Case: Association Of Leasing &amp; Finanl.Ser.Cos Vs. Union Of India

In this batch of Civil Appeals, the controversy pertains to validity of Sections 65(12) and 65(105)(zm) of the Finance Act, 1994 (as amended) insofar as the said provisions seek to levy service tax on leasing and hire purchase. The appellants contend that service tax imposed by Section 66 of the Finance Act, 1994 on the value of taxable services referred to in Section 65(105)(zm) read with Section 65(12) of the Finance Act, 1994 (as amended), insofar as it relates to financial leasing services including equipment leasing and hire purchase is beyond the legislative competence of Parliament by virtue of Article 366(29A) of the Constitution.Facts in Civil Appeal @ SLP (C) No. 24704 of 20093. Appellant is an Association of leasing and financial companies. Finance Act sought to levy service tax on "banking and other financial services". Section 137 of the Finance Act, 2001 substituted Section 65 of the Finance Act, 1994 by a new Section 65 which defined "banking and other financial services".Subsequently, this definition also underwent some changes by way of Section 90 of the Finance Act, 2004 and Section 135 of the Finance Act, 2007. The relevant part of the definition as on date contained in Section 65(12) of the Finance Act, 1994 is asIn this Chapter, unless the context otherwise requires –(12) "banking and other financial services" means –(a) the following services provided by a banking company or financial institution including a non-banking financial company or any other body corporate or commercial concern namely: -(i) financial leasing services including equipment leasing andAppellant had filed a writ petition under Article 226 of the Constitution before the High Court challenging the levy of service tax imposed by Section 65(12)(a)(i). During the pendency of the writ petition, Union of India issued a Notification ST dated 1.3.2006 exempting 90% of the amount repayable under hire-purchase/ equipment leasing agreement(s) from service tax on the ground that the said 90% represented interest income earned by the service provider. According to the appellant, the concept of "service tax" was first introduced by the Finance Act, 1994 which came into force w.e.f. 1.7.1994 under Chapter V. No service tax was levied by the said Act or by its subsequent amendment till 2001. However, vide Finance Act, 2001 service tax was imposed on "banking and other financial services". Vide Section 137(a) of the Finance Act, 2001, Section 65 of the Finance Act, 1994 was replaced by a new Section 65 which defined "banking and other financial services" vide clause (10). By virtue of the said definition under Section 65(10)(i), Parliament has sought to bring within the service tax net, transactions in the nature of financial leasing, equipment leasing and hire-purchase. By Section 65(72), the expression "taxable service" has been defined to mean any service provided to a customer, by a banking company or a financial institution including NBFC, in relation to banking and other financial services [See Section 65(72)(zm)]. Being aggrieved by the inclusion of hire-purchase and leasing services within the service tax net, the appellant herein challenged the amendment of 2001 as ultra vires the legislative competence of the Parliament. By the impugned judgment, the Madras High Court has dismissed the writ petition, hence, this civil appeal.

Reasoning:
The service taximposed by Section 66on the value of taxable services referred to in Section 65insofar as it relates to financial leasing services including equipment leasing and hire-purchase is within the legislative competence of the Parliament under Entry 97, List I of the Seventh Schedule to thethis connection, as and by way of illustration we need to give an illustration which brings out the distinction between a "finance lease" and "operating lease". A finance lease transfers all the risks and rewards incidental to ownership, even though the title may or may not be eventually transferred to the lessee. In the case of "finance lease" the lessee could use the asset for its entire economic life and thereby acquires risks and rewards incidental to the ownership of such assets. In substance, finance lease is a financial loan from the lessor to the lessee. On the other hand an operating lease is a lease other than the finance lease. Accounting of a "finance lease" is underwhich as stated above, is mandatory for NBFCs. It is a completely different regime. According to Chitty on Contract, aagreement is a vehicle of instalment credit. It is an agreement under which an owner lets chattels out on hire and further agrees that the hirer may either return the goods and terminate the hiring or elect to purchase the goods when the payments for hire have reached a sum equal to the amount of the purchase price stated in the agreement or upon payment of a stated sum. The essence of the transaction is bailment of goods by the owner to the hirer and the agreement by which the hirer has the option to return the goods at some time or the other [See para 36.242, 36.243]. Further, in the bailment termed "hire" the bailee receives both possession of the chattel and the right to use it in return for remuneration to be paid to the bailor [See para 32.045]. Further, under the head "equipment leasing", it is explained that it is a form offinancing. In a finance lease, it is the lessee who selects the equipment to be supplied by the dealer or the manufacturer, but the lessor [finance company] provides the funds, acquires the title to the equipment and allows the lessee to use it for its expected life. During the period of the lease the risk and rewards of ownership are transferred to the lessee who bears the risks of loss, destruction and depreciation or malfunctioning. The bailment which underlies finance leasing is only a device to provide the finance company with a security interest [its reversionary right]. If the lease is terminated prematurely, the lessor is entitled to recoup its capital investment [less the realizable value of the equipment at the time] and its expected finance charges [less an allowance to reflect the return of the capital] [parais in this background that we have considered the question whether the power to tax indivisible contracts of works should be conferred on the States. It is in the above background that the Law Commission in fact observes "Supreme Court with respect appears to have adopted an unusually restricted interpretation of the word "sale"". It is true that the word "sale" is not defined in the Constitution but is well recognized canon of construction that the words used in the three legislative Lists should receive the widest interpretation and not to the narrow definition of the word "sale" contained in the Sale of Goods Act for the purpose of interpreting that expression in Entry 54, List II. That is the principal juridical ground on which we have expressed our preference for the transfer of power to tax such contracts to the State Legislatures. That, the Commission would prefer restoration of the power to State legislature [See pages 19 and 20]. Thus, to restore the power to levy sales tax on such contracts, the Commission suggested the third out of the threealternatives:(i) amending State List Entry 54;(ii) adding a fresh Entry in the State List;(iii) inserting in Article 366 a wide definition of "sale" so as to include works contract.27. It is the third alternative that brought in Article 366(29A) vide the ConstitutionAmendment) Act, 1982 (page 21). Even in the context ofcontracts the same alternative is opted for by the Commission. However, two observations of the Commission may be noticed. The first is in para 25, page 32. It reads aseffect of the judgment in K.L. Johars case is to reduce the tax base on which sales tax is payable. A tax onwithout sale can be levied on the full value of thetransaction by the Union under the residuary powerentry 97 of Union List.To the same effect is the observation of the Commission at pagepower to taxwithin the State also vests in the Union under Union List, entry 97.Thus, before the Constitutionase transaction could have been taxed by Union under Entry 97, List I but as a matter of policy Parliament brought in Article 366 (29A) as recommended by the Commission. The point to be noted is that reliance on the report [though it helps our above reasoning on some of the aspects] placed by the appellant (s) only shows that service tax was not in the mind of Parliament when the ConstitutionAmendment) Act stood enacted. It was not even in the mind of the Law Commission. That, as stated above, only on the principal juridical ground that the word "sale" in Entry 54, List II should have been read widely, the Commission suggested that Article 366 be amended so thatpower to taxsuch contracts remains with the State Legislature as originally intended. In fact at page 20, the Commission states "before the judgment of the Supreme Court in Gannon Dunkerleys case, the word "sale" was usually regarded as including works contract and works contract was regarded as falling in Entry 54, List II and that taxes were in fact being levied and recovered by the States".Scope of Article 366(29A)30. If one examines Article 366(29A) carefully, one finds that clause (29A) provides for an inclusive definition and has two limbs. The first limb says that the tax on sale or purchase of goods includes a tax on transactions specified in(a) to (f). The second limb provides that such transfer, delivery or supply of goods referred to in the first limb shall be deemed to be a sale of those goods by the person making the transfer, delivery or supply and purchase of those goods by the person to whom such transfer, delivery or supply is made. Now, in K.L. Johars case, this Court held that the States can taxtransactions resulting in sale but only to the extent to which tax is levied on the sale price. This led the Parliament to say, in the Statement of Objects and Reasons to the ConstitutionAmendment) Act, "though practically the purchaser in atransaction gets the goods on the date of entering into thecontract, it has been held by the Supreme Court in K.L. Johars case that there is a sale only when the purchaser exercises the option to purchase which is at a later date and therefore only the depreciated value of the goods involved in such transaction at the time the option is exercised becomes assessable to sales tax which position has resulted in avoidance of tax in various ways." Thus, we find from the Statement of Objects and Reasons that the concept of "deemed sale" is brought in by the ConstitutionAmendment) Act only in the context of imposition of sales tax and that the words "transfer, delivery or supply" of goods is referred to in the second limb of Article 366(29A) to broaden the tax base and that as indicated in the Report of Law Commission prior to the judgment of this Court in Gannon Dunkerleys case, works contract was always taxed by the States as part of the word "sale" in Entry 48/54 of List II. The object behind enactment of Article 366(29A) is to tax the composite price so that the full value of theprice is taxed and to avoid the judgment in K.L. Johars case whose implication was to narrow the tax base resulting in seepage of sales tax revenue. It is in that sense "splitting" of the contract needs to be understood. Thus, it cannot be said that Parliament divested itself of the power to levy service tax vide enactment of the ConstitutionAmendment) Act. Even in the Report of the Law Commission, it has been observed that "if atransaction results in a sale,is undoubtedly leviable by the States. No doubt, it is difficult to determine the "sale price" for the purpose of the sales tax law but this has no bearing on the question of legislative competence" (page 26). Thus, reliance placed by the appellant(s) on the expression "splitting up" in K.L. Johars case is misconceived because the "splitting up" referred to in K.L. Johars case was, as stated above, in regard to valuation and not in regard to legislative competence.For answering the above, we need to keep in mind the doctrine of "pith and substance" and the rule of interpretation of legislative entries. These have to be applied to what is stated hereinabove in the earlier part of our judgment in which we have dealt with the concept of "banking and other financial services" and the nature and character of "service tax" as a tax on activities. We may reiterate that Equipment Leasing andFinance are activities of long term financing and they fall within the ambit of "banking and other financial services". As stated above, a financial lease is a lease that transfers substantially all risks and rewards incident to ownership. In the said lease, the lessor (NBFC) merely finances the equipment/ asset which the lessee is free to select, order, take delivery and maintain. The lessor (NBFC) arranges the funding. It accepts the invoice from the vendor (supplier) and pays him. The income which the lessor earns is by way of finance/ interest charges in addition to the management fees or documentation charges, etc. It is this income which constitutes the measure of tax for the purposes of calculating the value of taxable services under Section 67 of the Finance Act, 1994. Thus, a financial lease would come within "financial leasing services" in terms of Section 65(12)(a)(i). There are different types of financial leases, namely, afinancial lease, a leverage lease and an operating lease. In the present case, there is no adjudication of the matter. The appellant(s) approached the High Court directly without proper adjudication by the competent authority under the Finance Act, 1994. Even in the matter of allocation between the principal and finance/ interest charges, adjudication under the Act was warranted which has not been done. One must also bear in mind that Article 366(29A) is essentially sales tax specific. It was brought in to expand the tax base which stood narrowed down because of certain judgments of this Court. That is the reason for bringing in the concept of "deemed sale" under which tax could be imposed on mere "delivery" on[See clause (c)] which expression is also there in the second limb of the said article.Now coming to the main point whether the whole field is covered by Entry 54 and that the levy of service tax is incompetent, it is important to note the language of Entry 97, List I and Article 248 except for the word "other" in Entry 97. This is because when one reads Entry 97 of List I with Article 246(1) it confers exclusive power first, to make laws in respect of matters specified in Entries 1 to 96 in List I and, secondly, it confers the residuary power of making laws by Entry 97. Article 248 does not provide for any express powers of Parliament but only for its residuary power. Article 248 adds nothing to the power conferred by Article 246(1) read with Entry 97, List I. In the context of an exhaustive enumeration of subjects of legislation what does the conferment of residuary power mean? Entry 97, List I which confers residuary powers on Parliament provides "any other matter not enumerated in List II and List III including any tax not mentioned in either of those lists". The word "other" is important. It means "any subject of legislation other than the subject mentioned in EntriesLastly, we must keep in mind a clear distinction between the subject and measure of tax. [See Goodricke Group Ltd. v. State of West Bengal, (1995) Suppl 1 SCC 707] 37. Applying the above decisions to the present case, on examination of the impugned legislation in its entirety, we are of the view that the impugned levy relates to or is with respect to the particular topic of "banking and other financial services" which includes within it one of the several enumerated services, viz., financial leasing services. These include long time financing by banks and other financial institutions (including NBFCs). These are services rendered to their customers which comes within the meaning of the expression "taxable services" as defined in Section 65(105)(zm). The taxable event under the impugned law is the rendition of service. The impugned tax is not on material or sale. It is on activity/ service rendered by the service provider to its customer. Equipment Leasing/finance are long term financing activities undertaken as their business by NBFCs. As far as the taxable value in case of financial leasing including equipment leasing andis concerned, the amount received as principal is not the consideration for services rendered. Such amount is credited to the capital account of the lessor/service provider. It is the interest/ finance charge which is treated as income or revenue and which is credited to the revenue account. Such interest or finance charges together with the lease management fee/ processing fee/ documentation charges are treated as considerations for the services rendered and accordingly they constitute the value of taxable services on which service tax is made payable. In fact, the Government has given exemption from payment of service tax to financial leasing services including equipment leasing andon that portion of taxable value comprising of 90% of the amount representing as interest, i.e., the difference between the instalment paid towards repayment of the lease amount and the principal amount in such instalments paid (See Notification No. 4/2006Service Tax dated 1.3.2006). In other words, service tax is leviable only on 10% of the interest portion. (See also Circular F.No.dated 9.7.2001 in which it has been clarified that service tax, in the case of financial leasing including equipment leasing andwill be leviable only on the lease management fees/ processing fees/ documentation charges recovered at the time of entering into the agreement and on the finance/ interest charges recovered in equated monthly instalments and not on the principal amount). Merely because for valuation purposes inter alia "finance/ interest charges" are taken into account and merely because service tax is imposed on financial services with reference to "hiring/ interest" charges, the impugned tax does not cease to be service tax and nor does it become tax onleasing transactions under Article 366(29A) read with Entry 54, List II. Thus, while State Legislature is competent to impose tax on "sale" by legislation relatable to Entry 54 of List II of Seventh Schedule, tax on the aspect of the "services", vendor not being relatable to any entry in the State List, would be within the legislative competence of the Parliament under Article 248 read with Entry 97 of List I of Seventh Schedule to theour view, the judgment in Bharat Sanchar Nigam Limiteds case has no application to the present case. As stated above, what is challenged in this case is the service taximposed by Section 66of the Finance Act, 1994 (as amended)on the value of taxable services referred to in Sectionread with Section 65(12) of the said Act, insofar as it relates to financial leasing services including equipment leasing andas beyond the legislative competence of Parliament by virtue of Article 366(29A) of the Constitution. In short, legislative competence of the Parliament to impose service tax on financial leasing services including equipment leasing andis the subject matter of challenge. Legislative competence was not the issue before this Court in the Bharat Sanchar Nigam Limiteds case. In that case, the principal question which arose for determination was in respect of the nature of the transaction by which mobile phone connections are enjoyed. The question was whether such connections constituted a sale or a service or both. If it was a sale then the States were legislatively competent to levy sales tax on the transaction under Entry 54, List II of the Seventh Schedule to the Constitution. If it was service then the Central Government alone had the legislative competence to levy service tax under Entry 97, List I and if the nature of the transaction partook of the character of both sale and service, then the moot question would be whether both the legislative authorities could levy their separate taxes together or only one of them. It was held that the subject transaction was a service and, thus, the Parliament had legislative competence to levy service tax under Entry 97, List I. In para 88 of the said judgment, this Court observed that "No one denies the legislative competence of the States to levy sales tax on sales provided that the necessary concomitants of a sale are present in the transaction and the sale is distinctly discernible in the transaction. This does not however allow the State to entrench upon the Union List and tax services by including the cost of such service in the value of the goods". The principle of law in para 88 squarely applies to the present case. As stated above, we are concerned with "financial leasing services" which are sought to be taxed under Section 65(12)(a)(i). The taxable event is indicated in Section 65(105)(zm). As stated above, the impugned provision operates qua an activity of funding/financing of equipment/ asset under equipment leasing under which a lessee is free to select, order, take delivery and maintain the asset. The lessor (NBFC) arranges the finances. It accepts the invoice from the vendor (supplier) and pays him. Thus, the lessor (NBFC) renders financial services to its customer(s) and what is taxed under the impugned provision is the income, by way of finance/ interest charges in addition to management fees/ documentation charges, which is earned by the financier (lessor). The taxable event is the service which is rendered by the finance company to its customer(s). The value of taxable service under Section 67 is income by way of interest/finance charges (measure of tax) which is not determinative of the character of the levy. Thus, Section 67 of the Finance Act, 1994 seeks to tax financial services rendered by the appellant(s) with reference to the income which the appellant(s) earns by way of interest/ finance charges. In the circumstances and for the reasons given hereinabove, the question of splitting up of transactions, as contended on behalf of the appellant(s), does not arise. As held hereinabove, equipment leasing andfinance constitute long term financing activity. Such an activity was not the subject matter of the discussion in the Bharat Sanchar Nigam Limiteds case.The service taxin the present case is neither on the material nor on sale. It is on the activity of financing/funding of equipment/asset within the meaning of the words "financial leasing services" in Section 65(12)(a)(i). Lastly, we may state that this Court has on three different occasions upheld the levy of service with reference to Entry 97 of List I in the face of challenges to the competence of the Parliament based on the entries in List II and on all the three occasions, this Court has held that the levy of service tax falls within Entry 97 of List I. The decisions are in the case of T.N. Kalayana Mandapam Association (supra), Gujarat Ambuja Cements Ltd. (supra) andFederation of Tax Practitioners (supra).