SEPTEMBER 02, 2024

By Gurinder Pal Singh

THE mechanism of "input service distribution" ("ISD") has been a talking point for quite some time but it gained pace in the last one year after CBIC clarified certain aspects vide its Circular 199/11/2023-GST dt. 17.7.2023 and then the bounty of amendments surrounding the ISD mechanism proposed in this year's Finance Bill. The prime question being asked is "Is ISD mandatory". In few circles, the same question is being asked by debating ISD vs. Cross Charge. In this paper, we study the provisions concerning ISD as evolved over the years and try find the correct answer to these debates.

To have a better understanding of the issue, we need to answer more questions including - How and why this mechanism was introduced? Let us look back and trace the journey of 'ISD' mechanism in the realms of India's tax law books.

The expression 'head office' was not uncommon in those days and the corporates used to have their head office located in big cities while the factories were in the countryside. There was a tendency to file bill of entry for import of goods in the name and address of head office while the consignment was moved directly to the factory. It was leading to the denial of MODVAT of countervailing duty. The CBEC came to the rescue of the trade where it allowed MODVAT in such cases provided the bill of entry is endorsed by the Head Office' in favour of the recipient factory. This way, the Government allowed distribution of input tax credit from Head Office to the factory purely to avoid loss of credit. It was a trade facilitation measure undertaken by the Government which can be termed as the advent of "ISD mechanism".

The concept of "ISD mechanism" was formalized with the introduction of CCR, 2004 where the term input service distributor was first used and defined along with the procedure governing the distribution of credit by an ISD. The mechanism afforded a window to the office of a manufacturer or provider of output service to distribute input tax credit to such manufacturer or provider of output service. The reason for bringing such a mechanism was to ensure evacuation of input tax credit by the office to its tax paying units as otherwise such office had no means to use the credit. Someone can pose a question as to why the 'office' did not issue a tax invoice to transfer such credit along with corresponding costs to its recipient units. The answer is that under the service tax regime 'service to self' was not taxable. So, there was no occasion for the 'office' to transfer such credit through cross charge.

The scope of ISD mechanism under service tax regime was further extended by permitting an 'office' to transfer credit to a contract manufacturing unit in respect of common input services attributable to the turnover manufactured by such contract manufacturer. This again was a trade facilitation measure as without such a facility the FMCG companies were losing common ITC proportionate to the turnover of contract manufacturers.

So, what is coming out from the above discussion? Was the ISD mandatory in the service tax regime? Answer is No. The legislature had acknowledged the fact that the office of a manufacturer or service provider is unable to utilize the input tax credit as it does not have any output tax liability and, therefore, a mechanism is necessary to enable such office to distribute the ITC to its tax paying units. In fact, in service tax regime, there was no other way to evacuate ITC by the "office" as "service to self" was not taxable then.

Here, let us agree that the concept of 'ISD' originated mainly to avoid loss of input tax credit for the manufacturers and service providers. At this stage, if I were to answer a question whether ISD mechanism under service tax regime was optional or mandatory, I would say such a question is misplaced. If a provision is introduced as a facilitation measure, it is upon the trade to decide whether it intends to use it or not. It cannot be called mandatory. Of course, the dynamics changed in the GST regime which we will discuss in the following paragraphs.

Now, let us enter the GST era and understand how "ISD mechanism" was positioned before the amendments were carried out by the Finance Act, 2024. The definition of 'input service distributor' as per section 2(61) CGST Act reads -

"Input Service Distributor" means an office of the supplier of goods or services or both which receives tax invoices issued under section 31 towards the receipt of input services and issues a prescribed document for the purposes of distributing the credit of central tax, State tax, integrated tax or Union territory tax paid on the said services to a supplier of taxable goods or services or both having the same Permanent Account Number as that of the said office".

The definition of ISD under the CGST Act was worded on the same lines as was there in service tax regime. It continued with the proposition that ISD is an office of the supplier of taxable goods or services, not a supplier and, therefore, the ISD mechanism was considered necessary to evacuate ITC received at its end. However, there was a fundamental shift in GST law vis-à-vis service tax law was relevant to and impacted the usability of ISD mechanism. As we spoke earlier, 'Service to self' was not taxable in the service tax regime. However, such activities have been found taxable under GST with the introduction of the 'distinct person' concept and deeming supplies between distinct persons as taxable under Schedule I of the CGST Act, 2017. 'Distinct Person' has been separately defined as entities under the same PAN.

With this change in fundamentals, for the purpose of supply of service to distinct persons or precisely the activities of cost recovery, the 'Office' assumed the role of a supplier under the GST regime. Once, it became a 'supplier of service', it compulsorily needed to take registration as a supplier and issue tax invoice for supplies to distinct persons with charge of applicable GST. The input tax credit attributable to such supplies/ cost recoveries was available for utilization which resulted in its evacuation in the normal course. It eventually resulted in redundancy of ISD mechanism in most of the cases as the sole purpose of ISD mechanism i.e. the evacuation of ITC was largely being served through 'cross charge'.

At this stage, let us ask another question. Whether cross charge is optional or mandatory? The answer is - "cross charge" can never be optional. It is because once the transaction between the distinct persons falls with the scope of 'supply' as per section 7 CGST Act, 2017, there appears no option left with the "office" / supplier to issue a tax invoice with charge of tax.

To have a better view of this controversy, let us understand the nature of transactions between an 'office' and its supplier of goods and services. 'Office' or commonly called as Head Office or Registered Office or Corporate Office, perform functions like preparation of financial statements, auditing, secretarial, business and sales strategy, investor relations, IT infrastructure. etc. Undisputedly, the 'office' performs such functions for the whole organization. In a way, the 'office' takes responsibility for such functions centrally and incurs various costs while performing such function. Such costs are then allocated to its units in line with the generally accepted accounting and costing principles. Let us take a pause and pose a question to ourselves. Whether the activities performed by an 'office' for its units can be construed as 'supply' and whether such "office" can be called a 'supplier' for the performance of such activities. To my understanding, the answer is affirmative, because services performed by a distinct person for another distinct person under same PAN is taxable under the GST law. Once the activities of the 'office' are 'supply', it is bound to take registration under GST as a supplier and issue a tax invoice in favor of the recipient distinct person to recover charges towards such services. In a manner, the GST law affords a dual character to an Office' both of ISD and of a supplier unlike in the service tax regime when provisioning of services between the same PAN was not taxable.

Yes, for the remaining activities which do not qualify as 'supply' or where the underlying cost is not allocated or not required to be allocated to the units and there exists ITC behind such costs, the "office" can very well distribute such ITC to its units by adopting the ISD mechanism. If the above is true, then the question whether ISD is optional, or mandatory is meaningless.

The present issue was not only discussed by various Advance Ruling authorities, Courts but it went up till GST Council to decide whether it is optional or mandatory and eventually the mechanism was apparently made mandatory through an amendment made in the CGST Act, 2017 by the Parliament, to be effective from 1.4.2025.

The reason of reaching this issue at the higher echelons lies in Rule 28 CGST Rules, 2017 which provides that for supplies between distinct or related persons, the value declared in the invoice shall be deemed to be the open market value of the goods or services provided the recipient is eligible for full input tax credit, In a way, the valuation issues for transactions between distinct or related persons have been made irrelevant which gave an impression to certain sections in revenue that the said rule opened door for the entities to play with the value either side in the transactions commonly called as 'cross charge'. It was a wrong notion. The liberal approach adopted under Rule 28 was on the sole ground that once the recipient is eligible to avail ITC there cannot be a case of revenue leakage even if the supplies are undervalued.

Let us now have a look at the latest amendments in CGST Act relevant to ISD effective from 1.4.2025 purported to be made to make the ISD mandatory in certain situations.

The substituted definition of "Input Service Distributor" reads as "...an office of the supplier of goods or services or both which receives tax invoices towards the receipt of input services, including invoices in respect of services liable to tax under sub-section (3) or sub-section (4) of section 9, for or on behalf of distinct persons referred to in section 25, and liable to distribute the input tax credit in respect of such invoices in the manner provided in section 20";

Further, section 20 has been substituted to indicate that if the procurement by an ISD is "for or on behalf of a distinct person", the credit involved in such procurement shall be distributed through ISD route.

From the substituted provisions, I could find two key changes in the provisions viz. (a) the substituted definition of ISD as per Section 2(61) provides that any input tax credit which corresponds to an input service procured "for or on behalf of" a distinct person is liable to be distributed through ISD route. In short, it provides that where an office procures a service "for or on behalf" of a "distinct person" the office must distribute the underlying ITC to the recipient distinct person through ISD route. (b) The other marked change in section 20(1) and section 20(2) is the repeated usage of the word "shall" which appears to have created an impression as if the "office" of a distinct person satisfying the features of section 2(61) has no option but to distribute the credit through ISD route.

I believe the above-mentioned amendments are not making any meaningful change in the conclusions which we have achieved in the forgoing paragraphs.

In the first place, the expression "for or on behalf of" is being seen in a restricted manner and trying to achieve an incorrect conclusion that where the procurement is made by an "office" "for or on behalf" of another person/ distinct person, it cannot be further transferred by way of a "supply". To my understanding, every procurement by the supplier is "for or on behalf of" the intended recipient. The supplier procures services for further supply in the same form or in another form. The factum of procuring and further supplying in the same form is like trading in services which qualifies to be a "supply" under the GST provisions. "Bill to Ship to" concept which is prevalent in the supply of goods is equally available for services. Evidence to that effect lies in Explanation (ii) to section 16(2)(b) where it permits availment of ITC by the recipient even where input service is provided by the supplier to any person on the direction of and on account of a recipient. The transaction contemplated in the said provision is "Bill to Ship to" or trading in services where the services are procured by a person "for and on behalf of" a third person. Once ITC is permitted for such services, it is deemed that the recipient is expected to make further supply to the end customer.

Further, the transactions between agent and the principal, which mirror the expression "for or on behalf of" are equally taxable in the GST law.

Thus, the ITC involved in the procurement "for or on behalf of" a distinct person can very well be evacuated through supply. Mandating the usage of ISD in such situations appears not legal.

Even if we see the nature of activities undertaken by a typical "corporate office", they perform all activities "for or on behalf of" its tax paying units and in the process incur costs which may or may not involve ITC. I believe the moment an "office" recovers costs from its tax paying units, it is permitted to assume the character of a supplier and cross charge is the appropriate mode to evacuate ITC. However, if creditable costs incurred by an "office" are either not transferred or not liable to be transferred to the distinct persons, the corresponding ITC can be evacuated through ISD.

The usage of "shall" in the substituted provisions also does not make any difference to the nature of ISD mechanism as it cannot be interpreted as 'notwithstanding section 7 of the CGST Act'. The principle of 'supply' is prime and cannot be dethroned by any other provision including by the ISD provisions.

In a nutshell, we can find that even in the substituted provisions, ISD is not mandatory.

The Government needs to appreciate that the utility of ISD has been squeezed in the GST regime because the transactions between distinct persons are regarded as taxable unlike in the service tax regime when such transactions were not taxable and ISD was the only route to evacuate ITC by the "offices". There should not be any attempt to impose ISD on the trade where the purpose of ITC evacuation is well served by 'cross charge' which is more scientific and legal. It should be left on to the trade to decide how they want to design their intra-organization transactions in line with their accounting policies. The hyper-technical interpretations of ISD provisions will only open the doors for another bout of litigation which needs to be avoided.

[The author is Head, Indirect Taxes, L&T Construction and the views expressed are strictly personal.]