OCTOBER 20, 2021

By Rohan Muralidharan & Vishvas Bharadwaj

WHILE deliberating upon the imposition of any commodity-based taxation, ascertainment of the rate at which tax is to be charged becomes imperative. To determine the rate of tax, 'classification' of goods and services is paramount. Under the erstwhile Central Excise regime, the system for classification of goods was aligned with the Harmonised System of Nomenclature (HSN). This article explores a fascinating overlap between the HSN and a provision of law unique to the GST regime.

Harmonised System of Nomenclature

The HSN is a self-sufficient system for classification of goods which also contains General Rules of Interpretation (GIRs) to resolve doubts/ambiguities in the classification of goods. Accordingly, the Customs ¹ and Central Excise ² regimes adopted the HSN (along with the GIRs) as the tariff which specifies rates of tax for various goods.

Composite goods/services

In practice, goods are often supplied in conjunction with each other either as a marketing strategy or for functional utility. This poses a challenge from a classification perspective - how does one classify the bundle of the so-called 'composite good'? As classification determines the rate of tax, the answer to this question has a significant revenue implication and cannot be brushed aside.

Fortunately, GIR 3 provides a ready solution and states as follows:

"(a) the heading which provides the most specific description shall be preferred to headings providing a more general description. However, when two or more headings each refer to part only of the materials or substances contained in mixed or composite goods or to part only of the items in a set put up for retail sale, those headings are to be regarded as equally specific in relation to those goods, even if one of them gives a more complete or precise description of the goods.

(b) mixtures, composite goods consisting of different materials or made up of different components, and goods put up in sets for retail sale, which cannot be classified by reference to (a), shall be classified as if they consisted of the material or component which gives them their essential character, insofar as this criterion is applicable.

(c) when goods cannot be classified by reference to (a) or (b), they shall be classified under the heading which occurs last in numerical order among those which equally merit consideration."

So far, GIR 3 uniformly governed this field and was routinely referred to when the classification of composite goods was in dispute.

In the realm of Service Tax as well, Section 65A(2) of the Finance Act ³ set out principles for the classification of composite/bundle of services which largely followed the same pattern as GIR 3.

The bottom line of this discussion is that under Customs, Central Excise, and Service Tax, composite supplies of goods and/or services have been governed by a single rule for classification viz. GIR 3 and Section 65A(2) respectively.

GST

Under the GST regime, commodities are classified into Schedules - each with a different rate - by referring to the applicable Chapter/Heading/Sub-Heading/Tariff Item ⁴ of the Customs Tariff ⁵ and the description of the goods.

Explanation 4 to the Rate Notification borrows the GIRs for interpreting the GST Rate Schedules. ⁶

Therefore, as one must first determine the appropriate heading of the Customs Tariff (for which reference to GIRs is often required) before identifying the GST rate, the GIRs (including GIR 3) remain relevant in the classification of goods under GST.

The Conflict

We had earlier discussed that under Customs and Central Excise, a single test (GIR 3) governed the classification of composite goods. This is not true under GST. The GST scheme introduced a provision for the first time - 'composite supply' ⁷ and 'mixed supply' ⁸ in Section 8 of the CGST Act, 2017. Section 8 provides that composite supplies are to be taxed at the rate applicable to the principal supply and mixed supplies shall be taxed at the highest rate attracted by its constituent supplies.

A reading of the definitions of composite and mixed supply may cause one (and rightly so) to draw parallels to GIR 3(b) and GIR 3(c). Section 8 of the CGST Act and GIR 3(b)/(c) impose different tests for the same subject. A domestic supply of a set of goods in conjunction with each other may be classified differently based on the test applied. For convenience, the comparison between the two has been tabulated.

A quick reading of the above table reveals the depth of the contradiction between GIR 3 and Section 8 of the CGST Act. Consequently, the following questions arise when one seeks to supply composite goods:

- Which test is to be applied?

- If both tests are applicable and yield different results, which one prevails?

Illustration A:

Consider an Uninterrupted Power Supply (UPS) device supplied along with a battery. On application of GIR 3(b), one may conclude that despite the UPS and battery being different components of the same system, the UPS provides the "essential character" of the supply and identify the rate of tax accordingly.

However, on application of the composite supply test in Section 8, an Appellate Authority for Advance Ruling held that as the UPS and battery are not "naturally bundled" (a test unique to GST), it is a mixed supply (rather than composite supply) attracting tax at the highest competing rate. ⁹

Illustration B:

Consider a retail baking kit containing flour, sugar, yeast, vanilla extract, and cocoa powder. This is a set of goods put up for retail sale to which the essential character test is not applicable, since each ingredient is indispensable, and none can be attributed the "essential character" of the kit.

On application of GIR 3(c), one may classify this kit under Heading 2102 - "Yeasts (active and inactive)", as the last in the numerical order among those which merit consideration.

On the other hand, on application of the mixed supply test in Section 8, one would classify this kit under Heading 1805 - "cocoa powder not containing sugar or added sweetener", as it attracts the highest rate.

The above illustrations demonstrate that these are questions without easy answers for the time being. One view could be that the test of composite/mixed supply will prevail as it is a statutory scheme for determining the nature of supply, whereas the GIRs are just an aid in classification for determining rate of tax.

Per contra, it may be argued with equal force that the GIR should prevail as it is a part of the HSN, which is an internationally recognised system with an abundance of literature and jurisprudence around which India's entire classification system is built.

Implications and Conclusion

As is the case in almost all classification disputes, arriving at the correct position through judicial decisions will likely be a laborious and time-consuming exercise. One can reasonably foresee that taxpayers and the Department will adopt different positions on which test should prevail on a case-to-case basis, based on the rate arbitrage. Since wildly different classifications (and consequent rates of tax) emerge from the overlapping application of GIR 3 and Section 8, the importance of this issue cannot be overstated. In the authors' view, the most feasible solution is for an amendment to be made to the CGST Act itself to clarify which test will prevail. Until such an amendment is introduced, taxpayers and the Department are destined to lock horns and battle this issue out in Court.

[Rohan Muralidharan is Principal Associate & Vishvas Bharadwaj is Associate at Lakshmikumaran & Sridharan, Chennai and the views expressed are strictly personal.]

¹ The HSN as well as the GIRs have been incorporated as the First Schedule to the Customs Tariff Act, 1972.

² Prior to 1st July 2017, the First Schedule of the Central Excise Act, 1944 was aligned with the HSN and included the GIRs as well. Post 2017, the levy of Central Excise has been restricted broadly to tobacco and petroleum products, as set out in the Fourth Schedule. However, even the Fourth Schedule includes the GIRs and makes reference to Heading, and Sub-Headings of the HSN.

³Inserted by the Finance Act, 2003 with effect from 14.05.2003.

⁴ Explanation 3 to the Rate Notification states that the terms "Tariff item", "sub-heading", "heading", and "Chapter" shall have the same meaning as specified in the Customs Tariff.

⁵The Customs Tariff is itself a reproduction of the HSN system.

⁶ Explanation 4 states that the rules for the interpretation of the Customs Tariff, including the Section and Chapter Notes and the General Explanatory Notes shall, so far as may be, apply to the interpretation of the Rate Notification.

⁷ Section 2(30) read with Section 2(90) of the CGST Act, 2017.

⁸ Section 2(74) of the CGST Act, 2017.

⁹ In Re: Switching AVO Electro Power Limited - 2018-TIOL-4-AAAR-GST.