Drafting of Agreements and Nomenclature in Accounts – a tool to avoid unwarranted litigation on taxation

[dipsang vadhel]

In our professional life, we come across many instances where litigation on taxability or valuation of Excise duty, Sales tax or service Tax is based on the terms used in the agreement or treatment made by business entities made in its books of account.

Law is well settled in case of Delhi Cloth and General Mills Co. Ltd., etc. vs. The Commissioner of Sales Tax, Indore, reported in 1971 (7) TMI 133 - SUPREME COURT OF INDIA that the levy and collection of tax is regulated by law and not by contract (Para 10 of the judgment). Therefore, merely naming sale proceeds as Administrative charges or service charges or buyer as dealer or agent or distributor will not convert a transaction of sale & purchase in to transaction of service or vice-versa. Similarly, naming commission as trade discount or vice versa will not change its impact for valuation rules. This is also well supported in case of CIT v. Vaikundam Rubber Co. Ltd. 1999 (9) TMI 57 - KERALA HIGH COURT wherein it was held that When the question is whether a receipt of money is taxable or not or whether certain deductions from that receipt are permissible in law or not, the question has to be decided according to the principles of law, and not in accordance with accountancy practice. Accountancy practice cannot override the provisions of the Act.

We also come across the agreements, MOU, contracts and their accounting treatment in books of as business entities containing liberal usage of terms such as (i) buyer, Agent, handling agent, distributor, purchaser, (II) Commission, trade discount, service Charge etc. Here it is needless to say that such liberal usage of the terms may not attract more tax as it is well settled that while interpreting the terms of agreement, the court looks to the substance rather than form of it but surely give rise to more unwarranted litigation & avoidable cost. Therefore, the drafting of agreement or Memorandum of understanding assumes greater significance in recent times due to revolutionary change in concept of sale and service. Careful drafting will long way in avoiding that unwarranted litigations. Some of the commonly used terms and its implication illustrated as under:

1) Distributor-Agent-Agency V/s. Buyer –

Generally, the terms dealer-distributor-agent- handling agent-buyer are used liberally in contracts, agreements and accounts. Use of the term “agent” or “agency” will result in to litigation as to whether the contract is for sale or service. The revenue authorities may demand tax on such transactions or a part treating as Service if goods in question are exempted or non-taxable or vice versa either in hand of buyer or in hands of dealer depending upon circumstances of the case.

Such loose usage of the term “agent or agency will lead to the question:  whether transaction is of sale or was of agency for sale.   In this regard, a reference is made to the judgment of Supreme Court. The court in case of The Bhopal Sugar Industries ltd v/s. Sales tax Officer Bhopal 1977 (4) TMI 151 - SUPREME COURT OF INDIA wherein the question was whether the contract was of agency or sale. The court held that the question will have to be determined having regard to the terms & recitals of the agreement, the intention of the parties as my be spelt out from the terms of the document and the surrounding circumstances and having regard to course of dealing between parties. While interpreting the terms of agreement, the court looks to the substance rather than form of it. The mere fact that the word ‘agent’ or ‘agency’ is used or the words” buyer’ or ‘seller’ are used to describe the status of the parties concerned is not sufficient to lead to the irresistible inference that the parties did in fact intend that the said status would be conferred.

It is needless to mention that tax treatment of such sale & purchase under Excise, Service tax & sales tax law would be different in hands of parties concerned depending upon fact that whether transaction is of sale or was of agency for sale.

2) Commission – Service charge V/s. Trade discount-

You will also come across the instances when the discount is termed as either Commission or as service charge in agreements/ contracts/MOU or accounts. It is appreciated that Excise & sales Tax law etc. allows deduction of certain items like discounts. But, the same payment may not be allowed routinely if it is termed as “commission/Service Charge”. Therefore, prudently, the terms should be used only after careful consideration of implication arising out of appearance of a particular term in the circumstances of case. In similar cases, the revenue authorities may also demand Service tax from the dealer who has received such Trade discount in the name of Commission.

In this regard, a reference is invited to judgment of the Supreme Court in case of Moped India ltd. v/s. Astt. Collector of Central Excise, Nellore and Ors.  1985 (2) TMI 42 - SUPREME COURT OF INDIA wherein, it is held that the amount deducted while determining excisable value of mopeds has been referred to in agreements as commission but the level given by parties cannot be determinative because if we look at the terms of agreement, it is clear that the agreement was between the appellants and the dealers on principal to principal basis. The clauses of the agreement which we have set out above clearly show beyond doubt that under the agreement, the mopeds were sold by the appellants to the dealer and the dealers did not act as agents of the appellants for the purpose of effecting sales on behalf of appellants. The relationship between the appellants and the dealers was clearly on principal to principal basis and circumstances it is difficult to see how the amount allowed to dealers can be regarded as anything other than trade discount.

It is needless to mention that if such terms are loosely used, business entities will have to litigate the matter to get due treatment.

Thus, given the present days complexities of the transactions emerging out of expanding needs of the society and business needs to be analyzed in circumstances of Individual case to understand its accounting & tax implication. The terms to be used in agreements, contracts, MOU etc. should be selected keeping in view the substance of transaction rather than usual accounting way of looking and recording such transaction. This approach is advisable particularly in view of penalty & prosecution provisions as exists under various tax laws. These penalty & prosecution provisions provides that a person can be prosecuted if the transactions maintained in books of account does not represent true & correct picture of the transactions. Further, penal provisions are liberal where transactions are captured fully & truthfully in records & books of account.

In nutshell, Prevention is better than Cure & this applies to business as well. Therefore, agreements should be drafted only after careful evaluation of implication of such terms deployed in the contract on taxation aspect of transaction.