ITC Reversal Of Common ITC U/s17(2) Required In Relation To Activity Of Subscription And Redemption Of Mutual Funds

BRIEF FACTS OF THE CASE

• The Applicant, Zydus Lifesciences Ltd., is engaged in the manufacturing, supply & distribution of various pharmaceutical products.
• The Applicant invests their surplus/idle funds in various mutual fund schemes to ensure effective working capital management. The units of the mutual funds are redeemed as and when the business requirement for liquidity arises.
• The Applicant receives inward supplies of common inputs and input services that are used for affecting both the taxable supplies and also towards the activity of subscription and redemption of mutual funds.
• Currently, the Applicant is making proportionate reversal of ITC on the common inputs and input services in terms of section 17(2) of the CGST Act, 2017, r/w rule 42 of the CGST Rules, 2017. However, the Applicant is of the view that the said reversal is uncalled for and hence the present application for advance ruling was preferred before the Authority.
• Accordingly, the Applicant sought an advance ruling regarding the eligibility to avail of ITC of tax paid on common inputs & input services used in relation to the subscription and redemption of mutual funds.

SUBMISSION MADE BY THE APPLICANT

The Applicant made the following key averments in support of its claim that no ITC reversal is required:

• In a mutual fund scheme, the investor subscribes and redeems unit of the fund. There is no buying/selling of units involved.
• The definition of the term ‘exempt supply' as contained in section 2(47) is defined to mean supply of goods or services or both that attract nil rate or are exempt from tax. As units of mutual fund being ‘securities' are excluded from the definition of ‘goods' and ‘services', they are neither goods, nor services and therefore cannot be included within the scope of ‘exempt supply'.
• Redemption of mutual funds cannot be termed as ‘exempt supply' having been excluded out of the scope of supply of goods or services, and thus section 17(2) regarding ITC reversal does not apply.
• Although the term ‘transaction in securities' (not defined under law) creates a deeming fiction by including value attributable to transaction in securities in the value of exempt supply, securities being neither goods nor services cannot be considered as ‘exempt supplies'.
• Rule 42 values ‘transaction in securities' at 1% of sale value of securities, but redemption of mutual fund units is not same as a sale transaction.
• Without a specific valuation mechanism, ITC reversal cannot be enforced; there is no provision to determine the value of exempt supply for mutual fund redemptions.

FINDINGS AND CONCLUSION DRAWN BY AAR

• The AAR acknowledged that securities are neither goods nor services and thus not exempt supplies. However, they dismissed the argument of non-reversal of credit citing that the Applicant had in their submissions accepted that, as per the deeming fiction, transactions in securities must be included in the value of exempt supply under Section 17(2).
• Under section 16(1), ITC is allowed only for supplies of goods or services used in the course or furtherance of business. Since mutual fund units are neither goods nor services but securities, subscribing or redeeming them doesn't qualify as a supply, and thus, ITC on such transactions cannot be claimed.
• As the term ‘redemption' has not been defined, it has to be understood by applying the common parlance test. After perusing websites of various Mutual Funds, the Authority concluded that redemption of units is nothing but the sale of mutual fund units by the unit holder to the Asset Management Company.
• Basis the above, the Applicant's argument that there's no machinery to determine exempt value was rejected, and the case laws cited by the Applicant were not delved into by the Authority.
• The Authority concluded the Applicant must reverse common ITC as per Section 17(2).

AURTUS COMMENTS

• The AAR failed to analyze that to constitute an exempt supply, the pre-requisite test of an activity being a ‘supply' has to be met. Since ‘securities' find an exclusion from the ambit of ‘goods' and ‘services' themselves, the question of it qualifying as an ‘exempt supply' would not arise, more so when the said terms are exhaustively defined. Section 17(3) merely bears the task of determining the ‘value of exempt supply' u/s 17(2) and it cannot define an activity to be ‘exempt supply', which is otherwise not a ‘supply' in the first place in terms of the substantive provisions contained in section 2(47) and 2(78) which define an exempt supply or non-taxable supply.
• The Authority has erred by resorting to a narrow interpretation of the term redemption and applying the common parlance test in the present case. The Authority has failed to appreciate the distinction between the transaction of ‘sale' and ‘redemption' and simply equated both, stating cessation of ownership. As per Sale of Goods Act, 1930¹ , the core of a transaction of ‘sale' includes the transfer of ownership, and not merely cessation of ownership, from the seller to the buyer for a price, i.e. a consideration paid by a buyer for a value. A mutual fund ‘redemption' transaction does not involve any transfer to a buyer / third party for any sale price, but extinguishment of the redeemed units for a redemption amount determined at Net Asset Value (NAV) of the underlying asset. To then conclude that there is a sale of mutual fund units back to the fund would mean that the fund is now holding the units, which conclusion is not correct.
• Typically, Overnight funds and Liquid funds, where surplus working capital is temporarily invested for a shorter duration, are Open-ended schemes which are not capable of being ‘sold' but only ‘redeemed'. Neither the Authority nor the Applicant have emphasized the distinction between open-ended and closedended mutual fund schemes, and that only closed-ended mutual fund schemes are capable of being ‘sold'. It is relevant to appreciate the following difference between open-ended and closed-ended schemes:
  • Open-ended schemes are open for subscription and redemption on a continuous basis, but not available for trading at a market price. Such mutual fund units are valued on NAV basis which is determined by the value of fund's underlying pool of securities. After redemption, the units are extinguished and cannot be re-issued unlike in the case of sale of units. Typically, open-ended mutual fund units such as typically cannot be sold but only redeemed.
  • Closed-ended schemes are open for subscription only at the time of the initial offer and redeemed only upon end of the fixed maturity period. While such units are also valued regularly on NAV basis, however, these are also available for sale on an exchange at a sale price (different from NAV), depending upon its supply and demand.
• While section 17(2) states that ‘transaction in securities' shall be considered as an exempt supply, however, the machinery provision for arriving at the value as per Explanation (2)(b) is based on the ‘sale value' of the security. In the case of openended schemes like mutual funds, there is no actual sale in the conventional sense, as units are issued and redeemed by the fund itself at NAV, not sold to third parties. As a result, no sale value can be ascertained, rendering the machinery provision unworkable. It is a settled legal principle² that where the machinery provision fails, the corresponding levy also fails. It is also a settled position in law³ that while interpreting the provisions, the courts need to avoid all circumstances of head-on clash between the provisions. Therefore, the only harmonious interpretation of Section 17(2) and Explanation 2(b) is that no value of exempt supply arises in such cases, and consequently, no input tax reversal should apply.
• The basis of arriving at value of exempt supply for transaction in securities in terms of the Explanation 2(b) is arbitrary, as it fails to consider complex scenarios like redemption of debentures (which is nothing but a grant of loan), futures and options contracts and the like, which are tied to the market value of underlying assets and don't have a standard ‘sale value'. These contracts are continuously marked to market, involve the exchange of contract premiums and are settled before expiry, making the standard valuation method prescribed under Explanation 2(b) unclear and ambiguous. Any allegation requiring taxpayers to reverse ITC based on an arbitrary profit percentage (which could be substantial) with an inconsistent basis of valuation can also be legally challenged.
• The entire objective for introducing the provision seems to be that the direct credits (such as GST on brokerage paid) are not availed. An argument could be made that even that is eligible. The Government has failed to appreciate that in the conduct of business operations, the treasury plays a very critical role, and entities would always intend to optimize returns on idle funds. Hence to say that investing in mutual funds and shares (to optimize returns) is not in the course or furtherance of business is not correct. Sometimes such transactions could be by way of strategic investments in group companies which are later liquidated. A provision which requires reversal of credit each time investments is made and sold clearly has no basis and is bad in law, specifically when the treasury functions do not require any substantial expenditure. The common services availed such as rent, audit, consulting services etc., are clearly not for carrying out treasury functions, but for the conduct of the business. Clearly, there is a need to create a carveout under Rule 42 and 43 for treasury operations, as has been done for interest income. It is only expected that an amendment is introduced to address this anomaly.

Footnotes

1. – In Commissioner of Service Tax, Delhi vs PN. Vijay Financial Services (P) Ltd. [2008 (9) TMI 72 CESTAT-Del] it has been observed that the phrase ‘stock and shares' under the definition of ‘goods' under Sale of Goods Act, 1930 shall be interpreted widely to include ‘securities' such as mutual fund units.

2. – Ace Creative Learning Pvt. Ltd. Vs. Commissioner of Central Tax, Bengaluru South GST Commissionerate [2021 (4) TMI 687 – CESTAT Bangalore] and M/s Ambuja Cements Ltd. Vs. Commissioner of Cus, CEx. and GST, Nagpur [2023 (5) TMI 806 – CESTAT Mumbai]

3. – Commissioner of Income Tax vs. Hindustan Bulk Carrier [(2002) Supp. (5) S.C.R. 387]

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