In an era of zealous consumers wanting everything at the drop of a hat, we see a number of new start-ups mushrooming everyday with their unique and ingenuous ideas. We recently met the founderts of one such start-up (“Company”) that made us explore quite an interesting proposition.
The start-up offers various items of clothing on rent to its customers including casual wear, party wear and designer wear which, for valuable consideration, are rented out to the customers for fixed number of days.
The modus operandi of the Company is that it buys designer clothes, domestically as well as from outside India by paying VAT and make them available on its website. Within 3 hours of placing the order over the website, the clothes are delivered to the customer at its doorstep for a fixed number of days or sometimes even for few hours.
In case of designer clothes, the Company charges an amount equivalent to 20% of the actual value upfront as collateral security, which however is later refunded to the customer within 7 days of return. Additionally, the Company requires its customers not to alter the clothes so rented out or destroy/damage the same in any manner failing which the Company charges a penalty amount over and above the rental price.
This being the nature of the transaction, the key issue before us was whether renting of clothes on a temporary basis amounted to ‘transfer of right to use’ subject to VAT or whether it got covered as a ‘declared service’ under the Service tax legislation.
The reason of confusion whether the transaction was a deemed sale or a provision of service was purely because the Founder wasn’t clear how temporary renting of clothes could by any stretch of imagination get considered as a deemed sale. Being a techie with no tax background, he was under the impression that this activity at best could be a service.
In order to examine the transaction and the issues involved, we referred to the statutory provisions briefly discussed below:-
- As per Section 66E of the Finance Act, 2012 transfer of goods not involving a transfer of right to use such goods is a declared service subject to Service tax;
- As per Article 366 (29A) (d) of the Constitution of India, the transfer of the right to use any goods for any purpose (whether or not for a specified period) for a considertion is considered as a deemed sale subject to VAT.
Thus, it is clear for a transaction to get qualified as a ‘sale’ or a ‘service’ was only dependent on one issue – ‘whether there is a transfer of right to use that good’. Since the term ‘transfer of right to use’ hasn’t been defined in any of the legislations, we resorted to judicial precedents that are available on this issue. There are numerous judgments on the issue of ‘transfer of right to use’ and some of the prominent ones are listed below:
- Rashtriya Ispat Nigam Ltd. V/S Commercial Tax Officer reported as 1989 77 STC 182 AP
- Bharat Sanchar Nigam Limited & Anr v/s Union of India reported as AIR 2006 SC 1383
- Hindustan Coca Cola Beverages P. Ltd v CST 2015-TIOL-2899-CESTAT-DEL
Although each Court has discussed in detail the issue at hand, terms of the agreements and various judgements of other Courts, the first principle that emerges is that Courts always look at the clauses in the agreements entered inter se the contracting parties. The contractual terms and conditions of the agreements are key in determining whether there is a transfer of right to use or not and one or two words/clauses in the contracts are not sufficient enough to take a stand, rather the entire contract has to be read as a whole to determine the taxability. If the nature of the agreement is such that it limits the transferee’s right to use the goods, even though ex facie it seems contrary to the same, then the transaction cannot be taken to be a case of transfer of right to use.
What is also imortant is identifying the intention of the parties at the time of entering into the contract. Therefore, the right drafting of the contract is extremely critical at the time of starting the venture.
At the time of reviewing the agreements and determining whether the transaction involved the transfer of right to use or not, the hon’ble Judges have always emphasised on three key words – ‘custody’, ‘possession’ and ‘effective control’. In most of the rulings, the Courts have held that where custody, possession and effective control over the goods has passed to the hiree, there should be a transfer of right to use the goods, subject to VAT. However, it is important to understand that simply by looking at the transaction, it is not easy to determine whether there is a transfer of possession and effective control of the goods and one has to deep dive to check if there actually is a transfer of the right to use.
For a transaction to be taxed under VAT as a transfer of right to use providing a facility which involves the use of goods nor even a right to use the goods is enough, there must be a transfer of that right.
Since the above terms are critical, we checked the Black Law’s Dictionery to understand the meaning of these terms:
Custody – “The care and keeping of anything; as when an article is said to be “in the custody” of the court.”
Possession – “to the exclusion of all other persons, and either held personally or by another who exercises it in one's place and name. That condition of facts under which one can exercise his power over a corporeal thing at his pleasure proprietor of a qualified right in itor as the either as owner The detention and control, or the manual or ideal custody, of anything which may be the subject of property, for one's use and enjoyment, ” .
Transfer – “The common use of the word ‘transfer’ is to denote the passing of title in property, or an interest therein, from one person to another, and in this sense the term means that the owner of the property delivers to another person with an intent of passing the rights which he had it to the latter” (Salmond on Jurisprudence)
The terms ‘possession’ and ‘effective control’ play a key role to answer this question. While giving the goods on hire it is important that the hiree should have full control over the goods without any restriction. Any restriction, whatsoever, on usage of the goods would lead the Courts to believe a non-transfer of the right to use.
The restriction can however be limited to ensuring the subject goods are not damaged and returned in the same condition. Any restriction asking the hiree to maintain the goods in a safe condition shouldn’t in our opinion be considered as not passing the effective control over the goods.
The Hon’ble Supreme Court took up this issue in BSNL’s judgement (supra) and laid down the following five conditions for a transaction to qualify as transfer of right to use: -
1. There must be goods available for delivery;
2. There must be a consensus as to the identity of the goods;
3. The transferee should have a legal right to use the goods, consequently all legal consequences of such use including any permissions or licenses required therefor should be available to the transferee;
4. For the period during which the transferee has such legal right, it has to be the exclusion to the transferor this is the necessary concomitant of the plain language of the statute - viz. a "transfer of the right to use" and not merely a “licence to use the goods”; and
5. Having transferred the right to use the goods during the period for which it is to be transferred, the owner cannot again transfer the same rights to others.​
The conditions in para (3), (4) and (5) are critical to follow and rightly so because in the absence of these conditions, there is a high liklihood of the transaction not qualifying as a deemed sale.
What is also interesting to note is that Courts have variedly interpreted the ‘exclusivity’ clause in the agreements, wherein some of them have held it to be essential in determining transfer of right to use, whereas few have held it to be not essential. This was recently taken up by the Authority of Advance Rulings reported in 2016-TIOL-03-ARA-ST.
Use of Intangibles - Sale or Service
The case becomes interesting in the case of grant of use of trademarks and copyrights that are also considered as ‘goods’ under all the state VAT laws. Relying on the TCS judgment by the hon’ble Supreme Court, the Courts have held intangibles to be goods and a right to use them typically attracts the discussion whether it’s a transfer of right to use ‘goods (i.e. trademarks and copyrights) or a declared service under Section 66E of the Finance Act defined as “temporary transfer or permitting the use or enjoyment of any intellectual property right”.
This issue has evoked enough debate and discussions, leading to contrary judgments by different High Courts. Whereas the Mumbai High Court in the case of TATA Sons has held grant of trademarks to be a transfer of right to use goods subject to VAT, the Kerala High Court in the case of Malabar Gold pronounced its judgment to the contrary holding trademark license agreement as a service in the absence of the exclusivity clause.
Recently, the Mumbai High Court has admitted a writ petition in the case of Monsanto and Subway to examine whether license to use intangibles such as ‘know-how’ and ‘trademarks’ constitute transaction of service or sale. The issue revolves around the fact whether it’s a transaction of ‘transfer o right to use’ or a mere ‘licence to use’ the trademarks, later being subject to Service tax and not VAT.
Our advice to the young Founder of the start-up revolved around these legislative principles. His website did offer exclusive use of the clothes to customers without the clothes being able to be used by any other customer for the period they were given on hire. The customers had all the rights to use the clothes for unlimited no. of times and they could have passed on the cloth to anyone they like. Though, the customers didn’t have the right to change the basic character of the cloth, this condition shouldn’t have militated against the aspect of transfer of the right to use that cloth. To that extent, his transactions over Internet did appear to get covered as ‘transfer of a right to use’, subject to VAT.
Authored by Nimish Goel, Head of Indirect Taxes and GST at International Business Advisors (www.ibadvisors.co). Nimish has spent almost 13 years practicing indirect taxes including VAT, Service tax, Excise and Customs. He has worked with BIG4s including EY and KPMG both in India and in Europe. For any queries he can be reached at nimish.goel@ibadvisors.co
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