Xiaomi India Pvt Ltd v State of Karnataka: Can contracts shape tax outcomes?

Dr. Nigam Nuggehalli [1]

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The case of Xiaomi India Pvt Ltd v  State of Karnataka (hereafter Xiaomi), decided by the Karnataka High Court, is actually a simulation of a case because it did not yield a decision. The court remitted the case back to the Joint Commissioner of Commercial Taxes (the ‘adjudicating officer’) to review the case once again after hearing the parties more comprehensively on the applicable law. It is likely that after the adjudicating officer has taken his decision, the case will once again reach the Karnataka High Court on the rebound.

In the meantime, the issues in the case are remarkable enough for an immediate review. A more thorough analysis will have to wait when (or if) the case comes up through the appeals process. This case note analyses the tax issues in this case from a private law lens: the ability of contracts to shape tax consequences. The ability of contracts to shape the reality of legal parties inter se is well known. By making binding promises to each other, contracting parties change their legal entitlements and obligations that were not present before the contracts were entered into.^[2] Contracts, by creating legal rights and duties, are also able to change other juristic realities; for example, in the domain of tax law. A person can, in principle, use contracts to change his tax consequences.[3]

The famous McDowell case is an example of the use of contracts to impact tax obligations. The issue in McDowell was about the payment of a sales tax on liquor. Sales tax is usually imposed on the price at which a seller supplies their products in the market. This price in the normal course also includes any taxes paid by the seller such as excise taxes. The taxpayer in McDowell, a seller of liquor, entered into a contract with his customers such that the customers were under a separate contractual obligation to pay the excise duty on the liquor. The taxpayer’s contractual arrangements with his customers allowed the taxpayer to argue that the sales revenue for sales tax purposes did not include the excise duty paid on the liquor, because the excise duty was not paid by the taxpayer but by his customer. Until the government amended the applicable sales tax law and until these amendments received judicial benediction in McDowell, the taxpayer was able to get away with his tax planning scheme through the manner in which he structured his contracts.

Xiaomi is another example of the use of contracts for purposes of tax mitigation. The case dealt with the GST liability of Xiaomi India Pvt Ltd (Xiaomi India). Xiaomi was an Indian company that was one part of a tripartite business arrangement. At the apex of this arrangement was its ultimate parent company, the Chinese giant Xiaomi, a manufacturer of mobile phones. However, for the Indian market, Xiaomi did not manufacture phones directly. Instead, the manufacturing was delegated to Indian third-party manufacturers under license. The third element in this business was Xiaomi India, which was the Indian distributor of the mobile phones manufactured by the third-party vendors.

What happened next is a matter of contracts and GST legislation. It would be useful at this point to outline the basic architecture of the GST legislation. The GST legislation imposes a tax on the supply of goods and services (see s.7 of the CGST Act, 2017). When a vendor supplies goods to the purchaser, the GST legislation imposes a responsibility on the vendor to calculate the GST on the supply and remit the tax to the government. The purchaser can deduct the GST imposed on the supply to him from any onward GST obligations when the purchaser in turn supplies his goods or services to his customers. This ability to deduct GST paid earlier from onward GST obligations is a special feature of the GST legislation and is termed as an input tax credit (‘ITC’).

Normally, if the ITC exceeds the onward tax liability, the supplier receives a refund from the government. The use of the ITC is blocked if the onward supply by the vendor is exempt from GST, as the supplier will get a double benefit of an exemption from GST and a refund of ITC. One exception to this rule is the case of exports. Even though exports are exempted from GST, the exporter is allowed under the GST law to obtain a refund of unutilised ITC, presumably to encourage export activities.

For reasons that were not made clear in the judgment, Xiaomi India had substantial unutilised ITC from its supplies received from the Indian third party manufacturers. Xiaomi India claimed these unutilised ITC on another contract it had with its parent company. It is this second agreement that was controversial. This was a Sales Reward Agreement (SRA) under which Xiaomi India would earn a bonus if the Indian market share of Xiaomi phones reached certain targets. It was the amounts paid under the reward agreement that formed the point of contention between the taxpayer and the revenue. The taxpayer argued that the reward money was in consideration of an export of services to its parent. Since the services rendered under the reward agreement comprised an export for GST purposes, it was a zero-rated service and entitled the taxpayer to utilise its unutilised input tax credits.

The revenue resisted the refund of ITC. The revenue did not deny the status of export to the services rendered by the taxpayer under the SRA. Rather, the revenue took a different tack. The revenue argued that the SRA did not result in a supply of services that is captured by GST legislation. This is the kind of argument that comes usually from the taxpayers arsenal. That this argument came from the revenue bears a more careful analysis, and once again concerns the foundations of the GST legislation.

Under the Indian GST legislation, a supply of goods and/or services is the trigger for the imposition of GST. The CGST Act defines supply in an expansive fashion. The charging section (see s.9, CGST Act, 2017) begins with a standard clause providing that supplies of goods and services are subject to GST. A supply is defined separately and in a circular fashion as ‘all forms of supply” of goods and services for consideration and in furtherance of business (see s.7, CGST Act, 2017). The  legislation’s default approach is to avoid placing any limitations on the ambit of a supply other than what is contained in the legislation itself. With this approach, the GST legislation is following the model of the income tax legislation, which likewise defines income in an inclusive and expansive fashion (see, for instance, s.2(24) of the Income Tax Act, 1961). Nevertheless, as we have seen in the context of income tax, all definitions can, in some circumstances, be bent to the aid of taxpayers. In this case, as is discussed below, it is paradoxically the revenue that tried to take advantage of the meaning of supply in the GST legislation.

The broad ambit of supply in the legislation is subject to four deeming devices. The first device deems certain transactions as supplies even if these are not in the furtherance of business (see S. 7(1)(b), CGST Act, 2017). The second device deems certain transactions as supplies even if there is no consideration involved (see CGST Act 2017, Section 7(1)(c) read with Schedule I). The third device deems certain transactions as non-supplies regardless of whether they meet or fail to meet any of the elements of a supply (see CGST Act 2017, Section 7(2)(a) read with Schedule III). The fourth deeming device designates supplies as either a supply of a service or a supply of a good regardless of how these might be characterised in reality (see CGST Act 2017, Section 7(1A), read with Schedule II). Whether a supply is considered as a supply of a good or a supply of service is important because there are different rules for certain events: for example, the time of supply, depending on whether it is a supply of a good or a service.

It was the fourth deeming device that was implicated in Hyundai. Schedule II of the CGST legislation develops the fourth deeming device by identifying supplies with certain characteristics as deemed supplies of services. One of these deemed supplies of services is “Agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act.” On the face of it, the inclusion of this deeming provision is odd. Aren’t all contracts of services about obligations?

All contracts are not about obligations on both parties. A might agree to compensate B without B being under an obligation to do anything. This would be the case if A agrees to give B a certain sum of money if and when B provides A with a good or a service. There is consideration flowing from both sides but the consideration received by A (eg B painting A’s house) is not connected with any obligations undertaken by B, because there aren’t any. This kind of contract is in fact not a contract of service but only a conditional contract. People won’t normally enter into such contracts unless it is to encourage or incentivise a certain behaviour (if you get me a book, I will reward you) or for marketing purposes (the reward of £1000 offered in Carlill v Carbolic Smoke Ball Co. to people who did not contract Influenza after using the Carbolic Smoke Balls.) Schedule II is not interested in such contracts because the person receiving money under the contract is not really performing a service in return for money; he is receiving money because a certain event or contingency mentioned in the contract makes it the case that he receives money on the happening of the event or contingency.

Let us call this version of deemed services as an ‘obligation based deemed service.’ The concept of an obligation based deemed service has resulted in a number of controversies including, for example, the issue of whether a receipt of liquidated damages would be considered as a supply of services for GST purposes. The revenue came out with a circular that clarified the scope of obligation based deemed services where it stated that any agreement in which one party received consideration in return for an obligation (to do or not so something) would result in an obligation based deemed service. The key point here is that the circular treats obligation based deemed services as those contractual services where one party has undertaken a distinct and identifiable obligation in return for consideration.

The revenue in Xiaomi relied on its circular to argue that the SRA did not result in a deemed supply of services for purposes of GST because the rewards were not a consideration in return for providing a distinct service that Xiaomi India was obliged to render to its customer. The reward agreement provided some sales targets which if met by Xiaomi India provided it with some monetary rewards. This arrangement was not the kind of arrangement envisaged under Schedule  II.

Xiaomi India argued that the SRA was precisely the kind of agreement envisaged under the rule discussed above. Xiaomi India had one looming problem in making this argument: the SRA did not contain any term explicitly imposing an obligation on Xiaomi India. For Xiaomi India to succeed in this argument, it had to argue that there was an implied obligation under the SRA. Xiaomi argued that the SRA contained an implied obligation on the part of Xiaomi India to use its ‘best efforts’ or ‘reasonable efforts’ to provide marketing services to its parent in return for which it was rewarded based on a certain formula. In recent years, both Indian and UK contract law jurisprudence has moved towards recognizing some concrete contractual obligations arising out of ‘best efforts’ and ‘reasonable efforts’ clauses.

The problem for Xiaomi India was not that the ‘best efforts’ or ‘reasonable efforts’ clauses could impose discrete obligations but whether such obligations could be implied into the SRA. Xiaomi India argued that these clauses could be implied in the SRA based on the test applied by the Supreme Court in Nabha Power Limited v. Punjab State Power Corporation (2017), where it was held that terms could be implied into a contract if the terms were: (1) reasonable and equitable, (2) necessary to give business efficacy to the contract, (3) it should ‘go without saying’, (4) capable of clear expression and (5) must not contradict any express term of the contract.

It is not clear how Xiaomi India expected to use Nabha because the ‘best efforts’ or ‘reasonable efforts’ term was not required to give business efficacy to the SRA. The SRA was perfectly efficacious even without such terms as all that was needed was for Xiaomi India to meet its sales targets and it would be entitled to its rewards. Further, Xiaomi India had already entered into a distributorship agreement with its parent under which it was required to ‘diligently and honestly execute its distributorship responsibilities in compliance with good industry practice’. It is not clear why, in the light of this clause in the distributorship agreement, there was any need to imply a ‘best efforts’ or a ‘reasonable efforts’ term in the SRA.

It is also puzzling that both parties’ primary focus was on the deeming definition of a supply of services as if the deeming definition exhausted the description of supply under the GST legislation. But that is clearly not the case. The definition of supply in section 7 is broad and inclusive. The deeming definition is only meant to clarify whether a given supply is a supply of a good or a supply of a service.[4] Xiaomi India could have argued that regardless of the deeming provisions in schedule II, the SRA resulted in a supply of services for purposes of the GST legislation. The revenue might have resisted this argument as well, stating that nothing can be a supply unless the contracting party is supposed to do or refrain from doing something distinct, as opposed to relying on an event (meeting sales targets) over which it had only partial control at best. The revenue made this argument in the context of the deeming provisions but there is nothing to indicate whether the revenue believed that its argument on supply went beyond the deeming provisions.

Xiaomi is an example of a taxpayer arguing the case for a certain kind of contract, namely a contract where one of the contracting parties ‘undertakes an obligation to do an act’. The taxpayer used arguments seeded from contract law to fashion tax outcomes relating to exports and supplies for GST purposes. Whether the contracting parties will succeed in their objectives will be known only if and when the appellate processes in this case are activated once again by either the taxpayer or the revenue.

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[1] Prof. (Dr.) Nigam Nuggehalli is a Professor of Law, and Chair Professor, Department of Revenue Chair, at the National Law School of India University, Bengaluru.

^[2] See HLA Hart, The Concept of Law (1961) 28, where he states that ‘The power thus conferred on individuals to mould their legal relations with others by contracts, wills, marriages is one of the great contributions of law to social life.’ See also, HLA Hart, “Positivism and the Separation of Law and Morals”, Harvard Law Review, Vol. 71, No. 4 (Feb., 1958), 593, 604, where he makes a similar point.

[3] On this connection between contracts and taxation, see Nigam Nuggehalli, International Taxation (2021) Ch 1.

[4] Section 7(1A) assumes that there is a GST supply in place before it is deemed to be either a supply of a service or a supply of a good under Schedule II.