Taxation of economic surplus — why liquor companies still getting GST demand notices despite clarification

The complexities in the alcoholic beverage industry in India are manifold. One such area is obtaining necessary approvals from various State authorities. In order to manage these intricacies, the industry enters into a unique arrangement wherein two parties, namely, a contract bottling unit (‘CBU’) which has the necessary infrastructure and licenses to manufacture liquor; and a Brand Owner (‘BO’) who possesses the know-how and ownership of brand of liquor to be manufactured, collaborate for production of liquor.

In this arrangement — known as ‘contract bottling arrangement’, the CBU agrees to produce liquor of brands of the BO using its own infrastructure under the supervision of employees of the BO. The various costs associated with the production such as cost of raw materials license fee and VAT are borne by the BO. 

It is worth mentioning that the CBU is only responsible for production of liquor and is paid for the liquor manufactured irrespective of the actual sale of liquor. The risk and reward vest with the BO who ensures that liquor is produced using its know-how and trade secrets. As the risk and rewards vest with the BO, any surplus amount (typically known as “economic surplus”) remaining after deduction of various costs required to be borne by BO from the sale proceeds belongs to the BO. 

While the CBU pays applicable service tax/ GST on the amount received from the BO as consideration for manufacturing liquor, the taxability of economic surplus has been a bone of contention between the department and taxpayers. Despite a clarification that such amount is not taxable being profit of the BO, the department has been disputing the non-levy of Service Tax on such amount from time to time. 

In the Notices issued to BOs demanding Service Tax, the primary allegations revolve around the economic surplus being a consideration for services of transfer of right to use intellectual property (‘IP’) or for franchisee service by the BO. In the appeals before the Appellate Tribunals in various cases including the case of BDA Pvt. Ltd, the Tribunals consistently held in favour of the BOs. Further, this dispute appeared to be settled when the matter finally reached before the Honourable Apex court in appeal filed by the department in case of BDA Pvt. Ltd and the Apex court also held in favour of the BO i.e., BDA in the said case.

 With the onset of GST regime, the negative orders issued by Advance ruling Authority (‘AAR’) and Appellate AAR (‘AAAR’) has reignited the questions of taxability of the economic surplus. 

The moot question is whether there is any substantial change in levy of tax on services in the GST regime which requires an examination of taxation of those services when such taxability was settled in the pre-GST regime. The answer seems to be in negative considering that the charging event for levy of tax in case of supply of services is same under both the regimes i.e. tax is levied on supply/provision of services. 

It is worth noting that as far as payment of GST on economic surplus is concerned, there exist divergent stands in the industry. On the one hand, there are certain industry players who are discharging GST on economic surplus, there are others who have taken a stand not to pay GST on such surplus. It is interesting to note that appeal filed by department in one of service tax matter is presently pending before the Hon’ble Supreme Court. In case, the matter is decided against the assessee, the same may have severe implications under GST regime as well. 

It is noteworthy that recently, the Government has provided, or it has been proposed in the GST council meetings to provide relaxation to various industries such as insurance, film distribution and foreign airlines after representation from these industries.

It remains to be seen whether any pre-emptive approach would be adopted by the Government to clarify the taxation position for such disputes which were settled by the Apex Court in pre-GST to save industry from the hassles of uncertainty and unnecessary litigation. The need for such clarification arises more so in the backdrop that in pre-GST regime, CBIC had issued similar clarifications as mentioned above. 

It is worth highlighting that in the GST regime, though a draft circular is already pending for consideration of the GST Council, in the absence of any specific clarification on this issue, any disputes on this account are not likely to be settled in the foreseeable future. Considering that industry is following different approaches, relief by Government should be provided on ‘as is where is basis’ to safeguard the interests of all. 

In the above background, it is of paramount importance for the industry players to bear this in mind that entering into such bottling arrangements with a surplus model may give rise to tax dispute from the department.