Nexus theory in CENVAT credit - Losing nexus with roadmap for future

JANUARY 25, 2013

By M S Mani and Harsh Shah, Deloitte Touche Tohmatsu India Private Limited

THE Report of Kelkar Task Force on Indirect Taxes had as early as in 2002 envisaged need for integration of service tax and central excise legislations and had suggested a common credit mechanism for service tax and central excise for eventual integration of the two legislations. Introduction of CENVAT Credit Rules, 2004 (‘CCR') by integrating the erstwhile CENVAT Credit Rules, 2002 and Service Tax Credit Rules, 2002 was a move primarily for giving effect to the above mentioned recommendations of Kelkar Task Force. Further, the Report strongly recommended expansion of credit mechanism so as to avoid cascading effect of taxes.

CCR provide for a common credit mechanism for goods and services with credit of capital goods, inputs and input services being available to manufacturers of final products and providers of taxable service in a common credit pool. However, despite the intent of legislature to extend credit in respect of all input taxes and hence abolish cascading effect of taxes, the issue of input taxes being cost burden on the industry has intensified over a period of time. The narrow interpretations of definitions of capital goods, input and input services have resulted into a lot of input/ input services which actually contribute to final products/ output services not being eligible for CENVAT credit. Services such as architect's services used in relation to factory of manufacturer/ premises of output service provider; catering/ convention services used for business meetings; services availed for employee welfare activities, etc. have been subject matter of constant litigation and the authorities have been denying CENVAT credit on such services and various other services on the ground of lack of direct correlation with manufacture/ service provision. The cascading effect of taxes springing forth from narrow interpretations of definitions under CCR can be observed from the fact that even in cases of cost-plus billing, CENVAT credit of inputs/ input services forming part of value of final products/ output services is being denied on the ground of lack of nexus.

At the stage of determining eligibility for CENVAT credit, provisions of CCR since its inception have contained requirement to establish nexus between the activity of manufacture/provision of service and goods/service in respect of which credit is being claimed. The nexus theory has been interwoven in the definitions of capital goods, inputs and input services providing that in order to be eligible for CENVAT credit, goods/ services should have been used ‘in the factory of manufacture of final goods' or ‘for providing output service' or ‘used in or in relation to manufacture of final products and clearance of final products up to the place of removal', etc. While a nexus as mentioned above is required in order to be eligible for CENVAT credit, the proximity of nexus required has been not clarified under CCR and hence has been a subject matter of considerable litigation . While in some cases the expression ‘used for…' has been given wide interpretation to include all activities having even remote connection with provision of output service/ manufacture of final products, there are precedents wherein direct and immediate connection with the provision of service or manufacture has been warranted. Further, in a number of cases, a very narrow interpretation of the expression ‘used for…' has been resulting into authorities denying CENVAT credit on services which are actually used in the business of provision of output service. Denial of credit on inputs/ input services forming part of value of final products/ output services in case of cost-plus billing, as discussed above, illustrates such narrow interpretations.

The insistence by the authorities in various cases to substantiate direct correlation between goods/ service used on input side with the goods/ service on output side has been causing practical difficulties and denial of CENVAT credit on a number of goods/ services, ultimately resulting into cascading effect of taxes. In the age of modern business practices where a complex combination of goods and services go into making of final products/ output services, establishment of immediacy of nexus may be difficult. Further, establishment of direct nexus becomes even more difficult in case of services because of intangible nature thereof. The difficulty is multiplied due to lack of clarifications on issues which have been subject matter of litigation since long.

The scope of respective definitions of capital goods, input and input services have been gradually narrowed down by amendments expanding list of exclusions. Deletion of phrases “used in or in relation to manufacture of final products whether directly or indirectly and whether contained in final products or not…” and “activities relating to business” from the definitions of input and input service respectively has resulted into the authorities demanding immediacy of nexus. While there has been an expansion in the taxability of services by way of introduction of negative list based taxation of services, a negative list by way of exclusions from definition of input service has resulted in reduction of services on which CENVAT credit can be availed.

It is understandable that a reasonable degree of nexus for determining eligibility of CENVAT credit may be warranted in order to prevent undue benefits being derived by certain section of assessees, requirement of immediacy of nexus narrows down the scope of CENVAT credit mechanism. Attaining a balance between these two factors becomes quintessential to ensure grant of due benefits to compliant assessees. The cascading effect of taxes can be avoided by ensuring flexibility of statutory provisions and broad interpretation of the nexus requirement to recognize all direct and indirect links between goods/ services used on input and output side.

Wide tax base covering almost all goods and services and a sound credit mechanism to eliminate cascading effect of taxes are the fundamentals of Goods and Service Tax Regime (‘GST'). While various steps such as introduction of negative list based taxation of services towards implementation of GST have been taken and even bigger changes are expected in the days to come rigid interpretation of nexus theory supported by recent amendments in CCR is expected to cause cascading effect of taxes and hence conveying an unintended intention. The very purpose of introduction of CCR was integration of service tax and central excise legislations and hence to create a base for GST. However, the same appears to be facing challenges in the wake of amendments made in recent past. Efforts should be made to ensure that we walk hand in hand as regards expansion of tax base and credit base and not seek to expand the tax base and restrict the credit base.

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