Karnataka High Court

No Service Tax on Carried Interest: GST Applicability Remains an Open Question

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In a recent decision the Karnataka High Court has held that a Venture Capital Fund (‘VCF’) is not liable for service tax on carried interest. The decision reversed Customs, Excise & Service Tax Appellate Tribunal’s (‘CESAT’) ruling which was under appeal. CESAT had held that service tax was payable by the VCF primarily on the grounds that a VCF constituted as trust can be considered a person and that the doctrine of mutuality was not applicable to it since it further invests the money of its contributors with third parties, breaching the mutuality. The High Court viewed the VCF as a pass-through entity and viewed the asset management company appointed by trustee as the service provider. The decisions take contrary stands on whether VCF constituted as a trust is a person, its role, and the applicability of doctrine of mutuality. And while we do seem to have some answers about the taxability of carried interest under service tax regime, the same issue under GST regime remains an open question. I focus on the role of trusts and doctrine of mutuality in this article.  

Role of VCFs and Investment Managers

The appellants before the Karnataka High Court were established as a trust under the Indian Trusts Act, 1882 and registered as a VCF with Securities and Exchange Board of India (‘SEBI’). The appellants were managed and represented by a trustee. The terms and conditions in the formation of the appellant’s trust were contained in the Indenture of Trust, an offer document inviting subscribers and contributors to be part of the trust. The trust in turn appointed an investment manager to handle the funds of contributors. The Revenue Department demanded service tax on the expenses incurred by the trust – which they argued should have been characterized as service income as well as service tax on disbursement of carried interest to Class C unit holders in the VCF, i.e., typically the investment manager itself, among other trust expenses which were sought to be characterized as income of the VCF. Service was demanded under the head of ‘banking and financial services’ under Sec 65, Finance Act ,1994.   

Returns on investments are termed as carried interest, and as per the Indenture of Trust, the contributors receive the same as per the terms stated in the trust. Since the investment manager can and does invest alongiwth the contributors, it becomes entitled to carried interest on its investment in addition to the performance fee charged by it for its services. The former money is paid to it in its capacity as an investor and the Revenue’s case was that it should be subjected to service tax, though the applicability of service tax on the latter was not in dispute. CESAT’s understanding of the arrangement was that the trust was engaged in asset management and was responsible for managing the funds of contributors until delegated to the investment manager. (para 40.2) The Karnataka High Court, on the other hand, observed that VCF does not make any profit or provide any service and merely acts as a ‘pass through’ wherein funds from contributors are consolidated and invested by investment managers. VCF acts a trustee holding the money on behalf of the contributors and invests the money as per advice of the investment manager. (para 21) The latter understanding is proximate to the real nature of transaction and it was influential in the High Court’s conclusion that no service tax was payable by VCF. However, CESAT in overemphasizing the role of trust in the entire transaction arrived at the questionable conclusion that trust was providing banking and financial services by indulging in asset management of its contributors. CESAT was persuaded by the Revenue’s argument that carried interest paid to investment manager was a disguised performance fee and should be subject to service tax, an argument that – if one reads the two decisions – is not entirely proven by facts.       

Trust as a Person and Doctrine of Mutuality 

The appellant’s argued that trust was not recognized as a person and thus cannot be held liable to tax. The appellant’s further argument was that VCF, constituted as trust, was not providing any service to the contributors, and expenses incurred by the trust cannot be considered as consideration for ‘services’. Also, the appellant added, assuming but conceding, that the trust was providing a service – no service tax was payable due to the doctrine of mutuality. There was complete identity between the trusts and its contributors. The appellants relied on the jurisprudence of doctrine of mutuality, with the Calcutta Club case being the focal point of reference. The doctrine of mutuality postulates that when persons contributed to a common fund in pursuance of a scheme for their mutual benefit, having no dealings or relations with any outside body, they cannot be said to have traded or made profit from such mutual undertaking since there the identity of the persons and the mutual undertaking is the same. 

CESAT rejected all the above appellant’s arguments. CESAT noted that VCF is registered as a fund under the SEBI VCF Regulations and under the Regulations it is treated as a body corporate and it should be treated as such for tax purposes too. CESAT held that: 

As the Trusts are treated as juridical persons for the purposes of SEBI Regulations, we do not find any reason as to why they should not be treated so for the purpose of taxation. (para 37.4)

On the same issue, the Karnataka High Court took an opposite view and held that while SEBI and other legislations may treat a trust as a juridical person, the relevant statute for the purpose of service tax liability is Finance Act, 1994 and the latter does not treat trust as a juridical person. The High Court held that definitions of each statute must be read with the object and purpose of that statute as intended by the legislature and accordingly refused to treat trust as juridical person for the purpose of Finance Act, 1994. (para 15)

The Karnataka High Court’s emphasis on the intent and context of each legislation is vital. It is important to note that courts should be circumspect before importing definitions of one statute into another, unless there is complete silence on the issue in the latter. In the context of tax, the issue is even more vital as the general rule of construction of tax statutes is that a burden cannot be imposed on an assessee, unless expressly stated in the statute. It thus follows that if an entity is not expressly regarded as an assessee, it cannot be subjected to tax.  

As regards the applicability of doctrine of mutuality, the Karnataka High Court gave a succinct  and correctfinding. The High Court observed that the trust and its contributors cannot be dissected into two distinct entities because the contributors investment is held in trust by the fund and investments the money on the advice of investment manager. Thus, the trust cannot be held liable for providing service to itself. CESAT had a different opinion and noted the doctrine of mutuality as applied in various cases in India was in the context of member clubs where the contributions were made by members and the clubs were not pursuing profits. While in the impugned case the main purpose of VCF was to earn profits. The CESAT observed that VCF had violated the principle of mutuality by engaging itself in commercial activity and using its discretionary powers over funds to benefit a certain class of investors. Relying on the Calcutta Club case, the CESAT rejected the applicability of the doctrine of mutuality. 

While attributing profit to VCF was not incorrect, CESAT’s understanding of the scope of discretion VCF possessed over the funds of its contributors and the importance placed to profit motive is perhaps misplaced. Profit motive of an entity that collects funds does not per se rule out the applicability of the doctrine of mutuality. And if the trust in this case was retaining some money as expenses for holding the money, it was per the terms of trust and that factor also is relevant but not determinative in ruling out the doctrine of mutuality. While it is important to understand the context of previous decisions, the scope and applicability of the doctrine needed a better articulation in the CESAT’s decision.  

Finally, CESAT relied on ‘common parlance’ to state that no common man would consider VCF trusts like clubs. Here again, the reliance on a common man’s view of the role, object, and relevance of VCF is inaccurate as the tribunals are bound to consider the statutory definitions and not rely on an elastic and ambiguous understanding of entities as adopted in common usage.      

GST and Doctrine of Mutuality 

The doctrine of mutuality already has a small history under the GST regime. In reaction to the Supreme Court’s decision in Calcutta Club case, the definition of supply was amended – with retrospective effect – and the following clause was added via Finance Act, 2021:

(aa) the activities or transactions, by a person, other than an individual, to its members or constituents or vice-versa, for cash, deferred payment or other valuable consideration. 

The Explanation stated that notwithstanding anything contrary contained in any judgment or decree, the person and its members or constituents shall be deemed to be two separate persons and the supply of activities or transactions inter se shall be deemed to take place from one person to another. While the above clause, does signal to a significant extent that doctrine of mutuality is truly buried, and has not survived the 46th Constitutional Amendment, despite the Supreme Court holding otherwise, its applicability to the specific context of VCFs and carried interest remains uncertain and untested. This also because trust is included in the definition of a person under Section 2(84)(m), CGST Act, 2017 meaning that arguments relevant in the impugned case may not be entirely transferable to similar demands of tax under GST.    

Conclusion

CESAT’s decision created turmoil as VCFs have never been understood to be service providers, but only conduits for channeling the investments and holding the money in trust. The actual investment advice is provided to the contributors by the investment management company. CESAT overemphasized the role of trust, to some extent misunderstood the nature of payments, and decided that trust was acting as a service provider. The Karnataka High Court has corrected this position, but its applicability and relevance is for service tax levied under the Finance Act, 1994. We yet do not know if similar demands will made under GST and their likely fate. 

Pre-Deposit Under CGST Act Does not Include Penalty and Fee: Kar HC

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The Karnataka High Court in a recent decision[1] interpreted Section 107, CGST Act, 2017 and adopted a literal interpretation of Section 107(6)(b) to hold that it only mentions that the remaining amount of tax in dispute needs to be deposited before filing an appeal excluding fee, penalty and fee. Since the provision does not mention interest, fine or fee, the same cannot be read into the provision to create an onerous burden on the assessee before admitting its appeal. 

Facts and Arguments 

The facts of the case are brief: the petitioner’s appeal before the appellate authority was rejected on the ground that the condition prescribed under Section 107, CGST Act, 2017 had not been fulfilled. Section 107(1) states that any decision or order passed under CGST Act, CGST Act or UTGST Act by an adjudicating authority may be appealed by a person to such Adjudicating Authority as may be prescribed. Section 107(6) states that no appeal shall be filed under sub-section (1), unless the appellant has paid – 

  • in full, such part of the amount of tax, interest, fine, fee and penalty arising from the impugned order, as is admitted by him; and 
  • a sum equal to ten per cent of the remaining amount of tax in dispute arising from the said order, subject to a maximum of twenty-five crore rupees, in relation to which the appeal has been filed: (emphasis added)

The petitioner argued that it was disputing the entire amount confirmed in the confiscation order and under Section 107(6)(b), the tax in dispute would only include the tax component and not the interest, fee and fine. The appellant authority erred in not admitting its appeal by stating that 10% of the entire amount needs to be deposited and not 10% of the tax in dispute. The petitioner approached the Karnataka High Court via a writ seeking appropriate directions. 

The Revenue Department had a meek reply and argued that the petitioner was virtually trying to defeat the provision of appeal under Section 107. The Revenue Department argued that since the petitioner was disputing the entire amount, it was obliged to deposit 10% of the entire amount and not 10% of the tax. 

High Court Adopts Strict Interpretation 

The Karnataka High Court gave three broad reasons for agreeing to the petitioner’s arguments: 

First, the High Court cited Section 107(6) and observed that there was a statutory basis for asserting that the petitioner should only deposit 10% of the disputed tax before filing an appeal. The High Court noted that the interpretation also aligned with the legal principle that penalties are consequent to determination of tax liability. 

Second, it observed that if the statute provides that a thing has to be done in a particular manner, it should be done only in that manner. (para 8) Adopting the principle of strict interpretation of tax statutes, the High Court observed that the terms fine, fee, penalties were not used in Section 107(6)(b), but only the term ‘disputed tax’ was used, and the provision should be interpreted as per the words mentioned in it. The High Court added that the isolation of the term ‘a sum equal to ten per cent of the remaining amount of tax’ reflected legislative design and an intention to limit the pre-deposit requirement to only 10% of the disputed tax amount.  

Third, the High Court noted that the presumption is that the legislature has not made any mistake and the language employed is the determinative factor in ascertaining legislative intent. If there is any omission or defect in the provision, the Courts cannot correct it.

Conclusion The Karnataka High Court in the impugned case adopted a reasonable approach and appreciably adhered to the principle of strict interpretation of tax statutes to rule in favor of the petitioner. The High Court’s decision is clearly and unequivocally supported by the language of the provision. In fact I would argue further and recommend and in similar cases where the appellate authority takes such stance which is obviously and clearly against the written text, Courts should consider levying a penalty or costs for forcing the assessee’s hand to approach the High Court merely to get its appeal admitted.   

[1] M/S Tejas Arecanut Traders v Joint Commissioner of Commercial Taxes TS-686-HCKAR-2023-GST. 

DTAAs are Relevant for TDS Provisions under IT Act, 1961 

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In a recent judgment[1], the Karnataka High Court reiterated the ratio of Engineering Analysis case, more specifically the applicability of Double Taxation Avoidance Agreements (‘DTAA’) vis-à-vis withholding tax obligations under the IT Act, 1961. 

Introduction 

The assessee was an International Long Distance (‘ILD’) licence holder and was responsible for providing connectivity to calls originating/terminating in India. The assessee entered into agreements with non-resident telecom operators for the aforesaid purposes and was required to pay them inter-connectivity charges. In the impugned case, the centrepiece was an agreement assessee entered into with a Belgium entity which had no permanent establishment in India. Equally, all the equipment and necessary submarine cables were situated outside India. 

Arguments 

The Revenue made several arguments, the core, for the purpose of this post was that the assessee failed to discharge its statutory obligation to withhold tax/deduct TDS before making the payments to the Belgium entity. The Revenue argued that the agreement between the assessee and the Belgium entity did not specify that the income was not taxable in India and if in the opinion of the assessee no tax was deductible it should have approached the Assessing Officer and secured a nil certificate. The Revenue further argued that the income belonged to the payee. 

The assessee, on the other hand, argued that the payments made by the assesee could neither be considered as royalty, fee for technical services or business profits since no part of the business activity was conducted in India. The assessee also resisted Revenue’s attempt to apply the expanded definition of royalty amended via insertion of Explanations to Section 9(1)(vi) and instead argued that the definition of royalty under DTAA needs to be relied on.  

Observations of the High Court 

The High Court engaged with the questions relating to the interplay of DTAAs and withholding tax provisions. It cited the GE Technology case[2] and Engineering Analysis case[3] which had held in the context of Section 195, IT Act, 1961 that DTAAs are relevant while implementing tax deduction provisions. Relying on the said observations, the Karnataka High Court in the impugned case held that the assesee can take the benefit of DTAAs. And that the ITAT – whose order was under appeal – was wrong in stating that DTAA cannot be considered in proceedings under Section 201, IT Act, 1961. 

Another crucial question that the Karnataka High Court answered by relying on Engineering Analysis case was that the amendment to Section 9(1)(vi) by insertion of Explanations did not amend the DTAAs. The amended definition of royalty was thus only applicable if IT Act, 1961 was the relevant legal instrument. The High Court further clarified that in Engineering Analysis case it was observed that Explanation 4 added to Section 9(1)(vi) vide the Finance Act, 2012 was not clarificatory. Explanation 4 expanded the definition of royalty. And Supreme Court had observed that the person under Section 195, IT Act, 1961 cannot be expected to do the impossible, i.e., apply the expanded definition of royalty for assessment years when such definition was not factually in the statute. In view of the same, the High Court answered that the assesee was not obliged to withhold tax since the Assessment Years in question were 2008-09 and 2012-13 while the Explanation 4 expanding the definition of royalty was added to the IT Act, 1961 via Finance Act, 2012. Though this point was moot since the High Court had held that the assessee was entitled the benefits under DTAA (and consequently rely on more favorable/narrow definition of royalty.). 

While the High Court’s above observations were sufficient to clarify that the assessee did not have any obligation to deduct TDS on payments made to its Belgian contractual partners. The High Court also added, in response to an argument made by the assessee, that the Revenue Department did not have the power to bring to tax income arising from an extra-territorial source. The High Court held that: 

It is also not in dispute that the facilities are situated outside India and the agreement is with a Belgium entity which does not have any presence in India. Therefore, the Tax authorities in India shall have no jurisdiction to bring to tax the income arising from extra-territorial source. (para 22)

Conclusion

The Karnataka High Court’s observations are an unqualified endorsement of the ratio in Engineering Analysiscase especially regarding the interplay of TDS provisions and the applicability of DTAAs. The High Court’s observations bring specific clarity to the benefit of DTAAs available during proceedings under Section 201, IT Act, 1961. Whether the impugned case will be the subject of appeal is unknown, but the Revenue does not have a persuasive case against the assessee based on the facts and ratio of the High Courts’ judgment.  

[1] M/s Vodafone Idea Limited v Deputy Director of Income Tax, available at https://www.livelaw.in/high-court/karnataka-high-court/vodafone-idea-deduct-tds-inter-connectivity-usage-bandwidth-charges-karnataka-high-court-233692  

[2] GE India Technology Centre Private Limited v CIT (2010) 327 ITR 456 (SC). 

[3] Engineering Analysis Centre of Excellence Private Limited v CIT (2021) 125 taxmann.com 42 (SC). 

Revenue Misinterprets Jurisprudence on Game of Skill: Kar HC Introduces Sanity Through Gameskraft Judgment

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On 11 May 2023, a Single Judge Bench of the Karnataka High Court delivered a judgment in the Gameskraftcase[1] deciding that the actions of the Revenue Department against online intermediary company, M/s Gameskraft Technologies Pvt Ltd (‘GTPL’) had no basis in law. The Revenue Department inter alia has issued an intimation notice under Section 74(5), CGST Act, 2017 calling GTPL to deposit Rs 21,000 crores (appx) along with penalty and interest. The impugned intimation notice, and the subsequent show cause notice issued under Section 74(1), CGST Act, 2017 were the subject of the dispute. 

Before I delve into the judgment, I think it is worth clarifying that the gambling law jurisprudence in India divides games into games of skill and games of chance. The latter are typically understood to be synonyms of gambling/betting. And if a game has elements of both skill and chance, then the predominant element decides the nature of the game, e.g., a game which is predominantly skill-based is understood to be a game of skill while a game which is predominantly game of chance is classified as a game of chance.    

Core Issue 

GTPL’s/Petitioner’s main argument was that they are not involved in ‘betting/gambling’. While the petitioners relied on various judgments to support their two claims, their claim is best understood through description of their business model. The petitioners claimed that they operated a platform and acted as an intermediary for players to play a game of rummy. For example, two players ‘A’ and ‘B’ intending to play rummy would download their mobile application. Both players would deposit Rs 200 each, and the petitioner for facilitating and hosting the game would charge Rs 20 each from both the players and keep the remaining Rs 360 in trust. At the end of the game, the petitioner would disburse Rs 360 to the winner. The petitioner claimed that it had no lien or right over the prize money of Rs 360. Its revenue from the above transaction was only Rs 40 on which it paid GST. 

Petitioners claimed that the ‘buy-in’ amount or gross transaction money facilitated through their platform – which in the above example was Rs 400 – could not be treated as their revenue. The amount belonged to the players, and petitioners had no lien or right over the said amount, which in this case the Revenue Department alleged was Rs 70,000 crores. And presumably the gross transaction amount was the basis of GST demand of Rs 21,000 crores.      

Petitioners further claimed that they were not involved in supply of actionable claims. And that actionable claims if any were between the players which was also irrelevant because actionable claims were exempt from GST. Schedule III of the CGST Act, 2017 lists activities or transactions which shall be treated as neither supply of goods nor supply of services. Entry 6 of Schedule III states as follows: 

            Actionable claims, other than lottery, betting and gambling. 

Thus, actionable claims unless they are lottery, betting and gambling are outside the purview of GST. And the petitioners claimed that neither are they involved in supply of actionable claims nor are the games on their platform, specifically rummy, captured by ‘lottery, betting and gambling’ since rummy is a game of skill and not a game of chance.  

The petitioners relied on the decades old Indian jurisprudence that has clearly held rummy to be a game of skill. And petitioners argued that playing rummy online does not impart it the character of a game of chance and neither does playing rummy with stakes change its character from a game of skill to a game of chance. 

Revenue Department Makes Incredulous Arguments 

As is evident from the preceding discussion, the Revenue Department’s claim that the petitioner’s activities were subject to GST would have only succeeded if they could prove that the petitioners supplied actionable claims in the form of lottery, betting and gambling. And since it was the game of rummy in question, they had to establish that the game of rummy played online and with stakes would amount to a game of chance for it to be included in the phrase ‘lottery, betting and gambling’. To establish its case, the Revenue Department indulged in an exercise of selective, non-contextual and self-serving interpretation of relevant precedents. The Revenue Department made various far-fetched arguments, and to highlight its approach, I will elaborate on its two central claims, i.e., a game of skill when played with stakes transforms into a game of chance. In this case, it meant that rummy, a game held to be a game of skill, should be viewed as a game of chance since the players involved placed stakes on the game. Further, the commission charged by the petitioners should not be viewed as a commission but earning profits and gains from stakes because their commission amount varied depending on the stakes placed on the game and was not an across the board charge.      

The Revenue made bizzare claims based on their incorrect interpretation of the jurisprudence on game of skill and game of chance. To begin with, they denied that rummy was a game of skill, contrary to well-established jurisprudence[2] that stated otherwise. Instead, they quoted selective paragraphs out of context to back their incredulous claim.

The High Court was not swayed by the Revenue Department’s fanciful interpretive exercise and instead reiterated that rummy is a game of skill ‘where predominantly skill is exercised to control the outcome of the game.’ (para 5) It added that a playing rummy with stakes does not make it a wagering contract, since a wager requires that the person placing the wager should have no interest in the outcome of a game while a player is clearly interested in winning the game. The High Court stated that: 

The game of rummy played with stakes is played between players on the basis of the assessment of their own skill. Therefore, while playing for stakes, the player makes a value judgment on his/her skill. The outcome of the game is determined predominantly by the skill of the players. Therefore, rummy played with stakes same cannot be viewed as a ‘forecast’ or a shot at the “hidden target”. (para 11)

The Revenue relied on the Satyanarayana case to argue that petitioner’s earning commission fee for facilitating rummy with stakes on its platform amounted to facilitating gambling and running a gaming house. Satyanarayana case had clearly held that rummy is a game of skill even if played with stakes. The Supreme Court had added that if there is evidence of gambling or owner of house or club was making a profit or gain from rummy, the offence of running a gaming house could be established. The Karnataka High Court correctly read the ratio of Saynarayana case to hold that charging a sitting fees is not profit in context of a common gaming house and that organizer of a skill-based game is not prohibited from charging a fee from the players of the game. (para 5 and 7). Accordingly, petitioners making profits and gains from rummy played on their platform cannot be accused of running a common gaming house. The High Court concluded that: 

Irrespective of who wins, the Petitioners, in terms of its contract with the players, collects a percentage of the amounts staked as its platform fees / commission for providing its services as an intermediary. Thus, the Respondents cannot be permitted to supply words to these observations and say that placing of stakes on a game of skill amounts to gambling. In any event, from a reading of the whole judgment, it is evident that this last line is not the ratio of the judgment at all. (para 10)  

The edifice of the Revenue’s case collapsed with the Karnataka High Court rejecting its above two arguments. The High Court concluded that all the issues raised and argued were covered by Supreme Court’s judgment in All India Gaming Federation case[3], i.e., whether played physically or online, with or without stakes, game of skill does not lose its character and is determined by applying the predominance test. 

Karnataka High Court Dismisses the Revenue’s Case  

The Karnataka High Court combed through practically the entire post-Independence jurisprudence on game of skill v/s game of chance, cited the precedents copiously, highlighted relevant paragraphs of the ratio to emphasise that the context and meaning of the judgments was opposite to the Revenue Department’s arguments. The High Court concluded that the Revenue Department’s case was based on fragile footing and observed:  

After having dealt with the rival contentions as stated supra, it is significant to state that a perusal of the impugned show cause notice as well as contentions and submissions of the respondents will clearly indicate that the same are an outcome of a vain and futile attempt on the part of the respondents to cherry pick stray sentences from the judgments of various Courts including the Apex Court, this Court and other High Courts and try to build up a non-existent case out of nothing which clearly amounts to splitting hairs and clutching at straws which cannot be countenanced and is impermissible in law. (emphasis added) (para 7)

Accordingly, the High Court held that there is no difference between online and offline games of rummy and rummy does not become a game of chance if played with stakes. It held that Entry 6, Schedule III of CGST Act, 2017 was not applicable to only rummy played with or without stakes or any games which is preponderantly a game of skill and thus petitioner’s platforms were not taxable as ‘betting and gambling’ as contended by the Revenue Department. The show cause notice issued to petitioner’s was quashed for being illegal, arbitrary and without jurisdiction or authority of law.    

Way Forward 

The Revenue Department has made repeated claims that online gaming companies indulge in significant tax evasion. The credibility of tax evasion claims has not been established through actual numbers and neither has any evidence been shared publicly. But, CGST Act, 2017 and the IT Act, 1961 empower the Revenue Department sufficiently to tackle tax evasion and build a case of contravention of tax laws. 

However, after reading the Gameskraft judgment, the picture that emerges is that the Revenue Department had pre-determined that the online gaming platforms facilitate games of chance/gambling and earn the entire amount of transactions undertaken through them. And every argument was then moulded and force-fitted to reinforce the initial conclusion. The Karnataka High Court saw through the Revenue Department’s exercise and correctly chided it for indulging in such an exercise. In fact, so far-fetched was the Revenue Department’s claim that the High Court could have just referred to its previous decision in All India Gaming Federation caseand dismissed the Revenue Department’s claims. However, the detailed 325 page decision in this case might act as a deterrence for the Revenue Department since its central premise has been outrightly, painstakingly and comprehensively dismissed by the High Court by citing every major case on gambling law in detail. Whether the Karnataka High Court’s decision would deter the Revenue Department in any manner is tough to predict; but, if past is any indication the Revenue Department is likely to treat it as a minor hiccup in its pursuit of revenue, come hell or high water. 

[1] Gameskraft Technologies Pvt Ltd v DGGSTI 2023 SCC OnLine Kar 18. 

[2] State of Andhra Pradesh v K. Satyanarayana & Ors AIR 1968 SC 825, at para 12. 

[3] All India Gaming Federation v State of Karnataka & Ors AIR 2022 SCC OnLine Kar 435. 

Refunds for Zero-Rated Exports Viewed as Fundamental to GST Regime

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In a judgment pronounced on 16 February 2023, a Single Judge Bench of the Karnataka High Court in Tonbo Imaging India case[1] held that Rule 89(4)(C), CGST Rules, 2017 ‘is illegal, arbitrary, unreasonable, irrational, unfair, unjust and ultra vires Section 16 of the IGST Act and Section 54 of the CGST Act …’. (para 17) The writ petition filed by the petitioners challenged that the amendment to Rule 89(4)(C) – via Notification 16/2020-CT dated 23.03.2020 – was unconstitutional and the High Court upheld the same. I explore the arguments and the High Court’s reasoning in this post.  

Background to the Writ Petition  

The petitioners were engaged in designing, developing, and deploying various types of advanced imaging and sensor systems to control and understand complex environments. The petitioners exported the aforementioned products from May 2018 to March 2019. Accordingly, the petitioners claimed refunds of its zero-rated exports under Section 16, IGST Act, 2017 read with Section 54(3)(i), CGST Act, 2017 and Rule 89, CGST Rules, 2017. The petitioners claim was rejected by the Revenue Department for not filing proof as required under the amended Rule 89(4)(C) despite the petitioner contending that their case related to the period before the amendment and should be governed by the pre-amended rule. The petitioner argued that its case should be governed by the pre-amended version of Rule 89(4)(C) which stated as follows:

Turnover of zero-rated supply of goods means the value of zero-rated supply of goods made during the relevant period without payment of tax under bond or letter of undertaking as declared by the supplier, whichever is less, other than the turnover of supplies in respect of which refund is claimed under sub-rules (4A) or (4B) or both.

While the Revenue Department’s case was that the petitioner must show proof as required under the amended version of Rule 89(4)(C), which states as follows: 

Turnover of zero-rated supply of goods means the value of zero-rated supply of goods made during the relevant period without payment of tax under bond or letter of undertaking or the value which is 1.5 times the value of like goods domestically supplied by the same or, similarly placed supplier, as declared by the supplier, whichever is less, other than the turnover of supplies in respect of which refund is claimed under sub-rules (4A) or (4B) or both. (emphasis added)

The amended rule introduced the concept of comparing the value of exports of the supplier with its domestic supplies, and introducing an upper cap to the refunds based on the comparison. This would mean that if an exporter has paid a certain amount by way of GST on its purchases, then the Revenue Department may not refund the entire tax amount but only 1.5 times the value of like goods supplied domestically. 

Petitioner’s Arguments

The petitioner assailed the amendment to Rule 89(4)(C) on various grounds. First, that while Section 16(3) allowed refund of taxes made in the course of making a zero-rated supply, the Rule in whittling the refund is ultra vires the parent statute. Second, the petitioners claimed that the amendment to Rule 89(4)(C) creates a hostile discrimination between exporters who export without payment of duty under a Bond/Letter of Undertaking and those who pay duty. And only exporters who made exports without payment of duty were subjected to the restriction under Rule 89(4)(C). Extending the Article 14 argument, the petitioners argued that the impugned Rule was arbitrary and unreasonable because it had no rational nexus with the objective sought to be achieved by Section 16, IGST Act, 2017, i.e., zero-rating of exports. Third, the petitioners argued that amendment to the impugned Rule was violative of Article 19(1)(g) since it will affect availability of funds and hamper the rotation of their funds. Finally, the petitioners assailed the impugned Rule on the ground that it suffered from the vice of vagueness, did not define key terms nor did it prescribe the consequences if a similarly placed supplier was not found or the supplier did not supply similar goods domestically.       

High Court Accepts Petitioner’s Arguments 

The Karnataka High Court accepted almost all the petitioner’s arguments. It traced a brief legislative history of GST to conclude that zero-rating of exports was a core feature of GST in Section 16, IGST Act, 2017 and Section 54, CGST Act, 2017 with Rule 89 as a machinery provision to implement the policy of zero-rating. Based on this understanding, the High Court almost repeated all of the petitioner’s arguments approvingly. 

The High Court held that the amended Rule 89(4)(C) overrides the parent legislation since it restricts refunds while the parent provisions, i.e., Section 16, IGST Act, 2017 and Section 54, CGST Act, 2017, allow for full refunds for zero-rated supplies such as exports. It accepted the argument that the impugned Rule created hostile discrimination between two kinds of exporters, i.e., those who export without payment of duty and those who pay duty violating Article 14; especially since there was no rational nexus with the objective contained in Section 16, IGST Act, 2017. The High Court also opined that the impugned Rule was unreasonable since it affected the availability of funds and caused hardship to exporters. Further, it held the impugned Rule to be vague as phrases such as ‘like goods’ and ‘similarly placed supplier’ were not defined in the statute or relevant Rules. It concluded that:  

The object of zero rating would be lost if exports are made to suffer GST as the exporter would either pass it on to the foreign supplier or would absorb it himself; firstly it would mean that taxes are exported which is against the policy of zero rating supra and secondly, it would make exports uncompetitive being against the stated policy of the Government. The amending words therefore, do not sub serve the objectives set out in Section 16 of the IGST Act, 2017 nor Section 54 of the CGST Act, 2017 and are contrary to the clarifications given above. (Para 17(h))

The High Court viewed the impugned Rule at odds with the GST’s objective of making exports zero-rated and not subjecting them to the burden of tax. Zero-rating of goods is also in consonance with GST’s identity as a destination-based tax. The State had to discharge a heavy burden in arguing the reason for the departure from the core characteristics and policy of GST. However, no persuasive reason was argued by the State.  

Conclusion

The judgment is a closely reasoned judgment and supports its conclusions adequately. The entire premise of the judgment is that zero-rating of exports is a core feature of GST encoded in the legislation, and deviation from its via secondary legislation without a persuasive reason is impermissible. However, the judgment offers no perspective from the State and/or the Revenue Department. The Karnataka High Court never elaborated on the State’s arguments because considered them to be ‘neither relevant nor germane’ for adjudication of the petition. (para 27) Only argument of the State, i.e., the impugned Rule was amended to prevent misuse was referred to dismissed summarily. The High Court rightly held that in the absence of defining data the reason of misuse has no reasonable basis in law and neither can amendments to law be made on the premise of distrust without actually ascertaining the misuse. (para 22) Apart from the above, no detailed reference is made to the State’s arguments. Consequently, we never really get an insight as to why the amendment to Rule 89(4)(C) was made and the objective sought to be achieved by restricting refunds of exporters. And, at the time of writing, there seems to be no move to challenge this judgment either.    

[1] M/s Tonbo Imaging India Pvt Ltd v Union of India 2023 LiveLaw (Kar) 134. 

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