Designs or Specifications – Excise Duty trauma for the automotive industry

The days of Central Excise Duty (ED) are over[1], a cool and exquisite tax it was. Make no mistake about it, half of the Goods and Service Legislation’s learnings are down to the Central Excise Act, 1944 and its sub-ordinate rules. Revenue’s audits and investigations would be more of a dead letter, for the better part the maximum period of inventing new avenues of generating demands (outta nowhere) expires on 10^th July 2022. Some things never changes though, DG-CEI (now known by its fancy name DG-GSTI), has knocked the doors of backbone of automotive industry – the Tier 1s and Tier 2s again. Unsurprisingly, the door goes through the OEM (again).

The origination and core of dispute

The vehicle manufacturers (OEM) manufactures vehicles out of the parts and components (P&C) procured from Tier 1s. The P&Cs are customized for every item, such that they require customized Tools and Dies (T&Ds). The building up process of making T&Ds starts with goal setting, it requires Designs, Drawings and Specifications (DDSs) (in paper form or CAD/ CAM), and finally the T&Ds are made through CNCs.

In the present dispute, the investigation by DG-GSTI started off at the premises of one of the largest automobile manufacturer of India (‘OEM’). The kick off point being, the royalties being paid by the OEM to its overseas group company (GC) under the “License Agreement” (‘the agreement’). The covenants of the agreement covers multiple aspects of OEM’s right to manufacture and sell trademarked vehicles of GC.

In their investigation and show cause notices (SCNs), the revenue have showcased a position wherein the OEM is incurring expenditure for acquiring DDS from its GM and providing the said to component manufacturers free of cost. The component manufacturers USE the DDS to manufacture T&Ds, and sale the same to OEM. In the case presented by the revenue, the free of cost supplying of DDS are amenable to be added in the value of T&Ds as per clause (ii) of Explanation 1 to Rule 6 of the Central Excise Valuation (determination of price of excisable goods), 2000 (‘CVR’).

Examining the merits of the grounds in SCN

Through the succeeding paragraphs, the author confers as to where the SCNs have got it wrong and the un-tenability of the grounds therein to enhance the valuation of T&Ds.

1. Inapplicability of Rule 6

The revenue has gone into length to garner the value of DDS so as to load it upon the T&D, however, the very of basics of addition appears to have been taken for granted. It is an accepted and admitted position, that T&Ds are necessary to manufacturer P&C, as held by the Hon’ble Courts over the years.

Unfortunately, the revenue has merely assumed the rationale for DDS qua T&D also without first justifying their necessity of DDS for T&Ds. The valuation under Rule 6 ibid proceeds on the premise that the sale of the manufactured goods between buyer and seller is not on “sole consideration”[2], i.e. the seller is not receiving anything other than agreed price.

The vehicles manufactured by OEMs are exponentially unique, the engine of one wouldn’t accept the housing of another, the interior of one wouldn’t fit the dashboard of another etc. By furnishing DDS to the component manufacturer, the OEMs are only indicating, the boundaries, the size, the length, cutting in which the respective of P&Cs[3] needs to be accustomed to, they are not furnishing something which is pre-requisite for the very manufacturing of components.

The case is as good as a tailor, stitching shirt from the fabric provided by the customer. The body measurements noted by the tailor could either be on the spot, or the same could be supplied by the customer itself for a bulk stitching[4]. It cannot be said that tailor required measurement for him to stich shirt. The measurements are sine qua non for the customized stitching, but that doesn’t imply that without the same, the tailor can’t do the stitching itself. The difference therefore is mere customized and non-customized shirts.

The case of T&D vis-à-vis P&C revolves around the fact that T&Ds are absolute necessity for P&Cs, however that’s’ not the case with DDS vis-à-vis T&Ds. In the latter case, DDS are required only for customizing T&Ds and they are not necessity of T&Ds.

2. Condition for supply – not consideration

An important term that is often coined in for countering the application of “sole consideration” is “condition of supply”. The merchandise flowing from the buyer to the seller which are “condition of supply”, rather than “consideration for supply” are not includible in the value of goods. The Australian GSTR 2001/6 elaborates on the same;

“83. Many transactions involve exchanging various rights and obligations between the parties to the transaction. In particular, the true character of the transaction may characterise the payment as a condition of the contract rather than the provision of non-monetary consideration……………”

Example 9 – things used in making the supply

91. E agrees to supply services to M at a rate of 100. Under the agreement, E must perform the services on M’s premises in Melbourne. M agrees to allow E to use its computer facilities, stationery and safety equipment on M’s premises to perform the services. M also agrees to fly E to Melbourne and provide accommodation and meals during the period E performs the services.

92. There is monetary consideration for E’s services. The provision of the use of computer facilities, stationery and safety equipment and the transport, accommodation and meals is not part of the price paid for the services as it is not a payment or of value to E in return for his services. They are rather conditions of the contract that go to defining the supply made by E, and are used in providing the services, rather than being supplied to E in return for the services. They do not provide economic value to E in return for his supply. The provision of these things in these circumstances is not consideration in connection with the supply by E. There is no non-monetary consideration for E’s supply.”

To phrase from para 92, above, it infers that a condition of sale doesn’t provide economic value to the seller in return for his supply. The averment founds true for the automotive component manufacturers also, wherein the DDS supplied by OEM doesn’t given then omnibus saving over their costs for manufacturing T&D or anyhow increasing their margins. The DDS are merely piece of paper/ computer generated files, upon which component manufacturer has to undertake his processing, and not anything of economic value for them.

In Hindustan Polymers vs Collector of C. Ex.[5], the Hon’ble Supreme Court had examined the “necessity” context of an item supplied by the buyer in the manufacturing process to be undertaken by the manufacturer. The Court emphasized that the value of excise duty inextricably tends towards the “value of manufacturing and availability for sale in wholesale market”. The value of secondary packing that is supplied by the buyer, which is not necessary for either the manufacturing or making available the product for sale in wholesale market, is not amenable to be added.

In the opinion of author therefore, the component manufacturers therefore needs to arrive at the significance of DDS supplied by the OEM. In cases most often than note, component manufacturers have facility to develop T&D on their own, and DDS are mutely act as specifications only. Relying on the above, the application of Rule 6 ibid may not survive for value addition.

3. Royalties doesn’t represent DDS

The most fascinating part of the revenue’s investigation is their inability (intentional?) to decode the agreement between the OEM and GC. The covenants of similar agreements has been discussed by the Hon’ble Delhi ITAT in an Income tax judgment. The Court after producing the relevant parts of the agreement, deduced following arrangement between the OEM and GC;

• The main object of the license agreement is to provide the appellant exclusive right and license to manufacture and sell the licensed product for a specified limited duration.,
• All others rights vested in the license agreement including technology, technical know how and Trade Mark are linked to the core right to manufacture and sell licensed products.
• Single Package – Royalty in-severable: From the aforesaid extract of the agreement it would also be appreciated that the License Agreement is a single package, for which the consideration in the form of royalty is inseverable.
• Consequently, no part of the royalty can be split and determined for the use of ******* licensed trademarks. The split done by the TPO is arbitrary and wholly without basis.
• Primary intent being technology transfer: The primary intent of the license is transfer of technology and not trademark usage.
• The technology transfer from ***** has allowed the appellant to manufacture certain critical components required for manufacturing these cars and has allowed us to internalize and generate these models locally

In the short-sighted scheme of things, the revenue seems to have lost sight of the fact that impugned DDS are merely the deliverables of the licensee to manufacture and sell by the GC to OEM. The Court has explicitly laid out the essence of the agreement being to transfer technology and trademark in consonance.

The agreement of tech transfer and trademark is one appears to be an isolated agreement different from production of any goods. The royalty paid by OEM on the same to GC may tantamount to taxable service amenable to service tax. It is at this place, a fine line of difference needs to be drawn distinguishing the extra commercial consideration qua excise duty vis-à-vis additional services amenable to service tax. DDS are bare minimum deliverables of the services procured by OEM from GC, they are a separate financial cost for OEM, not inter-linkable with the production of goods.

In Nirulas Corner House Pvt. Ltd. vs CCE[6], the Principal bench of the Tribunal examined a similar issue, wherein the manufacturer was providing tech-transfer services to its franchisee, for lumpsum and running royalties, and paying service tax thereon. The revenue alleged that, such royalties are additional consideration and add-able in the sale value of goods by the Appellant to franchisee. The Hon’ble Tribunal held in negative, that tech-transfer and sale of goods are separate activities, and Rule 6 ibid is not invokable.

In the author of the opinion, the DDS are merely outcome of the services sourced by OEM, and should not be seen a factor for manufacturing value of T&Ds.

4. Jurisprudence over Specifications

Though the dispute has taken a gigantic form, however the dispute has been taken before the Hon’ble Courts earlier as well, with contradicting judgments flowing from the same forum.

In CCEx&Cus vs Bharat Forge Limited[7], the Mumbai CESTAT relying upon co-ordinate bench decision held that the Appellant was merely making forgings according to the “dimensions” provided by the buyer, and hence the value of dimensions are not to be added as additional value.

The Kolkata CESTAT in CCE vs Tata Motors & Ors.[8][9], dissuaded from following the order of Bharat Forge supra, for it being very short and passed in the light of earlier valuation rules. The Tribunal itself though didn’t adduced much ground for enhancing the value on account of dimensions other than noting that dimensions are not simple drawings but contains technical details of components.

In Technoweld Alloys (India) Pvt Ltd vs CCE[10], the Appellant argued that, they had not used the drawings provided by the buyer, so as to exclude additional valuation under Rule 6 ibid. The Tribunal however, held that the contract between the parties stipulates that the manufacturer had to use the drawings provided by the buyer for making goods, hence prima facie the value under Rule 6 ibid is liable to be added. The Appellant was not able to prove his substance, though the Tribunal seemed be principally agreed that use is important.

5. Akin provisions under the Customs Act

Clause (b) – sub clause (iv) of Rule 10 (1) of Customs Valuation (Determination of Value of Imported Goods) Rules, 2007 is provision akin to clause (ii) of Explanation 1 to Rule 6 ibid.[11] In the context of “specifications”, important tests were formulated in the case of M/s Dabhol Power Company (DPC) by the adjudicating Commissioner of Customs, Pune. The tests were subsequently approved by the Hon’ble Delhi Tribunal[12].

The Appellant DPC had imported plant and machinery for LNG facility from one foreign vendor (EEPC). Another contract was entered with another overseas service provider (EPC) for developing designs and engineering for the plant and machinery. DPC took the plea that service contracts with EPC related only to formulation of specifications, which is separate from drawings and designs required for manufacturing the plant and machinery and fell outside the purview of Rule 10 (1) (b) (iv)[13] ibid. DPC contended that these formulations were to be merely passed on to the manufacturers, relying upon Commentary on GATT Customs Valuation Code[14].

The Commissioner ceded that, “while specifications will not form part of the valuation to the extent they are an appropriate way of telling the manufacturer the specifications of what is being ordered, nevertheless it should be deemed of the part of the production process if engineering or drawing goes further.”

[Emphasis Supplied]

Analysing the factum of the things, the Commissioner loaded the value of service contracts on the two footholds;

• That specifications were not restricted to merely conveying the design and engineering specifications, but extends further to the very development of equipment.
• The co-ordination between service providers and manufacturers was humongous, that there was continuous review process to arrive at correct designs
• The manufacturer couldn’t make out the equipment without the specifications being developed by the service provider

The Tribunal concurred with the view the above view of Commissioner and upheld that specifications were so detailed that they were necessary for the very manufacturing of equipment. The Tribunal also held that services that had no impact on the production process are not includible in the value of equipment.

Rule of Thumb for loading: Importantly, the Tribunal also held that since entire value of includible services cannot be loaded into the value of goods, as rule of thumb 50?n be estimated to be relatable to the equipment.

The ruling as above further indicates that, to load value under Rule 6 ibid, it must be established that

1. Specifications were absolutely necessary for the component manufacturers to build T&D
2. The level of interaction between the specification supplier and the manufacturer of T&D also needs to be analysed

In the opinion of author, if the component manufacturer are able to exemplify that specifications are not absolute necessary for manufacturing T&D, the application of Rule 6 ibid could be escaped. It also appears that the level of interaction between GC and the component manufacturers is next to nil, therefore the harsh explored in DPC case supra, could be ably distinguished.

6. Absence of valuation mechanism

Another fatal attack that can be pounded on the findings of the revenue is the arbitrary valuation proposed by the revenue. The demand under SCNs received by component manufacturers is calculated on the basis of “total royalty” paid by the OEM to GC, as a percentage of the cost of material consumed by OEM. The percentage is then applied on the total sales by component manufacturer to OEM, and excise duty is calculated on the same.

In the opinion of the author, the valuation offer by revenue is erroneous. The royalty paid by OEM to GC is on account of a consolidated license to manufacture and sell, even if assumed for a minute, that some proportion is to be applied over DDS, the maximum of which should not exceed “significance of DDS in the component value”. The 100% application of royalty over DDS is gross unjustifiable.

In Commission of C.Ex. vs Wintac Limited[15], the Bangalore CESTAT had held that where the life of the technical know how was perpetual, the valuation cannot be applied over the goods due to lack of proper mechanism.

Moreover, the derivation of value of DDS should be in sync with the technical evaluation of the same. The derivation based on royalty has no legs, in as much as DDS are prima facie not qua royalty agreements. Furthermore the DDS may differ from SKUs to SKUs, from one model of vehicle to another etc. Even further, the royalty appears to be perpetual and co-relation with DDS is next to impossible. The ratio of Wintac Limited supra squarely applies in favour the assessees.

7. Non Exclusivity of the DDS

The OEMs have leveraged the cut throat competition in the automotive sector. This enables the OEMs to outsource manufacture of one particular P&C (and its corresponding T&D) to multiple vendors. The DDSs therefore are seldom exclusive for a vendor.

Owing to the non-exclusiveness of the DDSs, the component manufacture may also explore additional ground where it could be contended that DDSs are sunk costs and non-attributable towards the manufacturing value addition at their end. By incurring costs on the DDSs, the OEM has basically assumed the cost of the DDSs as non-BOM costs and therefore not attributable towards the value of components to be manufactured by the component manufacturers.

In cases where the DDSs are supplied along with RFQs issued by the OEM is also a meritorious case where the component manufacturer can argue that supplying of DDSs was per se an assumed cost by the OEM, and component manufacturing value was component vale ex-DDS.

8. Other Legal grounds to the aid of assessee

Demand to be restricted to shorter period: The investigations from the DG-GSTI is like waking up at 9:00 AM in the morning. Rule 6 ibid, the concept of amortization, jurisprudence over sole consideration, and the factual scenario of the OEM and component manufacturers are in existence from the days one could remember. The Act itself has been repealed, therefore the revenue could be said to be on very week footings when it comes to invocation of larger period. Over the years, multiple disputes have suffered same fate, and allegations of suppression has been jolted down by the Higher Courts. The shorter period for demand under the Central Excise Act, 1944 was 2 years from the relevant date (due date of filing monthly return). Since the (substantive) repeal of Central Excise Act, more than 20 months have already been elapsed, therefore substantive demand may well be pruned to very limited amount, if at all demands succeeds under shorter period.

Revenue Neutrality (RN): The excise duty (if any) leviable in most often case than not is available as Cenvat Credit to the OEMs, making the exercise revenue neutral. The shine of RN ground has been narrowing down over the years, however given the bona fide of the pertinent dispute, majority of the demands could be stuck down by the Higher Courts. With GST in place though, it has yet to be seen as to what extent the RN ground would be appreciated.

To conclude, the author believes that the operational aspects of the T&D manufacturing needs to be examined by the component manufacturers, and collect suitable evidence to contemplate that specifications are not more than just way to convey jobs by the OEM. DG-GSTI is still completing with the summon process for the remaining vendors asking them to classify them amongst given categories. The author believes that categorization and evidence are core remedies to be explored by the component manufacturers, in as much as the higher court is likely to appreciate the larger scheme of Rule 6 ibid and rule in favor of industry.

Special thanks to CA Manish Sachdeva for penning this article. For any further queries/comments please write to [email protected].