Tool Development Charges – Export or not under GST

The present article lays a discussion into the tax ability of Tools, Dies, Jigs familia when made for overseas customers but retained in India. The Indian government is crazy with forex and does everything a man does for his job (Eh?), to attract forex, the GST Legislation have made exports “zero-rated” under Section 16 of the IGST Act. Zero rated supply is broad term per international standards, however Indian laws only rewards “Exports” the status Zero rated, that too in an erratic way. For brevity, Section 16 ibid goes as follows;

16. (1) “zero rated supply” means any of the following supplies of goods or services or both, namely:––

(a) export of goods or services or both; or ……………..

The definition of export of goods is taken from the Customs Act, 1962 (‘CA’), as “taking out of India to a place outside India” [Section 2 (5)]. A conjoint reading of both provisions implies that goods shall be treated as zero rated only if they are taken Outside India. In fact, even the place of supply has no interference with Export status of a supply, therefore the need of Section 11(b) of IGST Act is doubted. Such embargo gives rise to formidable situations where some transaction although obeys the rules of VAT – consumption, however still gets fussed into the Originating state.

A cliché example should help the cause. The Tier 1 manufacturers – make automobile parts (‘SKU’) for OEMs. The SKUs manufactured by Tier 1 are tailor made for every OEM and they have to be made in accordance with OEM’s specifications and drawings. For manufacturing specified SKUs, Tier 1 requires Dies and Moulds (‘D&M’). Over the time, the Tier 1 have installed setups to manufacture D&M. Under such scenario the Tier 1 manufacturer make D&M and retains with them and thereafter continue with manufacturing of SKUs from such D&M. The consideration for D&M is a separate one from the consideration of the SKUs. A ludicrous cases comes up, when the OEM is an overseas customer and SKUs are to be shipped outside India for foreign exchange, although D&M are retained till their disposal via salvage.

A common nomenclature for D&M consideration is “Tooling Revenue” or “Tool Development Charges”. The earnings for Tooling are in Foreign Exchange, though the D&M are not physically dispatched overseas. Succeeding paragraphs gauges should these Tooling Revenue can be classified as Zero rated supplies under Section 16 ibid, or they are leviable to GST.

1. Taking out of India

Export under Section 2 (5) ibid is the brainchild of the Customs Law. A similar definition of export persists under Section 2(18) of the CA. Further the definition of India under Section 2 (56) of CGST Act expands India till the Exclusive Economic Zone. Conversely, the expression “Outside India” is basically, what is not India. It is also well settled that to export – means the goods must be loaded and shipped outside the territorial waters of India (B K Wadeyar vs Daulatram Rameshwarlal AIR 1961 SC 311)

In the present case D&M are never taken outside India, therefore in a strict sense it won’t be an exaggeration to say that the supplies of D&M are not eligible to be called exports under Section 2(5) ibid and therefore not Zero rated. However, Section 2 comes with a rider of “contextual reference” i.e. Section 2 defines Export as under sub Section 5 unless the context requires otherwise. Other legal meanings of Exports can be of use;

• To send, take, or carry an article of trade or commerce out of the country. To transport merchandise from one country to another In the course of trade. To carry out or convey goods by sea. State v. Turner, 5 Har. (Del.) 501. [the law dictionary.org]
• to export something abroad [Merriam-Webster]

The contextual reference is a debatable satire and requires the totality of facts in case divergence has to be adopted. The Hon’ble Supreme Court in case of Commissioner of Expenditure Tax vs Darshan Surendra Prekh [1968 AIR 1125] noted as follows;

“Undoubtedly the definitions in s. 2 of words and expressions used in the Act apply unless the context otherwise requires, and if the context in s. 4 requires that the expression “dependant” should not be given the meaning which is assigned thereto by the definition in cl. (g) of s. 2, the Court would be justified in discarding that definition. It is a settled rule of interpretation that in arriving at the true meaning which is assigned thereto by the definition in cl. (g) of to be viewed isolated from its context; it must be viewed in its whole context, the title, the preamble and all the other enacting parts of the statute. It follows therefrom that all statutory definitions must be read subject to the qualifications expressed in the definition clauses which create them, such as “unless the context otherwise requires”; or “unless a contrary intention appears”; or “if not inconsistent with the context or subject-matter”.”

In Printers (Mysore) Ltd v Asst. Commercial Tax Officer [1994 SCR (1) 682], the Hon’ble Supreme Court diverged with the expression “goods” used in Section 8 (3) (b) of the Central Sales Tax Act, 1956 in reference to the newspapers. The ruled that “goods” as appearing in first limb of the clause (b) has to understood as if defined under Section 2 (d), however “goods” occurring in last limb cannot be understood the same in as much as it would place the newspapers in a more unfavorable position than they were before an amendment, while holding that amendment cannot have such unfavorable consequence in intent in first place.

In Ashok Kapil vs Sana Ullah (Dead) and Others [https://indiankanoon.org/doc/1979947/], the respondents tried to achieve a mischief by contending that the constructed premises had no roof tops and hence was disqualified for being called as Building under Section 3(i) of UP Urban Buildings [Regulation of Letting, Rent and Eviction] Act, 1972. The Hon’ble Supreme Court diverged with the definition of Building of, in as much as by removing roof tops, the respondents are seeking an advantage of their wrong and declared that premises even though not a building under section 3 (i), but the contextual reference in the definition preamble gives enough room to a Court to diverge and correct the wrong.

An essence can be drawn from the above judgments that, although Zero rated are only exports, but exports must not necessarily be restricted with Section 2 (5) in isolation. If a good ground is propounded to exhibit that export can be things even other than those “taking out of India”, then the benefit of Zero rating shall be permitted.

2. Tax ability otherwise

For a moment, if it is agreed that Supply of D&M is not export, necessary provisions of Act are to be applied either way to tax it. To tax it, one needs a charging section, which can either be Section 9 (1) of CGST Act or 5 (1) of IGST Act. Location of Supplier and Place of Supply (‘POS’) are relevant criteria to determine the taxability

Place of Supply

Place of Supply of goods can be arrived by Section 10 or Section 11 of the IGST Act. Section 11 doesn’t seems to cover the supplies of D&M based on a premise that, it is not export per se. Clause (c) of Section 10 (1) applies in case of supplies which does not involve movement of goods giving POS as the location of such goods at the time of delivery to the recipient. Delivery should include ‘Symbolic Delivery’, therefore when it comes to supply of retained D&M, the POS is always going to be the State of manufacture – making the supply – Intra State in all situations. Having said that, it is imperative to say that Central Tax and State Tax will be leviable on the D&M, even when the contract is with an Overseas Customer.

Jurisprudence before GST

A similar situation was up before Disposal before Hon’ble High Court of Karnataka in case of IBEX Engineering [Sales Tax Appeal 91 of 2012] in the context of erstwhile Karnataka Value Added Tax, 2003. The Appellant received a payment labelled as “Tool Development Charges” from its foreign associate for manufacturing of Moulds. The Moulds never made out of the factory and used for manufacture of engineering parts, the appellant claimed exemption on the grounds (1) that in absence of delivery, the sale of goods is not completed, (2) In any case, the sale is one of export of goods. The High Court discerned with the views of the appellant and held that Vat is exigible on the basis of following;

• Since goods never moved out of customs frontiers, there is no Export Sales
• Delivery can be actual or symbolic, therefore even if there is no delivery, there is sale in the impugned transaction
• The judgment of Govel Plastic Ltd [2002] 128 STC 577 (Mad)., is not applicable in as much as the Madras High Court gave its verdict in the context of Central Sales Tax.

Much maligned Excise Duty also had the capacity of containing incidence of tax in India, since the situs of tax event was manufacture. Fortunately, however, the “D&M retention” escaped the wrath of Excise Duty by virtue of an exemption under Notification No. 67/95-CE. Although there was amortization on retained D&M, still though owing to the Complex nature of Taxable Event and Ludicrous procedures, the D&M were able to save itself from the tax cost in the eventual export.

Double Jeopardy/ Hypocrisy

The misery doesn’t stop at Indian sub-continent, but goes beyond. Most of the Overseas Jurisdiction charges Customs Duty on the D&M used for the making of imported goods. European Customs Community Code, Article 32 adds apportioned cost of D&M in the contracted price of SKUs. The situation becomes almost hypocrite in as much, the Indian Customs Valuation Rules, 2007 also tends to add value of D&M in the value of imported costs over the contracted price. In effect, Indian Tax Laws wants dual jurisdiction of same subject (at import as well as export), who is going to trade with these knob heads? Make in India, Eh?

The thrust of IBEX Engineering brings out the exact deficiency under the India Indirect Tax Legislations. Years ago, principles were laid down that Sales tax was to be levied based on the movements, and because of the revenue-mindedness approach, the same principles have been stuck since then. It appears that GST has taken the Indian VAT regime backward in as much as the Excise component will also accrue to the costs now.

3. Contract Optimization

Forget for a moment, that OEM will ever get the D&M. Such is the case most often than not, therefore, there is something to optimize. Following Models may be think of to neutralize the tax cost arising out of retained D&M supplies;

Split the value between goods and services

From a financial costing perspective, the costing of D&M is tilted more towards design and development and lesser towards the actual engineering. In fact, actual engineering in some cases merely extends to be only tightening of the fasteners and jolts. A major chunk of the cost is towards “In house Designing, Re-designing, developing the prototype on the computer, testing, and finalization”. These words could sounds more of services than goods. While it is difficult to testify that entire contract price for D&M can be slated towards services, still though it can be split to very good extent under the Umbrella of services. Support could be sought from the judgment of Hon’ble Chennai CESTAT in case of Mahle IPL Ltd vs Commissioner of Central Excise and Service Tax, Chennai III [2014 (036) STR 1118 (Tri. – Chennai)];

4. The definition of “design services”, would include services provided in relation to designing of furniture, consumer products, industrial products, packages, logos, graphics, websites and corporate identity designing and production of three dimensional models. On a plain reading of the definition, it is seen that the “Design Service” includes designing of industrial production also. We find that the applicant received charges for rendering service of design and development of tools.

Having satisfactorily split the value of D&M, the services of design and development can be quoted under “SAC 998391 – Specialty design services including interior design, fashion design, industrial design and other specialty design services.”  The place of supply in case these sort of general services is ‘location of recipient of services’ [Section 13 (2) of IGST Act] viz. the foreign territory in the present case [Circular No. 141/10/2010-TRU Dated 13/05/2011, Para 3]. The export criteria can be satisfied, when the Tooling Revenue are categorized as Services. Therefore to the extent possible, splitting is recommended in possible cases.

Moreover cases like Engineering Change Notice (‘ECN’) are apt example of services per S. No. 3 of Schedule II to CGST Act in as much ECN is a process on the goods belonging to the OEM. [Casual Views]

Supply as Composite Supply or Mixed Supply

Individual Contracts of (1) D&M and (2) SKUs with OEM could be merged or even modified with cross fall breach etc. The attempt is to club the multiple supplies of D&M and SKU as single supply. A singular contract with appropriate co-terminus clauses of D&M and SKUs can be offered as composite supply;

Composite Supply: At the end of the day, an OEM wants SKUs and not D&M, therefore for all intents and purposes, the supplies of SKUs are principal supply in the bundled contract and hence tax will be levied at the time of supply of SKUs, avoiding levy at the time of retention of D&M. Serving our purpose

Mixed Supply: Even if the bundling happens to be non-composite supply and hence mixed supply, the ultimate impact will be neutral, majorly because major Automobile SKUs are taxable at either at 28%, while the rate of tax for D&M is 18%. Composite, mixed, whatever, it serves the purpose. There is a little cause of concern just in case tax rate on D&M is higher than SKUs, in which case the mixed supply shall be treated as supply of D&M.

An Intermediary to the rescue

GST on D&M Supply is cost for an overseas OEM (unregistered), but an intermediary between the OEM and Tier could neutralize the tax cost. Unless of course, the legitimacy of transaction is challenged. Putting over an intermediary to save, is not a new phenomenon and has been happening ever since in West over the Entry Tax levies.

The GST 18 charged on D&M is un-absorbable, hence a tax cost. The said cost can be converted into ITC by introducing a ‘Tier 0’ or ‘Contract Party’ to execute the Exports.

4. The Foreign Way

The tax imbalance situation has cropped up internationally as well but to neutralize the tax costs that arise in the transactions, the countries have incorporated necessary provisions in their VAT Legislations.

In UK, United Kingdom Value Added Tax Act, 1994, unlike Indian GST, the scope of zero rated supplies is not limited to exports, so that imbalance or anti-VAT apprehensions could be countered qua other commodities/ transactions as well. Section 30 (2A) of the UK VAT Act read with S. No. 3 of Schedule 8, Group 13 provides zero rating of D&M to the extent they are used for exporting SKUs outside UK;

3. The supply to an overseas authority, overseas body or overseas trader of jigs, patterns, templates, dies, punches and similar machine tools used in the United Kingdom solely for the manufacture of goods for export to places outside the member States.

UK VAT Notice 701/22 (updated 05 Oct 2017) also clarifies position of D&M.

Similarly in Australia, Section 38-188 of A New Tax System (Goods and Services Tax) Act, 1999 provides for zero rating of Tooling used with synonymic conditions as provided in UK VAT Act.

38‑188 Tooling used by non‑residents to manufacture goods for export

A supply of goods is GST‑free if:

(a)  the *recipient of the supply is a *non‑resident, and is not *registered or *required to be registered; and

(b)  the goods are jigs, patterns, templates, dies, punches and similar machine tools to be used in Australia solely to manufacture goods that will be for export from Australia

Similar propositions are incorporated under Section 21A (1) of the Singapore Goods and Services Tax Act. Chinese also have a similar method of neutralization of D&M situation.

In New Zealand however, the position of New Zealand Goods and Services Tax Act 1985 was alike the Indian GST before 01^st April 2014, as it also had no special provisions for neutralizing the transaction. The facts before, The New Zealand Tax Review Authority in XX (An Exporter) vs Commissioner of Inland Revenue [2013] NZTRA 4 were that – The taxpayer entered into an agreement to export goods to an overseas-based purchaser. After entering the agreement there was a change of approach by the purchaser who arranged for the goods to be used in New Zealand to manufacture different goods. The taxpayer argued that its goods were still ultimately exported and therefore that supply could be zero-rated for goods and services tax purposes.

The Court found that the underlying goods had been consumed in New Zealand and therefore were not eligible to be zero-rated. In pursuance of such judgment, a discussion paper [http://taxpolicy.ird.govt.nz/sites/default/files/2011-dd-gst-businesstobusiness.pdf] was issued by the New Zealand IRD calling for neutrality of cross border B2B transactions and recommended that a zero rating system for Tooling be introduced citing UK VAT and Australian GST Act provisions, as predecessors. Accordingly, Section 11 (p) was introduced to neutralize the D&M situation at hand.

5. Wonder what they are going to do here in India.

Wonder what Courts will do?

It won’t be an exaggeration to say that Indian GST is introduced to litigate, because lets accept it, “manufacturing” was getting too old. Besides, what’s the fun in paying (conservative) tax? Also Anti Evasion teams are finding it difficult to warm the seats. Someday, somebody is surely filing a Writ or GST Appeal, just in case GSTN starts functioning. So I wonder what’s the (Hon’ble) Court are going to do.

Will the court follows the IBEX Engineering ratio?

As a matter of law and as matter of fact, it appears that IBEX judgment presents the correct ratio in terms of the KVAT Act. In fact, as elucidated in Para 2 above, there seems to be nothing wrong in the charging provisions of taxability under GST as well. At the same time, there is indeed some rationale in the taxation of D&M in as much as the consumption of D&M per se does happen in the territory of India, regardless of the peculiar positions adopted by the OEMs and Tier 1s.

Constitutionality Issues?

It has become a cliché people chiding government for embossing extra-territorial jurisdiction over services of which POS is outside India, but they do not qualify export of services. It seems, the services are not alone, wonder what’s going to be the mood of Court (while deciding a challenge) on extra territorial jurisdiction. The fact that Importing countries are going to double jeopardize the importers of SKU, wonder if the Court finds the grief of Tier 1s relevant.

Further where some ‘smart’ Tier 1s trans-shifts the D&M supplies scenario to Tier 2s, it’s certainly going to create a distort with the ‘not-smart’ Tier 1s, channeling the arbitrariness and unintelligent differentia vices of Article 14 of the Constitution into question. Wonder what Court might do to establish equilibrium?

Reading Export under a different context

It’s no secret that, any definition can be distinguished on the basis of context (Para 1), wonder how the Court might interpret Export in the given context? The plain definition of Export is definitely creating a distort, therefore can the Court read ‘taking out of India’ as ‘symbolic taking out of India’ for maintaining the neutralization. Surely, Customs Act jurisprudence can be easily read down while establishing jurisprudence of GST. Difficult, though, but what is easy in Indirect taxes?

To conclude, the bigger ask from the government is to acknowledge the broader sense of Zero rating. In Foreign Legislations, Zero Rating has numerous aspects, including the health care and education sector. The Indian government (still stuck with Central Excise Act), needs to get over that mere return filings won’t increase the tax base, but the rationalization of taxes will. In the meanwhile, exemptions should be granted to the D&M retention in export cases, at the same time providing fungibility of ITC.

Apologies for the Grammar.

(Author can be reached at masachdeva@outlook.com)