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UNEARNED INCOME (RENT, INTEREST AND ROYALTY)- SERVICE TAX IS CONCEPTUALLY WRONG.

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UNEARNED INCOME (RENT, INTEREST AND ROYALTY)- SERVICE TAX IS CONCEPTUALLY WRONG.
By: C.A.†DEV KUMAR KOTHARI
January 31, 2011
All Articles by: C.A.†DEV KUMAR KOTHARI       View Profile
  • Contents

Summary:

Unearned income or receipts like rent, interest, dividend, royalty for copy/ use rights (particularly on inherited properties) are received without rendering any service. These considerations are simply for allowing other person property for use without any activity by the owner. The property is handed over on temporary basis to other person for use. The other person may or may not use the property, yet the owner get his reward in nature of rent, interest or royalty. In such cases principally there should not be any levy of service tax because any service is in fact not rendered. We find that interest on any loan is not included in taxable value of service, in case of lease and hire purchase there is abatement equal to 90% of lease charges. In case of letting out of properties in nature of commercial PROPERTIES (LIKE BUILDINGS) or any other tangible properties like plant and machinery the rent is in nature of reward for capital invested/ or market value of property it is like interest, there is recompense for wear and tear of property and statutory levies etc. Therefore, in such cases, first of all service tax is not a proper levy in absence of any service and in any case there need to be substantial abatement measured with reference to amount of rent on account of reward for capital, and recompense for wear and tear and statutory levies etc.   

Service and service tax:

Service tax is basically a tax on service rendered by service provider to the service receiver. This means an active involvement of service provider in carrying an activity which is in nature of service to the service receiver. Thus, service tax is basically on a service which results into doing some work with help of service or facility provider and which has also effect of value addition in the hands of service provider as well as receiver. In one sense the service receiver, instead of doing some work himself; get it done from another person. In some cases services are of such nature that a specialized service provider is engaged as the service receiver cannot perform the same himself or from within his organization. For example, a company can have external person to do internal audit or can have own department for internal audit. However, company has to engage an independent auditor for doing statutory audit.

Service provider his remuneration and his resources:

Service provider receive consideration for activity performed  or service rendered to the service receiver –if there is no service provided, there will be no accrual on remuneration. Depending on nature of service, the service provider may have organized manpower and arrangements for organizational facilities in nature of buildings, plant and machinery, equipment etc. Some personalized services may be provided without much organizational support. 

Thus, basically service charges are for an activity or service. Such charges may be known by different names according to the nature of service and service provider for example; professional fees of a CA, CWA, and CS can be in nature of audit fees, attestation fees, certification fees, consultation fees, document drafting fees, representation fees, retainer ship fees etc. In case of doctor fees can be consultation fees, operation fees, retainer ship fees etc.

Employment vs. service provider:

An employee also render service, however, he is not a service provider but an employee of the employer. An employee work on behalf of employer and get remuneration in nature of wages or salary from the employer. This is not fees for service rendered, but remuneration paid to employee for hiring him for doing work on behalf of employer. Therefore, consideration paid to employees is not subject to service tax. There is no relationship of service provider and service receiver.

Some activities or services are such that they can generally be obtained from an outsider agencies due to large size of service provider   like service of Telecom Company, banking and insurance companies, internet service provider or due to statutory requirements etc. Whereas many services are such which can be performed by own team popularly called in house services or – captive services.

Charges earned or income earned:

Any charges or income which are earned for doing some work by personal efforts with or without support of organization and machines etc. are charges or income for an activity and are in nature of earned income.

Economic concept of unearned income:

Rent is the foremost primary category of unearned income in economic concept dividend and interest were added later on unearned income.  

http://www.enotes.com/econ-encyclopedia/unearned-income

Unearned income
Personal income derived from property ownership rather than work. It thus consists of rent, dividends and interest.

http://www.economics-dictionary.com/definition/investment-income.html

income (such as interest and dividends) from investments, not from salary, wages or profits of a business.

http://en.wikipedia.org/wiki/Unearned_income

Unearned income is a term in economics that has different meanings and implications depending on the theoretical frame. To classical economists with their emphasis on a dynamic competition income not subject to competition are “rents” or unearned income. In a Marxian context with labour as the only factor of production all income that is no wage is unearned. In a neoclassical frame it may mean income not attributed to any factor of production. Generally it may be used for windfall profits for example when population growth increases the value of a plot of land.

From Merriam Webster’s Dictionary and Thesaurus:

un·earned

1: not gained by labor, service, or skill

2: scored as a result of an error by the opposing team ‹an ~ run›

Earned income vs. unearned income illustrated:

Mr. Landlord has two buildings “A” and “B” which are used as follows:

Building “A” is used as  a hotel, restaurant and allied facilities including  lounge, Beauty salons,   swimming pool, yaga centre, banquet hall, common dining space for buffet meals,  etc. In this case there is an activity carried by Mr. Landlord, by running facilities the income is earned by way of room charges, restaurant bills, other facilities chares etc. These all are in nature of earned income of the owner of building Mr. Landlord. He may have income or loss depending on volume of business, occupancy of rooms, revenue earned vis a vis costs incurred etc. It is found that in initial four year he suffered loss in the business carried at building “A” because he could not achieve break-even status, in fifth year he just achieved break-even and earned a small profit. In sixth and seventh year in view of booming activity he earned very substantial profits. Again due to recession in eighth year he suffered loss due to lesser room occupancy. In last two years, he had good business by volume vise and better  room occupancy, however, due to increase in costs he could not make good profits because entire increase in costs could not be passed over to customers due to heavy competition in business thus he earned nominal profit.

Another building known as building “B” is let out to M/s. Hotels and Restaurant Ltd. Mr. landlord gets fixed rent from tenant as per agreement. The landlord is not carrying any activity in the building “B”. All activities of hotel business are carried by the tenant. Even repair and maintenance are carried out by tenant.  The tenant pay regularly rent as agreed. Mr. Landlord, as owner of building does not render any service to tenant.

The rent received from tenant is in nature of un-earned income because the landlord has not carried any activity and has not rendered any service to the tenant. Whether, the tenant runs hotel or not, whether he earns income or suffer loss is not consideration so far earning of rent is concerned. This is because the rent is received for the building “B” let out to tenant who may be able to or  may not be able to  use it fully  for running his business.  Therefore, there is no service and activity or value addition by letting out of building, there is no activity or  value addition in hands of land lord or tenant by mere activity of letting out building “B” to the tenant.

Therefore, in this case there is no service. In absence of any service there should not be any service tax.  

Provisions of the Finance Act 1994 in relation to service tax on some unearned income:

We find that attempts have been made to impose tax on some activities where there is no service or value addition. We also find that exemptions are also allowed from service tax on some unearned incomes. Few examples:

Interest: Interest on any loan is not included in valuation of taxable service.

Leasing- 90% of lease rentals and hire are not subject to service tax.

Rent on commercial property:

In case of rent on commercial property (the popular term) we find that there is no abatement except for a deduction in respect of tax on property actually paid to local authorities like Municipality.

As discussed earlier rent on commercial property is also an unearned income without any service rendered or value addition made by the owner of the property. The rent can be considered as reward or recompense towards:

  1. Some return on investment –this is like interest on investment or market value of building. In case of letting out of property, in economic sense we can say that loan is given in kind (property)  by the owner to the tenant (a borrower in kind). The tenant like a borrower   can use building for specified purposes. Just like in case of lending of money interest is payable irrespective of profits of loss of borrower, in case of let out property, tenant ahs to pay rent irrespective of profit or loss made by him by using the property.
  2. Towards wear and tear- a part of rent is supposed to be around meeting costs of replacement of property as it get worn out by use and passing  of time.
  3. Towards statutory levies like municipal tax, property tax, water tax, wealth tax etc.    

Therefore, taking entire amount of rent for valuation of service is also not proper. When an abetment of 100% in respect of interest on loan, and 90% in case of lease and hire purchase is allowed, there is no justification of treating entire amount of rent (minus municipal tax actually paid) as value of taxable service when in effect there is no service at all. In any case there should be substantial abatement with reference to the amount of rent for reward on capital (like interest), wear and tear, and recompense for statutory levies.

 

By: C.A.†DEV KUMAR KOTHARI - January 31, 2011

 

 

 
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