The department audit round has begun, and it will not be long before it will be in full swing. The first year(s) of the audit would be crucial in the sense that it would reflect revenue’s approach towards a number of controversial tax positions. One such critical tax position being, ‘taxability under S. No. 2 of Schedule I’ to the Central Goods and Services Tax Act, 2017 (the Act), stating as follows;


Supply of goods or services or both between related persons or between distinct persons as specified in section 25, when made in the course or furtherance of business:

This article examines, background and some of the contentious issues surrounding the above-stated deemed supply.

1. The necessity for taxation of inter-branch transactions

In a consumption-based VAT, the taxation of inter-branch transactions largely revolves around the economic impact of the transactions. If the goods are consumed in one jurisdiction, that jurisdiction would want the corresponding tax. The concept of taxing inter-legal entity cross border transactions is therefore already in vogue in many overseas jurisdictions.

Till now, there was a single government collecting tax across the nation [as was the case under service tax], the problem of economic impact did not pose a challenge. However, but in the light of multiple (artificial) jurisdictions, the taxation of inter-legal entity transactions (even for domestic transactions) became a necessity which gave rise to ‘distinct person’ [Section 25 (4)]. The VAT neutrality, therefore, is the key reason why the concept exists and for the very reasons, the concept might survive the constitutional tests also.

2. The scope of Schedule I

The effect and impact of the S. No. 2 could be far-reaching, in as much as not only, it includes the distinct persons, but also related persons within its ambit. Perusing the definitions of related persons [Explanation (a) to Section 15], the following transactions are also under the ambit of S. No. 2;

  •  Transactions/ Reimbursements between an employer and employee [clause (a) (iii)]
  •  Transactions inter se between companies within the same group, provided there is ‘control’ [clause (a) (iv)-(viii)]
  •  Transaction between the supplier and its sole agents [clause (c)]

The exercising of ‘control’ is one of the criteria that affects the relationship status of two persons. The expression control in terms of available jurisprudence under the Customs Act largely means ‘power to direct or exercising restraint’ on the other person . This power could either be driven by equity control or through management control.

Therefore, even those persons which do not directly hold equity in the other person may have to be careful if they are exercising implicit powers of direction or restraint. The whole time/ managing directors in a company are usually considered to exercise control over a company/ body corporate, but that should not be true for directors who are just nomination/ representing directors of a financer .

3. Reimbursement vs Disbursement

At times there are certain peculiar transactions, on account of back-to-back recoveries or where one branch acts as a communication link, such as [1] ‘pure’ reimbursements of freight by an Indian entity for foreign entity whose exporter material has to be re-exported due to rejection/ otherwise or [2] ‘pure’ recoveries of the import costs by one branch at the behest of the other branch [3] expenditure incurred by the employees.

In the first place, it is difficult to construe a supply here because one party is only acting as a communication channel for the other party, whereas the economic reality lies in the supply of the external supplier (on which the vendor would have been charging the appropriate tax). While there exists a school of thought that some sort of ‘facilitation’ does exist and in the expanded notion of supply, the recoveries be amenable to tax. However, in straightforward cases where there is facilitation only to the extent of payment, such should not be covered within the scope of supply . Whereas, in cases where the flow of facilitation services is patently clear, then there remains little doubt over its taxability .

4. Pure Agent deduction sans Rule 33

Another way to look at the reimbursements is from the point of view of ‘pure agent’. Assuming that there may be a facilitation, exclusion from valuation can have the net effect of zero tax. Rule 33 statutorily incorporates pure agent, however an extraneous condition in clause (iii) makes the mechanism infructuous in as much it stipulates that “pure agent supplies should be in addition to the principal supplies of the agent”.

Thinking from a logical perspective it would however be futile for a supply to become re-supply by mere change of hands. The pure agent deduction should be available even when the external supplies’ are re-shared, without the agent requiring to provide services of his own i.e. pure agent exclusion should be available sans Rule 33 also. Pure agent in this form is essentially mere payment facilitation, which should not be touted as a taxable supply.

5. Distinguishing reimbursements from P2P arrangement

At times, the reimbursements and not just vanilla reimbursements, the facilitator entity may add a certain profits margin, or it could end up facilitating numerous external supplies so much so that his position becomes that of a principal facilitator. Before taking the non-taxable position, therefore, it is apposite that the organization distinguish between pure reimbursement and facilitator arrangement.

Ideally only those transactions should be taxed which constitutes a supply in its own right. The best approach to look at these transactions is to identify the nature of the relationship i.e. whether the facilitating branch is acting as P2P or acting as an agent, the latter transactions should of course not be taxed. In fact even in P2P supplies, one could take an argument that pure reimbursements should be excluded from valuation (Intercontinental Consultants and Technocrats Private Limited).

The Singapore IRAS tax guide on reimbursement vs disbursement gives lucid and logical guidance on how such transactions should be dealt with, and it is plausible to apply the discussion in the Indian context also.

6. Input Tax Credit (ITC)

It is always sought after practice that where the recipient unit is entitled for the ITC of the tax charged by the supplier unit, it is preferable to just charge of tax. Per a logical interpretation, ITC should be available, if tax is charged, but nothing stops the revenue from hypothesizing in show-cause notices that ‘since no tax was chargeable, the ITC so availed is irregular’. Needless to say, that allegation of this sort may not pass the judicial muster .

And then there is Section 122 (1) saying that ‘supplying invoice without embedded supply’ is an offence. Of course, there would be show cause notices of this kind too, but it is likely that a capable judicial forum should be ruling the non-application of Section 122. But exceptional situations cannot be completely ruled out, as was the case in HCL Technologies Ltd vs CST , wherein the Hon’ble Tribunal denied Cenvat Credit on the commonly shared costs.

7. Valuation – benefit of 2nd proviso amidst full input tax credit

The valuation of supplies is another interesting controversy where the recipient supplies have exempt/ non-taxable supplies. In general, rule 28 of the CGST Rules follows that valuation in related/ distinct persons supplies shall be sequentially determined as follow [1] Open Market Value (OMV) [2] Like kind and quality value (LKQV) or [3] Value-based on cost. The cumbersome exercise of finding the values is relaxed by the 2nd proviso stating that if the recipient is entitled for “Full ITC”, then invoice value shall be deemed to be OMV.

The expression is not defined anywhere in the GST Law, and from a layman’s reading indicates a person who is entitled to avail ITC on all of his inward supplies. Conversely, a person is not in a position to take full ITC when either he is using the same for exempt supplies or non-business purposes. It, therefore, transpires that in order for the supplier to avail the benefit of the 2nd proviso, the recipient should not be engaged in exempt supplies.

While apparently, a recipient person operating under partial taxable/ exempt supplies, may not find himself under 2nd proviso however it could also be argued that if the person complies with Rule 42 and Rule 43 of the CGST Rules he essentially achieves the status of ‘Full ITC’. If not literally, but by analogical interpretation of Explanation 4 clause (iv) of the services rate notification , such argument could be taken as one of the defense in litigation.

It is also apposite to refer to the pari materia provisions under the Singapore GST, which follows de minimis for ascertaining the ‘Full ITC’ status i.e. if the exempt supplies are up to 5% of the total outward supplies, the person shall still be considered in the ‘Full ITC’ status. While de minimis is not explicitly stated, such argument could also be adopted in the Indian context, since the principal is available otherwise also (of course, whether the threshold should be 5% or otherwise is for Courts to rule upon).

8. Cross charge (CC) and Input Service Distributor (ISD)

The OECD’s International VAT/ GST guidelines stresses on the rationale of VAT neutrality. The guidelines emphasizes place of taxation rules for effective application of destination principle, it attempts to provide methods a VAT regulator may use to achieve proper jurisdiction for taxing the final consumption (of the services or intangibles). The guidelines provide for use of two approaches;

  •  Direct use or directly delivery i.e. Each supply should be identified to the person who has consumed such supply,
  •  Recharge i.e. the costs could be internally recharged to the multiple units based on the determined usage

Ideologically speaking, the OECD principles leaves the door to both the ISD and cross charge, and certain isolated interpretation that ‘ISD facility being the only mode’ should not curtail the recharge method. For all logical purposes, ISD and recharge method should co-exist in the Indian context.

9. Time of Supply of internal re-charge

A puzzling question comes into play when the entities undertake cross charge for the common costs (employee and/ or external costs), as to when should the invoices be issued and at what point, the point of taxation arises.

When the supplies are continuous , Section 31 (6) provides that invoice in such case be issued on the basis of the due date of invoicing/ payment/ milestone mentioned in the contract. This essentially means that the taxpayers can put any date in the contract and tax liability will not become due before such date [Section 13 (2)]. Unlike the UK VAT Regulations, there is no derogatory measure [fixing annual tax time of supply of supplies between related persons ] under the Indian GST.

That said, however, it is advised that the organization may freeze appropriate timely tax events [preferably lesser than 6 months] and strictly abide by the same, especially because the consequences of any adventure under the Indian GST are very costly [not only the penal interest but probably denial of ITC at the end of the recipient entity, on the anvil of Section 16 (4)].

10. Excludability of Shareholders’ function

The scoop of S. No. 2 trespass the conceivable, one can think of situations [1] where one entity of the group has extended Corporate Guarantee (CG) in favour of another group entity so as that the latter one can procure funds or [2] upon the instruction of government department one entity has agreed to act as surety towards payment of dues on the latter’s failure. Perusing the post negative list service tax jurisprudence , it transpires that extending of CG is a service and when S. No. 2 makes consideration irrelevant, it is logical to say that the above transaction between related persons is a taxable supply.

That said, such adventurous limits of S. No. 2 should be litigated before the Courts, one of the argument one may take is that extension of CG by one entity towards another entity is a shareholder’s function i.e. there is no supply of service but merely a promise made by the shareholding entity by virtue of it being shareholding entity.

The Income Tax jurisprudence [Manugraph India Limited ] the CG as facilitation should be distinguished from CG as share-holders’ activity. While the former could be a supply, the latter is only one of the ways the shareholders’ infuse funds into the company. When a guarantee compensates for the inadequacy of shareholder funding, it could be viewed as a mode of ownership contribution. Therefore, from this point of view, the GST-excludability may be argued in deserving cases.

11. Transfer Pricing Adjustments

The direct tax legislations across the world often prompts the MLEs to undertake adjustments on account of Arm Length Price (ALP). The year-adjustments inter alia include a single transaction to off-set the deficiency in transfer price. Say, the US entity was supplying services to Indian related person (IRP) at certain price. After numerous transactions throughout the year, it is decided that an amount of INR 10 Crores equivalent be recovered extra from IRP. The GSTR 9C reported by the multiple Indian entities revealed several of these transactions where no tax [under RCM] was discharged on these transactions.

Should, therefore, be any GST implications on the TP adjustments? In the Indian context, it is relatively settled that indirect taxes should be assessed at the time of their occurrence and post-facto events such as forex fluctuations , un-known price increase should be ignored . The EU VAT Committee in Working Paper 923 had identified the following tests for revising the value of goods or services on the basis of TP adjustment:

  •  The TP adjustment must result in a payment, either monetary or in-kind
  •  The payment must be attributable to a specific supply of goods or services
  •  There must be a direct link between the supply of goods or services and the payment

As a rule of thumb, it may be said that TP adjustments based on CUP method are more likely to face challenges from the point of GST in as much as the transactions are directly pegged.

12. Employer- employee transactions – cross charge

S. No. 1 of Schedule III excludes “services by an EE to ER in the course of or in relation to his employment” from taxability. What is not clear however is the ambit of EE. Wherever it’s seen, there would always be two views:

  • EE belongs to the legal entity or in-fact the group, therefore the exchange of services between two distinct persons [branch vs branch] or related persons [entity vs entity] is not a supply and excluded by S. No. 1 above.
  • The other view restores the tax neutrality i.e. the EE should be identified with the respective entity (1st) and if he is doing supporting the other (2nd) entity, it is essentially a supply of services by 1st entity to 2nd entity.

Pending the judicial clarity in this regard, it would be prudent to view the EE-ER on macro analysis. Joint employment cases (both explicit as well implied arrangements) are excludible from the tax net and so are the liaison office EE cases .

13. Facilities to employee

S. No. 1 supra excludes EE’s supply of services, the press release dated 10 July 2017 extends the scope of excludability (rightly so) from GST the consideration in kind made by ER’s provided they are part of the employment contract. The cross supply in the form of subsidized food, travel, awards and rewards in kind, etc., therefore should not be taxable when given to the EEs.

It is preferable for the organization to explicitly put the employment facilities in the employment contract or as part of the HR policy, but on a generous interpretation, even when the facilities are implied (i.e. available to all, impliedly understood, deployed), then also the facilities should be excluded from the tax net.

The Hon’ble AP High Court in Bhimas Hotels Private Limited had held that since subsidized food is included within the purview of ‘wages’ under Industrial Disputes Act it should be understood as part of the pay package and not otherwise. This overall acceptability of judgment is however likely to be re-tested, such that the definitions under labour laws do not well resonates with the interpretation of fiscal laws.

14. Sharing of common logo

The allowance of usage of logo by a person to another ‘for consideration’ does lead to supply of services . In the inter-company agreements, there is often a provision for allowances of usage of logo/ brand, etc., owned by one, to be used by another, these cases are exposed to S. No. 2. The most exaggerated cases would where the brand is tied to one branch and used by other branches.

It should however be not discounted that where the brand name, logo is not used for advertisement purpose, or not to indicate the relationship with the owner, then there is no allowance of usage of logo, brand name, but only a parcel practice.

The entities who would be doing the cross charge based on other parameters may also consider the argument that usage of brand name gets subsumed in the large spectrum of contract and there is no separate consideration for logo, brand names, and therefore no separate tax should be considered qua brand/ logo use .


It is safe to suggest that S. No. 2 imbibes within itself a multitude of GST issues. The concepts like cross charge, pure agent, employment status, 2nd proviso would soon be presented before the capable courts and it is likely that a whole lot of taxpayers would find themselves recalibrating their tax positions.

With GST audits coming up and time-gap for correction squeezing, it’s time to boot up. The ones who complied with cross charge should be ready with bulk load documentation to prove their bona fide qua valuation and 2nd proviso and the ones who didn’t should be ready with their litigation arsenal (and of course the pre-deposit funds).

Manish Sachdeva | [email protected]

Author Bio

More Under Goods and Services Tax

Leave a Comment

Your email address will not be published. Required fields are marked *

Search Posts by Date

June 2021