Recently, the Cenvat credit scheme underwent a major change by virtue of an amendment in Rule 6(3) of the Cenvat Credit Rules, 2004 (‘the Credit Rules’). Rule 6(3) of the Credit Rulesgovernsthe reversal of Cenvat credit required in case of taxpayers providing both taxable and exempt services.Vide this amendment, which became effective from 01 April 2016, one of the important modifications is the widening of the definition of ‘exempted services’ by way of insertion of Explanation-3 to Rule 6(1) of the Credit Rules. The explanation is reproduced as follows:

“Explanation 3. – For the purposes of this rule, exempted services as defined in clause (e) of rule 2 shall include an activity, which is not a ?service’ as defined in section 65B(44) of the Finance Act, 1994”.

The newly introducedExplanation-3 provides that for the purpose of Rule 6, ‘exempted service’ shall include an activity that is not a ‘service’ (for the purpose of present discussion let’s refer to such activities as ‘non-service activities’).

As a background to the present issue at hand, itis important to highlight that prior to the present amendment in Rule 6(3), Cenvat credit reversal was only required with respect to ‘exempted services’.Accordingly, the requirement to reverse the common credit was limited to the following activities covered in the definition of ‘exempted service’ provided under Rule 2(e) of the Credit Rules:

(a)   taxable service which is exempt from the whole of the service tax leviable thereon;

(b)   service on which no service tax is leviable under section 66B of the Finance Act; and

(c)  taxable service where abatement is provided & credit of inputs and input services is not available.

In the above context, it is relevant to point out that the activities on which no service tax is leviable under Section 66B of the Finance Act, 1994 are the services covered under the negative list as well as the services provided outside the taxable territory; whereas the non-service activities falling outside the scope of the definition of ‘service’ under Section 65B(44) are not covered in the definition of ‘exempted services’.

Consequent to the treatment of non-service activities as exempted services through the newly insertedExplanation-3, the apportionment isrequired to be made even with respect to input/ input services commonly used for ‘non-service activities’.

To illustrate, a transaction for sale of immoveable property is a ‘non-service activity’ and under the erstwhile Rule 6(3) (i.e. till 1 April 2016) no Cenvat credit reversal was required with respect to such activity notwithstanding the fact that the same involveduse of common inputs and/or input services.  Now, under the amended Rule 6(3), whereby non-service activity is treated as ‘exempted service’, Cenvat credit reversal would be required with respect to all such ‘non-service activities’.

At this juncture, it is relevant to point out that Explanation-3 has been further amended vide Notification number 24/2016 dated 13 April 2016 to state that a ‘non-service activity’ shall be construed as ‘exempted service’ only if such activity has used inputs or input services.The amended Explanation-3 (with effect from 13 April 2016) reads as under:

“Explanation 3. – For the purposes of this rule, exempted services as defined in clause (e) of rule 2 shall include an activity, which is not a serviceas defined in section 65B(44) of the Finance Act, 1994 provided that such activity has used inputs or input services”.

However, this amendment does not seem to be of rescue to the taxpayers due to the reason that for a non-service activity, use of some element of common services, cannot be ruled out completely.  For instance, in the above example of sale of immovable property it can be contended (successfully) by the tax authorities that for carrying out the sale activity the taxpayer ‘used’ the leased office premises in as much as the team responsible for the same operated out of that premise;therefore, on a strict interpretation of the provisions,common Cenvat credit pertaining to Service tax on office lease rentals should be reversed under the revised Credit Rules.

The rigour of this amendment can be well explained in the case of a real-estate company who is selling plots of land as well as apartments. Uptill March 31, 2016, such taxpayer was not required to apportion the credit on common expenses (such as advertising expense, accounting, office rent) incurred for construction activity (taxable service) as well as transfer of immovable property – i.e. plots (non-service activity). With effect from 1 April 2016, on account of introductionExplanation-3, such company would need to compute and reverse common credit attributable to sale of plots.In such a case,the option of reversing seven percent credit on the value of exempted services will be impractical, as it could result in reversal of the entire Cenvat credit owing to the high base (aggregate sale value of plots) on which such amount is computed.

Apart from the above, one of the other non-services activities that would require reversal is works contractservices, since this activity involves supply of goods that is deemed to be a sale under Article 366(29A) of the Constitution of India. As works contract activity is conceptually different from ‘trading’, the bigger issue is computation of the amount of Cenvat to be reversed, due to the absence of proper mechanism to compute margin on the supply of the goods involved in execution of works contract.

In the absence of an enabling rule requiring taxpayers to reverse Cenvat only with reference to margin in a works contract (i.e. like trading activity), taxpayers would need to reverse common Cenvat credit computed on the basis of gross amount charged.

Thus, in the light of the new set of Rules, from the taxpayer’s perspective, it is imperative to:

• identify whether any of their activities would qualify as ‘exempted service’ or ‘non-service activity’;
• compute the quantum of common credit used in provision of taxable and exempt services (including non-service activity);
• determine the most tax efficient option for reversal of credits;
• undertake relevant compliances such as filing of intimation with the tax authorities, maintaining records etc.

While this article points out only few such instances requiring reversal of Cenvat credit, the amended Rule 6(3) is bound to give rise to many unanswered questions that could lead to controversies and litigations. For avoiding such situation and also to give just and reasonable relief to taxpayers due to change in the scope of credit reversal, clarifications from CBEC on the applicability of reversal provisions as well as suitable amendments in the Credit Rules are highly desirable.

By Ankur Jain & Rashmi Kedia