In a decision last delivered last month, the Bombay High Court once again visited the debate over the meaning of ‘sale’, in the process of clarifying the scope of the obligation to deduct tax at source under section 194C of the Income Tax Act.
The factual matrix before the Court involved a unique business model adopted by pharmaceutical companies. Pharmaceutical companies adopt three methods for their products- certain products are manufactured by the company at its factory; the company gets some products manufactured on a license from third parties; and for some products, the company enters into agreements under which pharmaceutical products are manufactured by third parties to specifications and standards provided by the company under the trade-mark of the assessee. The issue was whether the third of these business models created an obligation to deduct tax on the pharmaceutical company under section 194C.
Section 194C provides that any person responsible for paying any sum to any resident for carrying out any work has an obligation to deduct tax at source on such payment. Thus, the crux of the issue was whether the supply of products by third parties to the pharmaceutical company constituted ‘work’ for the purposes of section 194C. The contention of the pharmaceutical companies was that these agreements were clear instances of sale, and given the well accepted distinction between sales contracts and works contracts, a sale could not be covered by the meaning of work. However, matters were complicated by the decision of the Supreme Court in Associated Cement Co. Ltd. v. CIT,  201 ITR 435. This case held that the term ‘work’ used in section 194C is wider than the phrase ‘works contract’. Hence, the first question before the Court was whether this widened meaning of the term ‘work’, would also include sales where some work was done on the product by the seller. In other words, the question posed to the Court was whether in cases like the one at hand, where the product which is sold is manufactured according to the specifications of the purchaser, can the process of manufacture according to specifications be considered to be ‘work’. The Court relied on a series of CBDT circulars, and came to the conclusion that even if the term ‘work’ was wider than the term ‘works contract’, it could not include sales within its ambit. Hence, it answered the first question against the Revenue.
The next issue that required to be considered then, was whether the transaction here was a sale. The Revenue contended that manufacture according to the purchaser’s specifications and the use of the purchaser’s trademarks on the product rendered the transaction something different from a sale. Rejecting both these contentions, Justice Chandrachud, speaking for the Bench, laid down the test as follows-
A contract for sale has hence to be distinguished from a contract of work. Whether a particular agreement falls within one or the other category depends upon the object and intent of the parties, as evidenced by the terms of the contract, the circumstances in which it was entered into and the custom of the trade. The substance of the matter and not the form is what is of importance. If a contract involves the sale of movable property as movable property, it would constitute a contract for sale. On the other hand, if the contract primarily involves carrying on of work involving labour and service and the use of materials is incidental to the execution of the work, the contract would constitute a contract of work and labour. One of the circumstances which is of relevance is whether the article which has to be delivered has an identifiable existence prior to its delivery to the purchaser upon the payment of a price. If the article has an identifiable existence prior to its delivery to the purchaser, and when the title to the property vests with the purchaser only upon delivery, that is an important indicator to suggest that the contract is a contract for sale and not a contract for work.
On this basis, the Court concluded that the transactions in questions were cases of sale, and did not amount to work for the purposes of section 194C. While these arguments were sufficiently persuasive, another factor that weighed heavily with the Court was the amendment made to the Explanation of section 194C by the 2009 Finance Act. Explanation II to section 194C gave an provided an inclusive list of activities that would considered ‘work’ . By the 2009 amendment, an addition was made to this list, which read-
For the purposes of this section, the expression, “work” shall also include –
(e) manufacturing or supplying a product according to the requirement or specification of a customer by using material, purchased from such customer, but does not include manufacturing or supplying a product according to the requirement or specification of a customer by using material purchased from a person, other than such customer. [emphasis supplied]
Relying on the Memorandum of Explanation of the 2009 Finance Bill, the Court came to the conclusion that this amendment was clarificatory, and hence should be given retrospective effect. In the case of the assessee pharmaceutical companies, the raw materials for production were not being provided by the pharmaceutical company. Thus, it clearly fell within the exclusion provided by the amended Explanation. Thus, for legislative and judicial reasons, the Court concluded, it is submitted rightly, that there was no obligation to deduct tax on amounts paid for the transactions in question.
One final issue that arises out of the present language of the amended Explanation needs to be addressed here. Though it was briefly touched on during oral arguments, this issue did not need to be considered by the Court, and finds no place in the judgment. The newly amended Explanation provides that, in cases where a product is manufactured according to the specifications of the purchaser, the tie-breaker for deciding whether it is work is the party from whom the raw material is ‘purchased’. While this term is apposite when referring to the transaction between the manufacturer and a third party, it seems highly erroneous to use it in relation to the manufacturer and the purchaser of the finished product. Surely, the intent of the legislature was that when specifications and raw materials are ‘provided’ by the purchaser, the return of the finished product to the purchaser does not constitute a sale. However, given the language of the section, it would be ‘work’ only if the manufacturer ‘purchases’ the raw material from the purchaser. Further, in such a case, where the manufacturer purchases the raw material, the title in the finished product will vest in the manufacturer, and when it is handed over to the purchaser, title will pass again. Applying the test laid down by the Bombay High Court in Glenmark, this passing of title would make that transaction a sale. As was suggested before the Court, the only solution is to read the term ‘purchased’ loosely; however, this is yet another instance of poor legislative drafting that could very easily have been avoided.