Introduction
In a recent order passed by the Bombay High Court in the case of Vedanta Ltd. v. Union Of India, the operation of Circular No. 204/16/2023-GST, dated 27-10-2023 declaring corporate guarantee by parent company to its subsidiary as “supply of services” under Section 7 of Central Goods and Services Tax Act, 2017 (CGST Act) has been stayed. The Circular has been challenged before the court on the ground that corporate guarantee do not constitute supply of services and hence, it is not taxable. Several High Courts, including the Punjab & Haryana High Court in Acme Cleantech Solutions (P.) Ltd. v. Union of India and Telangana High Court in M/s. Greenko Solar Power (Medak) Ltd v. The Additional Commissioner and others have also granted a stay on its enforcement. However, the final decision is pending in all these cases. Although the controversy of taxing corporate guarantee has been in existence since the service tax regime, however, the issue has escalated with the issuance of various circulars by the Central Board of Indirect Taxes and Customs imposing 18% GST on corporate guarantee.
Various legal complexities have come forward as to whether corporate guarantees should be considered as a taxable supply of services under the CGST Act, 2017 given the far-reaching implications of the same on the corporate sector. This blog intends to reconcile these interpretations by examining the interplay between the Indian Contract Act, 1872 and the CGST Act, 2017 while also proposing solutions which would essentially balance the rights of the assessee and the interests of the revenue.
Understanding Corporate Guarantee and its status in the pre-GST regime
Corporate Guarantee is a commitment undertaken by a parent company providing guarantee to financial institutions or banks to fulfill the financial obligations of its subsidiary in case of any default. In most of these instances, such guarantee is provided by the parent company without obtaining any consideration from its subsidiary, unlike the cases of bank guarantee.
However, when the revenue began imposing service tax on corporate guarantees under Banking and other Financial Services, a dispute arose regarding whether the corporate guarantee which is provided without any consideration could be considered as a supply. The Supreme Court cleared the air on this issue in the case of Commissioner of CGST and Central Excise v. Edelweiss Financial Services Ltd. by ruling that corporate guarantee given for subsidiary company without consideration is not liable to service tax.
Rationale of taxing corporate guarantees under the GST regime
With the introduction of GST in 2017, the issue of corporate guarantee again came to the forefront. The term corporate guarantee has nowhere been used in the CGST Act, however, Rule 28(2) of the CGST Rules which was inserted by way of Notification no. 52/2023dated 26/10/2023 clearly lays down that if a supplier provides corporate guarantee to a bank or financial institution on the behalf of the recipient, the same is to be deemed as “supply of services”, taxable to GST under Section 9 of CGST Act. The department’s rationale is that under the GST regime, the SC’s judgment would not apply since the term “supply” has been accorded with wider meaning. Although, for any activity to be treated as supply the same must include consideration, however this condition can be exempted if the activity falls within Schedule I of the CGST Act. Under Schedule I, supply of goods or services between related persons is considered to be supply even if the same is without consideration. Now, in accordance with Section 2(84) of the CGST Act, a parent company and its subsidiary would fall in the definition of related persons. Therefore, the department believes that the supply of services by a parent company to its subsidiary, even in the absence of consideration, would be chargeable to GST.
Legal Dilemmas regarding Corporate Guarantee
Although the department’s reasoning seems to be persuasive, however, the treatment of corporate guarantee as supply of services raises several legal questions which need to be addressed on an urgent basis.
Firstly, on a plain reading of Rule 28(2), it is clear that the holding company has been considered as the supplier of services and the subsidiary, which is the principal debtor in the present case, has been designated as the recipient of services. This classification in itself seems to be flawed since a contract of guarantee is essentially a tripartite contract between the guarantor, principal debtor and creditor as per Section 126 of the ICA, 1872. Therefore, a fundamental question that arises in this context is that if not the debtor then who should be considered the recipient of services. The identification of correct recipient is very crucial, as it forms the basis for determining the applicability of GST, the party liable to pay tax, the eligibility for input tax credit, and the appropriate place of supply under the CGST Act, 2017.
Rather than designating the subsidiary as the recipient, as the CGST Rules currently does, it is the creditor who should be recognized as the actual recipient of services. This is because, in substance, there is no direct supply of services from the holding company to its subsidiary. Rather, the guarantor offers the creditor the guarantee, and in the event that the subsidiary defaults, the guarantor is held accountable to the creditor. As a result, the fundamental flow of services is from guarantor to creditor. The supply of services cannot be compared to the benefit that the debtor receives, namely the capacity to obtain credit based on the guarantee. Since the main purpose of a corporate guarantee is to protect the interests of the creditor, the party to whom the guarantee is given is the real recipient of services. Now, if the creditor is considered the service recipient, a fundamental argument is that the guarantor and creditor are unrelated parties and there is no consideration involved in their transaction, consequently, the same cannot be treated as supply of services. However, this argument does not hold any water because, despite the absence of direct consideration, Section 127 of the Indian Contract Act states that any act benefitting the principal debtor may be a sufficient consideration to the surety. Therefore, from this perspective, such an activity qualifies as “supply of services” under the CGST Act, 2017.
Is Corporate Guarantee a shareholder activity not liable to tax?
Another key legal issue in this debate is that a corporate guarantee, being essentially a shareholder activity, is not subject to GST. The classification of whether an activity is a share-holding activity or an intra-group service is still something which requires a separate consideration especially in the absence of any extensive jurisprudence in India on the same.
The categorization of any transaction as a shareholder activity requires a case by case consideration. Various Indian cases like Micro Inks Ltd. v. Addl. CIT and the OECD guidelines provides us with certain factors which can be considered while determining whether a corporate guarantee is a shareholder activity or not. One of the key considerations is whether the guarantee is provided by the parent company solely because of its ownership interest in the subsidiary and same would not have been extended to an independent third party, then it would be treated as a shareholder activity. However, if it provides a direct commercial benefit to the subsidiary, then the same would fall within the ambit of services. Moreover, if a guarantee fee is charged from the subsidiary for providing the guarantee, it is more likely to be in the nature of service. Furthermore, if a corporate guarantee is used for the subsidiary’s own operational needs, it should be considered a shareholder activity, whereas a guarantee provided for acquisitions or expansion may be regarded as a service. Hence, all these factors have to be taken into consideration before reaching any final conclusion on corporate guarantees.
Conclusion
The blanket approach taken by the department of imposing GST on all kinds of corporate guarantee seems to be erroneous and misplaced. Instead, what is required is a nuanced and case by case consideration especially when such taxes can increase the financial burden of businesses and disrupt the intra-group synergies. It has to be examined whether such transaction falls into a shareholder activity or is it a supply of services. Before that, necessary amendments are required for the identification of the creditor as the recipient of these services instead of the debtor or the subsidiary. Moreover, it has to be noted that a corporate guarantee is essentially a contingent contract, that is, it becomes enforceable only in cases of default by the subsidiary. Imposing GST on a fixed value of 1% of the guarantee amount puts an onerous burden on the businesses. In light of these concerns, a more thoughtful and balanced approach is needed to ensure that businesses are not unfairly burdened by taxes and at the same time, ease of doing business is promoted.
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