to levy the tax under E 45 and 49 L II of S VII. (para 181)

The States were on the backfoot in their attempt to justify that the water cess/tax was within their legislative competence. And the drafting of statutory provisions and Notifications for tax rates, left little doubt that the tax was on generation of electricity, but the nomenclature used was that of a water tax. Equally weak was the State’s attempt to justify water as part of land. Finally, it is worth pointing out that the High Courts did not give enough credence to financial necessity of States to adjudicate a constitutional issue and correctly so as the need for additional sources of revenue cannot triumph Constitutional limits.

Revenue Ramifications for States

The revenue ramifications of States not being able to levy water cess are likely to be multiple. The obvious one is that States with rich water resources will not be able to use these water resources for generating additional revenue, at least for now. The Statement of Objects and Reasons of The Himachal Pradesh Water Cess on Hydropower Generation Act, 2023 clearly stated that the State of Himachal Pradesh has limited revenue generation resources, it faces financial constraints and the immense water resources can be used as a useful source for revenue generation. Similar reasons can be assigned to the State of Uttarakhand, in fact, the levy of water by the latter was one of the reasons cited by the State of Himachal Pradesh to levy its water cess. But, as I mentioned above, these reasons cannot inform interpretation of the Constitution, even if Constitutional constraints lead to revenue squeeze for States.

Successive Finance Commissions in their awards have enjoined States to explore additional revenue sources. While the recommendations of the Finance Commissions are well meaning, there are major hurdles for States to explore additional sources of revenue. To begin with, the distribution of tax bases under the Constitution is such that the taxes with greater buoyancy and wider bases have been allocated to the Union. And since 2017, relatively lucrative indirect taxes in State’s domain have been subsumed under GST. To the extent, States are being innovative such as by levying water cess, they are testing and also understanding the limits of their competence. While in the impugned cases, Courts have rightly not upheld the water cess, it will take equally innovative and proactive measures from various States to further test their taxation powers in their attempts to be able to finance themselves and not become increasingly dependent on the Union for their finances.

Conclusion

Both the judgments discussed above rely on a wide set of judicial precedents to determine the scope of each of the legislative entries that States used to justify their legislative competence. The High Courts correctly identified the nature of levy and its substance and relied on the relevant statutory provisions and Notifications to hold the levy as unconstitutional. Of course, the States can redraft the legislations in constitutionally compatible manner since resource crunch is a recurring issue. The thing worth seeing would be if States modify the way they wish to levy water cess/tax or will they now focus their efforts at trying to find other sources of revenue.

The dispute between the State of Kerala and Union of India involving disagreement on the latter’s scope of power to restrict debt levels of the former, was referred to a Constitution Bench by the Supreme Court. Previously, I’ve written about the dispute, likely issues, and interpretive questions that Kerala’s petition is likely to raise. In this article, I comment on the Supreme Court’s latest order where it has summarized the arguments raised by both Kerala and the Union of India and enlisted the issues involved.

Summary of Arguments

The overarching issue, to recall briefly, is that under Section 4, Fiscal Responsibility and Budget Management Act, 2003 the Union is obligated to ensure that total debt of the Union and State Governments does not exceed 60% of Gross Domestic Product (‘GDP’) by end of the Financial Year 2024-25. In a letter dated March 27, 2003 the Union imposed a ‘Net Borrowing Limit’ on Kerala and the flashpoint is that the Union included the borrowings of State-owned enterprises in the limit, a move Kerala views as unconstitutional and unprecedented intrusion on its borrowing powers.

Kerala’s arguments inter alia included that under Article 293 of the Constitution, the Union cannot impose conditions on all loans of a State government, but only on loans sought by the Union; second, liabilities of State-owned enterprises cannot be included in the borrowing limit. Kerala made two additional arguments, which prima facie seem contradictory. As per Kerala if it has underutilized the borrowing limit in the previous years, it should be allowed to use it in the current year while if it has over-borrowed in the previous years before Financial Year 2023-24, it cannot be adjusted against the net borrowing limit of the current Financial Year. A joint reading of the latter two arguments makes it seem that Kerala wants the benefits of under borrowing, but no hazards of over borrowing. Though the true import of the arguments may play out in full detail in the Court at a later stage and I discuss one further aspect of these arguments below.

The Union’s response was to categorise the dispute under the broad umbrella head of public finance and argue that the fiscal health of India will be in jeopardy if Kerala is allowed to borrow beyond its ceiling limit. And that the Union’s determination of the ceiling limit by including loans of State-owned enterprises in the limit is precisely to prevent State’s from bypassing the ceiling limit imposed under FRBM Act, 2003.

A preliminary survey of the arguments as summarized by the Supreme Court suggests that Kerala is trying to keep the dispute closer to the scope of Article 293, persuade the Court to adopt a narrow reading of the provision, and thereby preserve its right to borrow more money. The Union, on the other hand, has suggested that the issue is more proximate to the national debt management, public finance, and perhaps overall management of the economy. By suggesting that the larger issue of national finance and economy is involved, the Union gets to suggest that it has a pre-eminent power to regulate the economy and State’s rights should cede in favor of nationwide economic management. The legal issue that should cut across is that the Union’s power to regulate economy cannot traverse beyond the Constitutionally allocated powers. The Union’s power to regulate economy is not an all-pervasive power. Every power must be traced to a Constitutional provision and the Supreme Court will have to determine the outer limit of such power, which in the absence of any precedents is a tough ask.

Littany of Issues

The Supreme Court in its impugned order enlists certain ‘corollary’ questions that arise from Kerala’s petition and impact the fiscal federal structure envisaged under the Constitution. Some of these questions include: Whether fiscal decentralization is an aspect of Indian federalism? What are the past practices relating to regulating borrowing of the States? And whether they can form basis of legitimate expectations of the States? Whether the restrictions imposed by the Union in conflict with the role assigned to the Reserve Bank of India as manager of public debt of the State?

The foundation question, from a constitutional law standpoint is: whether fiscal decentralization is an aspect of Indian federalism? Indian federalism, relating to economic relations of the Union and States has, for decades, largely revolved around allocation of taxation powers and rarely on public debt management. This is perhaps because the latter has never been the site of contestation or because it has not been vital to the federal relations. Supreme Court’s framing of the question is interesting as the query is does not relate to allocation of powers on public debt but whether public debt can be viewed as part of fiscal federalism. And if the answer is yes, what are the implications? Again, questions that may not have easy answers. Public debt is managed by various

The Supreme Court also framed other questions such as: Does Article 293 of the Constitution vest a State with an enforceable right to borrow money from the Union and/or other sources? Whether borrowing by State owned enterprises can be included in scope of Article 293(3) of the Constitution? Answering all these questions will require an inquiry into intent of the Constituent Assembly, past practice, and their relevance to the current dispute.

While the Supreme Court may have termed the above questions as corollary, I doubt they are likely or should be viewed as corollary. Perhaps the questions are incidental to the immediate dispute at hand, but certainly not from the standpoint of constitutional law. Corollary or principal questions, the Supreme Court has acknowledged that since Article 293 has not been the subject of an authoritative interpretation by the Supreme Court, all the questions fell within the scope of Article 145(3) of the Constitution and should be decided by a five-judge bench of the Supreme Court.

Injunction is Ousted

Kerala pleaded for a mandatory injunction and requested that the Union should undo the imposition of net borrowing ceiling limit and restore the position that existed before imposition of the limit. The Supreme Court denied Kerala the injunction by agreeing with the Union’s argument on overutilization. As per the Supreme Court, Kerala’s argument that over borrowing in certain financial years is irrelevant once the net five-year period of a successive Finance Commission commences is not prima facie convincing. The Union’s argument was that if Kerala or any other State over borrows during certain financial years, then the borrowing ceiling can be adjusted in subsequent financial years even if the subsequent financial years are within the 5-year period of a new Finance Commission. In the impugned case, Kerala’s argument that both underutilization and overutilization of borrowing limit has to be made within the 5-year period of a Finance Commission was based on its reading of select paragraphs of the Finance Commission reports. For example, the 15^thFinance Commission specifically stated that the adjustments can be made ‘within our award period’. (para 12.64) But, whether the 15^th Finance Commission meant that adjustments can be made ‘only’ within its award period is not clear. To be sure, the Supreme Court has only made prima facie determination in favor of the Union and refused to grant Kerala an injunction. But, whether the refusal of injunction would cause irreparable harm to Kerala will be known in the future.

Conclusion

While hitherto our understanding and framing of Union-State economic relations has only centred around the issues of taxation, the issue of public debt has remained dormant and outside the lens of law. This case presents an opportunity to understand the statutory framework on public debt in tandem with the constitutional framework, and by extension the nature of State’s right to raise money from the market including whether Courts understand the power of a State to raise money as a right itself. Equally, this case may determine if the term fiscal federalism can encompass public debt in its scope. Finally, it is worh seeing if the Courts adopt an approach of deference, a well-entrenched judicial approach on all matters of taxation law. Or will it treat economic management, nationwide economic interests as justification in themselves and excuse itself from examining the underlying constitutional issues in a significant and meaningful manner.

Water Cess: States Run into a Constitutional Hurdle

Kerala versus Union: Dispute Lingers