Service tax implications : Brand licensing vs contract manufacturing
November, 10th 2008
The Central Board of Excise and Taxes (CBEC) has recently issued a circular on October, 27, 2008 to clarify several points in relation to service taxation of the production of alcoholic beverages. This circular has very substantially modified the earlier draft circular on the subject that was issued for public responses/comments in November 2006.
An earlier article in this column had highlighted the widespread concern in regard to the earlier draft circular which had sought to bring the activities typically carried out in the alcoholic beverages industry under service tax.
It is common practice in the liquor industry for the brand name owners, especially foreign ones, to enter into strategic tie-ups with third party manufacturers or contract bottling units (distillers or bottlers), for manufacture of branded liquor. The reason that it is so is that there are stringent licencing requirements for manufacture and/or sale of liquor in India and only distillers / bottlers who are in possession of such licences are able to manufacture and/or sell branded liquor, regardless of who the brand name owners are.
These arrangements are seen as a win-win for both parties, as the brand name owners are able to realise the benefits of sale of their branded goods in India and the distillers/bottlers are able to utilise fully their manufacturing capacities.
The draft circular had taken the view that the activities of blending, manufacturing, bottling and labeling of liquor would amount to business auxiliary services and would be chargeable to service tax. This was on the understanding that the exclusion from the applicability of the service tax to these manufacturing activities would not apply to alcoholic beverages at all since these products were not covered within the ambit of the Central Excise Act 1944 and therefore the definition of manufacture, under Section 2(f) of the Act could not, in terms, apply to the products in question.
The draft circular came to this conclusion without even attempting to identify whether or not the activities that were typically carried out by the bottlers amounted to manufacture. The recent circular moves decisively away from this obviously incorrect reasoning. The circular now states that manufacture as understood in Section 2(f) of the Central Excise Act can be understood and be made applicable even to goods which are not excisable under the Central Excise Tariff.
This conclusion has been reached on an analysis of Section 3 of the Act relating to the levy and collection of central excise duties. Accordingly, the circular now states that as long as the processes that are undertaken in relation to any goods amount to manufacture within the meaning of Section 2(f), in that a new product with a distinct name, character or use and capable of being marketed has emerged as a result of these processes, the exclusion from the ambit of the definition of business auxiliary services will apply and hence no service tax under this heading can be applicable qua the goods which have emerged as a result of these processes.
Accordingly, the circular states that if the operations carried out by the licensee/bottler of alcoholic products amounts to manufacture, no service tax can be chargeable. In the earlier article in this column, it was argued that the draft circular was wrong on the point and needed to be revised. The revised Circular is therefore, very welcome.
Before moving on to other points, it is also important to recognise that alcoholic products are, in any event, charged to excise duties, albeit at the State level. Consequently, the earlier draft Circular had the effect of double taxation of alcoholic products under both service tax as well as under the State excise. The revised Circular ensures that such double taxation, which is clearly impermissible, does not come about.
The circular has thereafter analysed the typical situations whereby the brand name owners enter into arrangements with third party manufacturers for manufacture of branded alcoholic products. It states that where the brand name owner owns the intellectual property rights over the brand name and has licensed it to the third party manufacturer who alone holds the licence issued by the state government for manufacture of alcoholic beverages, the consideration received by the brand name owner from such third party manufacturer for use of the brand name, would be charged to service tax under the heading of intellectual property services .
The crucial point on which the aforesaid conclusion is determined is that property, risk and reward in the branded products so manufactured rests with the licencee/manufacturer and not with the brand name owner who is paid an agreed sum of money for granting the permission to the licensee to use the brand name and the related technical know how.
The Circular avers that in these circumstances, the service tax under the heading of Intellectual Property Service would apply. As opposed to this situation, the contract manufacturing arrangement, which is more typically the model in operation in this industry in India today, would envisage the property, risk and reward in the manufactured products to remain with the brand name owner and the contract manufacturer to be paid a certain sum of money to undertake the activities of manufacture and bottling of alcoholic products.
On this understanding, and of course on the understanding that the activities carried out by the contract manufacturer do not amount to manufacture under the Central Excise Act, the Circular holds that no service tax is chargeable in relation to such contract manufacturing.
The implications of this very welcome Circular need to be very clearly understood. Pure brand name licensing arrangements of the nature described in the Circular would clearly attract the charge of service tax under the heading of Intellectual Property Services. On the other hand, contract manufacturing arrangements again of the nature envisaged in the Circular, are not chargeable to service tax.
It is important to understand that in the first situation, the service provider is the brand name owner and the service recipient is the licensee/third party manufacturer. The consideration is thus seen as being paid by the licensee to the brand name owner. On the other hand, as regards the contract manufacturing situation, it is seen that the contract manufacturer could be rendering a taxable service but the exclusion from the service tax under the particular heading of business auxiliary service comes into effect and consequently no service tax would apply.
The Circular envisages this exclusion to apply if the contractual arrangements support the conclusion that consideration is paid by the service recipient i.e. the brand name owner, to the service provider i.e. the contract manufacturer. It is therefore important to ensure that the contract manufacturing arrangements are carefully drafted in order to reflect the reality as envisaged in the Circular so that it can be demonstrated beyond any doubt that the property, risk and reward in the products so contractually manufactured reside with the brand name owner alone.