Service tax applicability on cost/revenue-sharing arrangements
March, 30th 2009
A recurring matter on service tax law is the appropriate tax treatment of cost/revenue sharing arrangements between two contracting parties. Increasingly, global businesses as well as businesses in India are forced to look at ways and means to reduce costs by means of shared facilities such as offices, office equipment as well as common services.
Similarly, from a business imperative, it is increasingly a felt need for companies to enter into joint venture arrangements whereby the two contracting parties enter into a contract for undertaking a economic activity based on an appropriate sharing of revenues which, in turn, would be based on the respective costs that the parties may incur and/or the value they may respectively bring to the joint venture.
In both these cost sharing and revenue sharing arrangements, there is never any intention to provide services. In the absence of any such intent, the service tax should typically not apply. However, the wordings of the underlying agreements relating to the cost and revenue sharing arrangements are invariably relied upon by the authorities to infer the provision of a service by the one to the other.
In certain other situations, common and joint procurement of services is also envisaged and references to such procurement of services in the underlying agreements are also problematic. Indeed, the service tax challenge is present even where the agreements are silent in this regard.
Coming first to revenue sharing arrangements, vide a recent Circular No. 109/03/2009-ST dated 23/2/2009 , which was issued with regard to the applicability of service tax on screening of films by theatre owners, the Central Board of Excise & Customs (CBEC) has clarified that under the particular type of arrangement which typically is undertaken between the theatre owners and the distributors of films, a revenue sharing model operates whereby a fixed and predetermined portion/percentage of revenues earned from the sale of cinema tickets goes to the theatre owners and the residual portion/percentage is paid over to the distributors.
The Circular clarifies that in such a situation, the two contracting parties act on a principal to principal basis and do not provide any services to each other and consequently no service tax would apply. This is a very beneficial Circular as it upholds for the first time the economic reality that in any revenue sharing arrangement, the contracting parties do not provide services inter se to each other but merely come together to jointly undertake an economic activity and to share the economic gains resulting from such activity.
It is important to note that even where services are actually provided, the parties would typically also act on a principal to principal basis. However, in a situation of revenue sharing, the parties act on a principal to principal basis to jointly carry on an economic activity for economic gain.
The service tax authorities, in the past, have endeavoured to impose a tax on payments made over by one contracting party to another, based on the revenue sharing formula as agreed under such joint ventures. For instance, bottling arrangements typically entered into between a brand name owner and the bottler are structured in the form of joint venture agreements whereby the revenues from the sale of bottled products are shared between the bottler and the brand name owner in fixed and predetermined proportions.
Similarly, joint venture arrangements are entered into for exploring a new market for certain products or for introducing new products into a market. In such situations, the contracting parties would come together in order that the products in question are appropriately advertised, marketed and finally distributed and sold in the defined market based on a pre agreed revenue sharing formula.
In the light of the above Circular, all such arrangements would be free of service tax. Earlier, they were under challenge. It must be noted that in several of such arrangements, it will be the case that one of the two parties will hold certain intellectual or other rights which have economic value and which therefore form their contribution to the joint venture. These rights could comprise of brand names, distribution rights and so on.
The point is that given the respective economic value that either of them possess, there is a merit in their coming together for the purposes of the joint venture, in order to earn an economic return as a consequence. Hence, the fact that there are appropriate headings for taxable services in relation to intellectual property, business auxiliary and business support services, to name a few, should be of no consequence as there is no intent to provide any services of any kind by one party to the other.
Indeed, the contracting parties do not envisage any payments in regard to these respective economic value that they constitute to the venture and all that is envisaged is that the profits accruing from the joint venture would be shared in certain proportions.
As regards cost sharing arrangements, the matter is more complicated. This is for the reason that in such arrangements, the costs incurred by one party are shared in defined proportions with the other contracting party and no other economic benefits are envisaged.
This is unlike the revenue sharing model where again the costs are also of course typically incurred by one party but are not recovered from or are reimbursed by the other party and only the profits or gains resulting from the joint venture are shared. In a cost sharing arrangement therefore, the parties come together to share costs and not profits. Here again, the intent of the contracting parties is decisive in order to determine the tax consequence.
It is entirely possible even with regard to cost sharing arrangements to argue that the parties do not intend to provide services inter se between themselves and what is envisaged is that certain costs as identified under the contract are intended to be shared in defined proportions. It is true of course that the underlying costs which are jointly shared between the two parties would typically pertain to services procured by the contracting parties and there would therefore typically be a service tax which would be charged at the time of procurement of such services.
The point however is that the contracting parties do not thereafter intend to provide services inter se and hence no further service tax ought to apply upon the subsequent allocation of such costs. The underlying contractual agreement, which would alone form the basis for a determination of the intent of the parties, is hence critical.
Consequently, if the contracting parties do intend to share costs in the manner described above, this intent must be appropriately demonstrated through the underlying agreement which, on a holistic reading, must support the conclusion that no services were at all intended to be provided by the one to the other.
It must of course be understood here that in such a situation where no services are provided by one party to the other and hence no service tax were to apply on the sharing of such costs, the service taxes that would have been paid out to the providers of services at the time of their procurement would not be eligible for input credits and would hence constitutes a tax cost.