Sales tax on Warranty Replacements: A case of Double whammy?

[Parthasarathy Rajagopalan]

On 15^th May, 2023, a three-Judge bench of the Supreme Court rendered the decision in M/S. TATA MOTORS LTD. VERSUS THE DEPUTY COMMISSIONER OF COMMERCIAL TAXES (SPL) AND ANR. - 2023 (5) TMI 744 - SUPREME COURT, holding that Free of Cost (‘FOC’) replacement of defective parts (under warranty) as between Automobile Dealer (Assessee)andend-customer, is in actuality a ‘taxable sale’ of such spares as between the Dealer and the Original Equipment Manufacturer (‘OEM’). This decision afflicts a severe blow to Automobile Dealers. Through the passage of this Article, the authors endeavour to deconstruct this decision, inter alia aid the industry in contesting the issue, and suggest the way forward. The authors endeavour to explain the issue shorn of its legal nitty-gritties, in simple, trade-friendly language.

The Transaction under the scanner

• Dealer-Assessee purchases automobiles from the OEM on Principal-to-Principal basis, in terms of the Dealership Agreement.
• Among other terms, the Dealership Agreement stipulates that the Dealer-Assessee is obligated to replace defective spares, as necessary, on FOC basis, if the customer approaches him while the warranty subsists (‘Warranty clause’).
• Upon fulfilment of this obligation, the OEM shall compensate the Dealer-Assessee by issuing credit notes qua warranty replacements made.

How the dispute reached the doorstep of the Apex Court

The issue was placed for consideration before the Three-Judge Bench vide Referral Order dated 05.02.2019. Through this Referral Order, the Two-judge bench before which the matter was originally placed, raised the following questions:

1. In the context of discussions concerning price of automobile intrinsically including cost of warranty replacement spares, whether such spares can again be subject to Sales tax?
2. Since the warranty replacements are made on FOC basis, whether it is a transaction sans ‘consideration’, thereby rendering it outside the ambit of Sales Tax law?
3. Whether ‘credit notes’ can be treated as a mode of payment contemplated by Sales Tax law?
4. Whether the decision of the Supreme Court in MOHD. EKRAM KHAN & SONS VERSUS COMMISSIONER OF TRADE TAX, UP. (AND ANOTHER APPEAL) - 2004 (7) TMI 341 - SUPREME COURT, which ostensibly governs the issue at hand, is good law?

An issue missed under broad daylight

For clarity, it is necessary to point out at this juncture itself that, even while the Referral Order (relevant excerpt reproduced in para 3 of the judgment) raises the 4 issues captured above, the Supreme Court confined to answering questions (ii), (iii) and (iv) alone. This is evident from paragraphs 4 and 5 and the concluding paragraphs of the decision. The decision nowhere touches upon issue (i).

Findings contained in the Judgment

As already outlined in the introduction, readers would be aware that the Judgment favours the Revenue.

In a nutshell, the Judgment holds that the Warranty Clause contained in the Dealership agreement [being the ‘contract to sell’ element in the sale transaction] is the collateral contract that binds the Dealer when a warranty replacement situation arises [being ‘promise’ element in the sale transaction]. Further, it holds that there is transfer of property at the behest of the OEM when there is replacement of spares [being ‘title transfer’ element in the sale transaction]done in exchange for ‘credit note’ issued by the Manufacturer [being ‘consideration’ involved in the sale transaction]. Thus, the judgment holds that all the 4 elements of a ‘taxable sale’- as required for attracting tax liability under Sales Tax law stand satisfied.

Most importantly, in arriving at this conclusion, this judgment holds out that this very position of law was already settled in Mohd. Ekram Khan & Sons, and concludes without contemplating any further.

Missing piece in the puzzle

As the saying goes, the devil is in the details. Thus, the role of Mohd. Ekram Khan & Sons case needs to be examined, albeit briefly, to understand this judgment in its entirety.

Admittedly, the facts in Mohd. Ekram Khan & Sons and the facts underlying this judgment are identical. Also, admittedly in Mohd. Ekram Khan & Sons, the Supreme Court decided issues (ii), (iii) and (iv), which is now held to be good law. Thus, by upholding Mohd. Ekram Khan & Sons, the Supreme Court decided upon issues (ii), (iii) and (iv).

In Mohd. Ekram Khan & Sons,Dealer-Assessees heavily relied on PREMIER AUTOMOBILES VERSUS UOI. - 1971 (11) TMI 159 - SUPREME COURT in an attempt to have the issue decided in their favour. In Premier Automobiles, although the Supreme Court dealt with a different set of issues arising out of similar facts, the Court emphatically recognized the trade prudence that the price of each automobile sold would necessarily comprise an in-built ‘warranty replacement cost’ component. Thus, the established trade practice was well-recognized by the Supreme Court in its earlier judgment in Premier Automobiles.

It is after acknowledging this very trade practice, issue (i) was specifically raised by the Two-judge Bench in their Referral Order. However, history repeated itself- this trade practice was completely ignored by Mohd. Ekram Khan & Sons in 2004 by merely factually distinguishing Premier Automobiles. Now again, this trade practice is ignored in 2023 by simply upholding  Mohd. Ekram Khan & Sons as good law.

Then and now, the role of an in-built ‘warranty replacement cost’ has been accorded a quietus. Interestingly, sans context, this Judgment vide paragraph 13.8, brings forth jurisprudence on this in-built ‘warranty replacement cost’/ complaint reserve by making a passing reference to BHARAT HEAVY ELECTRICALS LTD. VERSUS COMMISSIONER OF CUS. & C. EX., INDORE - 2003 (3) TMI 110 - SUPREME COURT only in vain!

Thus, while it may be true that the transaction under the scanner amounts to a sale, the Supreme Court has now seemingly ordered that these replacement spares which have already suffered tax as part of sale price of the Automobile, are now to be doubly jeopardized!

Thus, by adopting such a myopic view, this judgment (in its last paragraph) ends up dismissing the appeals filed by the Dealer-Assessees’ and allowing revenue appeals instead of simply deciding on the correctness of Mohd. Ekram Khan & Sons and remitting the matter back to the Two-Judge bench.

Way Forward...

The industry may press on this very point to pursue a Review petition. Dealer-Assessees may also contest proceedings before lower courts/authorities in second-round of litigation on the ground that the spares have already suffered tax.

The industry may note that this decision does not apply to cases where the OEM directly supplied the warranty replacement spares to the Dealer-Assessee.

It goes without saying that Dealer-Assessees are open to contend that relationship between them and OEM is that of Principal-Agent, in which case Service tax liability may be attracted (subject to subsistence of limitation period for assessment).

Any which way, these are testing times for the industry!