Substance Over Form: Debate Enters Indirect Tax Regime

  1. Background

Without elaborating how and why, the Supreme Court recently declared that it “has consistently applied one test: substance over form” to opine that the form and style of employee secondment agreement was “not decisive of its nature” and recharacterise the relationship between the parties as of “manpower supply services” by one to another. This declaration in Commr. of Customs, Central Excise and Service Tax v. Northern Operating Systems (P) Ltd.[1] has brewed a storm in the tax fraternity — particularly in the sphere of indirect taxation to which this decision relates — given that it unsettles the relatively tranquil interpretative rule that the tax authorities cannot disregard the legal structure and recharacterise the transaction in the absence of fraud or overwhelmingly compelling circumstances.

Taking note of economic realities and the “substance” of the bargain struck between the parties, the Supreme Court rejected the legal framework of their agreement to confirm demand of service tax on the transaction. In this process, the court failed to advert to its earlier precedents revalidating the taxpayers’ choice of form of transaction which continue to hold the field in view of the conspicuous parliamentary abstinence to enact “general anti-avoidance rules” in indirect tax paradigm unlike the income tax law. This note seeks to dissect the dichotomy which arises in the jurisprudential confines of indirect tax law on account of this decision.

  1. A Caveat

Before advancing further on the recent decision, it is crucial to highlight that the “substance over form” test is not totally unheard of in the indirect tax realm[2] and instead been applied in limited context to determine the “substance” of the transaction.[3] However, in these decisions the “substance” test has received a fleeting reference, perhaps only to revalidate the conclusion apparent on the first glance of the transaction.

In another sense, substance also intrinsically forms the core of “substantial compliance” test which is a key pivot in the indirect tax laws. This principle dispenses complete compliance with the statutory provisions and it is sufficient in the event the taxpayer demonstrates that the provisions have been complied with substantially.[4] Thus, the “substance” test has indeed been in vogue, albeit indirectly, in the indirect tax framework, but to a limited extent.

  1. Dispute before the Supreme Court

With the aforesaid background, we traverse the recent decision in Northern Operating case[5]. The facts in this case were simple, yet extensive debate arose on the nature of the transaction and the economic relationship underlying the agreement. The dispute arose with a demand of service tax raised by the tax authorities against Northern Operating Systems Pvt. Ltd., an Indian company (hereinafter referred as “I Co.”). The demand was in respect of various agreements executed by I Co. with its group companies located in many countries, such as US, UK, Singapore, etc. (hereinafter collectively referred as “NR Co.”).

In terms of these agreements, I Co. would request NR Co. “for managerial and technical personnel to assist in (I Co’s.) business and accordingly the employees are selected by the (NR Co.) and they would be transferred to (I Co.). The employees shall act in accordance with the instructions and directions of (I Co.). The employees would devote their entire time and work to the (I Co.). The seconded employees would continue to be on the payroll of the (NR Co.) for the purpose of continuation of social security/retirement benefits, but for all practical purposes, (I Co.) shall be the employer. During the term of transfer or secondment the personnel shall be the employee of (I Co.). (I Co. shall) issue an employment letter to the seconded personnel stipulating all the terms of the employment. The employees so seconded would receive their salary, bonus, social benefits, out of pocket expenses and other expenses from (NR Co.). The (NR Co.) shall raise a debit note on (I Co.) to recover the expenses of salary, bonus, etc. and (I Co.) shall reimburse the (NR Co.) for all these expenses and there shall be no markup on such reimbursement.”[6]

According to the tax authorities, the aforesaid arrangement was one of “manpower recruitment or supply” service being provisioned by NR Co. to I Co. which was exigible to service tax. The raison d’être for this premise was the opinion of the tax authorities that through this arrangement NR Co. were “providing skilled manpower, on secondment basis” to I Co. wherein NR Co. are the service providers and I Co., which receives skilled manpower, on secondment basis, is the service recipient. The tax authorities highlighted that in this “secondment arrangement a secondee would continue to be employed by the original employer during the secondment, and will, following its termination return to the seconder/original employer. As a consequence of this, the secondee does not become integrated into the host’s organisation” which confirmed the presence of “manpower supply” element of the concerned service.

I Co. contested the premise of the tax authorities to put forth its understanding that it was incorrect to view NR Co. as supply suppliers given that the transaction was limited to the seconded personnel acting as “employees” of I Co., which transaction was outside the service tax framework under the law. This view of I Co. was accepted in adjudication and also approved by the Appellate Tribunal. According to the Tribunal, NR Co. were not engaged in supply of manpower; “those seconded to the assessee working in the capacity of employees and receiving salaries by (NR Co.) were only for disbursement purposes”; employee-employer relationship existed between such personnel and I Co.; in effect I Co. “obtained from (NR Co.) directly or by transfer, service of expatriate employees who were paid salaries by the (I Co.) in India, for which tax was deducted and paid to statutory benefits — such as provident fund”, etc. and thus the demand of service tax was unfounded. Being aggrieved by this conclusion, the tax authorities approached the Supreme Court seeking validation of their premise. It was in this background that the lis came up for consideration before the Supreme Court.

In the Supreme Court the tax authorities pitched their argument higher to reflect upon the attendant circumstances and the relationship between I Co. and NR Co. as well to impress upon the court that in reality NR Co. “provided the services of its employees to (I Co.) for the performance of agreed tasks” which in turn “were handed over to (I Co.) by (NR Co.). It was not as if (I Co.) was free in regard to the manner of performance of the jobs assigned to it.” The tax authorities also sought to project that the “real employer” of the seconded employees was not I Co. and “the mere fact that the temporary control over the manner of performance of duties of the employees seconded (was with I Co.) did not take away or diminish the fact that their real employer was none other than” NR Co. In essence, therefore, the tax authorities argued that the agreements between I Co. and NR did not reflect the true state of affairs as “real reason or purpose for the secondment” was not what was sought to be portrayed in those agreements.

  1. Dissecting the Decision of the Supreme Court

In the wake of absence of precedent in the service tax context, the Supreme Court made reference to its decisions in DIT (International Taxation) v. Morgan Stanley & Co. Inc.[7] and CIT v. Eli Lilly and Co. India (P) Ltd.[8] rendered in the context of income tax laws, to underscore that such situations are frequent in the tax paradigm where one is required to determine the question “who is the employer, and whether the relationship between an employee and another, is one of master servant, or whether there is an underlying contract for service, by which the real employer, lends the services of his employee to another”. Furthermore, by accepting the application of “real employer” test, the Supreme Court dissipated the legal rights and obligations of the parties as the sole factor of consideration to make the factual construct also relevant, which implies expanding the zone of considerations to a wide variety of variables including economic costs.

The Supreme Court also imported its labour law jurisprudence to enlist the tests for distinguishing between “contract of service” vis-à-vis “contract for service” in order to delineate the relationship between I Co. and NR Co. Concepts such as “master-servant” relationship, “control” test, etc. were, thus, brought and instituted within the fold of tax law as critical facets of inquiry. The Supreme Court, thereafter, exposited another principle that “the nomenclature of any contract, of document, is not decisive of its nature”. Thus the stage was set for the Supreme Court to declare that the “task for this court, therefore is to, upon an overall reading of materials presented by the parties, discern the true nature of the relationship between the seconded employees and the assessee, and the nature of the service provided — in that context, by (NR Co.) to (I Co.)”.

Before one dissects the substantive contours of the decision, it is expedient to take note of certain objections to the aforesaid approach of scrutinising the factual ingredients:

(a) In its own description, the decision emphasises the need for the Supreme Court to appreciate the factual parameters of the transaction. This approach is at variance with the appellate jurisdiction, which was being exercised by the Supreme Court, which is statutorily restricted to determination of the “substantial question of law”. Thus, the Supreme Court appears to have exceeded the periphery of its examination.

(b) No reason by the Supreme Court has been assigned to disregard the factual conclusions of two authorities below which have examined the factual paradigm and found no reason to doubt them. Thus, the decision muddles the legal threshold for the Supreme Court to consider facts which, it is now well settled, is occasioned only when the factual appreciation by the lower authorities is “perverse”.[9]

(c) The decision of the Supreme Court does not reveal whether the tax authorities alleged impropriety in the factual setting so as to reject the legal form of the transaction. Furthermore, despite noting that the tax officer who first adjudicated the lis himself rejected the case of the Tax Department and found nothing objectionable in the legal arrangement, the Supreme Court proceeded to redraw the factual confines on which the parties transacted.

Having thus concluded that a factual reappreciation was indeed warranted, the Supreme Court culled out the underlying aspects of the contractual terms which were perceived to exist by it. The court even reflected upon the changing global economic dimensions and international hiring of labour to re-emphasise the need for applying the test of “substance over form, requiring a close look at the terms of the contract, or the agreements”.

Having said that, however, the findings in the decision are clearly inconsistent and reveal a dichotomy in the perception of the facts. This aspect is best understood by a comparative analysis of certain observations of the court. In one of the paragraphs, the Supreme Court observed as under:

  1. 57. The above features show that the assessee had operational or functional control over the seconded employees; it was potentially liable for the performance of the tasks assigned to them. That it paid (through reimbursement) the amounts equivalent to the salaries of the seconded employees — because of the obligation of the overseas employer to maintain them on its payroll, has two consequences: one, that the seconded employees continued on the rolls of the overseas employer; two, since they were not performing jobs in relation to that employer’s business, but that of the assessee, the latter had to ultimately bear the burden. There is nothing unusual in this arrangement, given that the seconded employees were performing the tasks relating to the assessee’s activities and not in relation to the overseas employer. To put it differently, it would be unnatural to expect the overseas employer to not seek reimbursement of the employees’ salaries, since they were, for the duration of secondment, not performing tasks in relation to its activities or business.[10] (emphasis in original)

Were one to read only the aforesaid paragraph, as a representative sample of the Supreme Court’s reasoning, one would perhaps be pardoned for concluding that the Supreme Court declared I Co. to be the de facto employer. In this scenario, the substance over form test would compel a conclusion that master-servant relationship existed between I Co. and the seconded employees, which fact alone would be sufficient to disregard the premise that NR Co. is supplying manpower to I Co. However, the Supreme Court flipped this conclusion inter alia observing as under:

  1. 60. Facially, or to put it differently, for all appearances, the seconded employee, for the duration of her or his secondment, is under the control of the assessee, and works under its direction. Yet, the fact remains that they are on the pay rolls of their overseas employer. What is left unsaid and perhaps crucial, is that this is a legal requirement, since they are entitled to social security benefits in the country of their origin. It is doubtful whether without the comfort of this assurance, they would agree to the secondment. Furthermore, the reality is that the secondment is a part of the global policy — of the overseas employer loaning their services, on temporary basis. On the cessation of the secondment period, they have to be repatriated in accordance with a global repatriation policy (of the overseas entity).[11]

(emphasis in original)

Thus, by introducing a “doubt” which the court harboured[12] (though it was not a fact on record or even an allegation), the Supreme Court rewrote its own understanding to conclude that I Co. was not the de facto employer, basing its conclusion on a perceived “reality”.

  1. Substance over Form: Unanswered Questions

The decision has created more doubts than the controversy it has settled, that too not just in the indirect tax paradigm. To illustrate, the decision sheds doubt over the propriety and operability of the “deputation”/”secondment” related employment models in vogue in the country. Supposing the same fact pattern was to be tried under an industrial dispute setting, there are some glaring questions requiring advertence were the substance over form test to apply. For example: (i) Who would be held liable for omission to perform legal obligations qua the employees? Would it be I Co., being their “operational or functional” employer or NR Co. as their “legal employer”? (ii) Would I Co. be vicariously liable for acts of the deputed/seconded employees? (iii) Can the foreign deputed/seconded personnel be denied employment visa (by government authorities) in India on the ground that they are not the employees of I Co.? Many issue arise with this ruling.

Notwithstanding, it goes without saying that the emphatic emphasis placed in decision on the substance over form test poses issues in the specific context of indirect taxes. To address these aspects, one is compelled to review the decisions propelling against application of “substance over form” test in this realm.

One of the leading decisions in indirect taxation is the three-Judge Bench verdict in the CCE v. Acer India Ltd.[13] While determining the valuation of supply a unanimous Supreme Court categorically ruled out the application of the substance over form test in this sphere of tax laws. Explaining the relevant propositions in the decision, under the heading “principles of interpretation of a taxing/fiscal statute”, the Supreme Court inter alia culled out the following rules governing the interpretation:

  1. It is also well-settled rule of construction of a charging section that before taxing a person it must be shown that he falls within the ambit thereof by clear words used as no one can be taxed by implication.
  2. It is further well settled that a transaction in a fiscal legislation cannot be taxed only on any doctrine of “the substance of the matter” as distinguished from its legal signification, for a subject is not liable to tax on supposed “spirit of the law” or “by inference or by analogy”.
  3. The taxing authorities cannot ignore the legal character of the transaction and tax it on the basis of what may be called “substance of the matter”. One must find the true nature of the transaction.[14]

Thus, unequivocally, the Supreme Court in Acer case[15] equated the “substance over form” test as falling with the prescription against taxation “by inference or by analogy”. There are many similar declarations, to enlist a few;

(a) It was also exemplified in State of Rajasthan v. Basant Agrotech (India) Ltd.[16] wherein the Supreme Court quoted with approval the opinion of the Privy Council in the celebrated Bank of Chettinad v. CIT[17] and other leading decisions[18] to conclude that taxation based on “substance of the matter” was antithetical to the settled jurisprudential norms.

(b) A five-Judge Bench in Kone Elevator India (P) Ltd. v. State of T.N.[19] reversed an earlier three-Judge Bench decision[20] which had inter alia opined that “[i]t is settled law that the substance and not the form of the contract is material in determining the nature of transaction”.

(c) Similarly a three-Judge Bench in BSNL v. Union of India[21] reversed a two-Judge Bench decision in State of U.P. v. Union of India[22] which had stressed upon the substance test.[23]

Thus clearly, the substance over form debate has generally been rejected in its application in the realm of indirect taxes.

Having said that, it would not be correct to state that in the indirect tax realm the “substance” debate has never arisen. For illustration, tax benefits have been denied by the courts in situations where allegations of fraud and subterfuge have been factually demonstrated.[24] The issue with the decision in Northern Operating case[25], however, is that there is neither an allegation of deceit nor a finding that the legal arrangement between the parties was a “sham” warranting its disregard.

Our quest to position substance over form rule in indirect tax paradigm gets further thrust from a review of developments in the context of income tax law, wherein the restatement of law in Cape Brandy Syndicate v. IRC[26] and the IRC v. Duke of Westminster principle[27] were emphatically approved by the Supreme Court to the effect that “what is material in the tax jurisprudence is the evasion of the tax, not the beneficial lawful adjustment thereof”[28] and consistently genuine commercial transactions, even if leading to a reduction in tax liability, have been accepted without demur.[29] There is no dearth of such judicial opinion,[30] though it was interjected briefly by in McDowell and Co. Ltd. v. CTO[31], but only to be reiterated subsequently.[32] Subsequently, to quell the debate once and for all, the Parliament intervened and enacted the provisions (i.e. general anti-avoidance rules or GAAR[33]) which enable the tax authorities to invoke the substance over form rule and recharacterise the transaction. However, the application of GAAR is permitted only in the wake of an elaborate set of procedural regimentation and substantive declaration of safeguards of taxpayer’s rights. Thus, a question arises whether substance over form test is permissible within the confines of indirect tax laws given the Parliament’s abstinence to enact such laws in this space despite making amends in income tax framework.

  1. Conclusion

A larger critique of substance over form test is the overwhelmingly disproportionate emphasis on facts in this line of inquiry which virtually renders impossible a dispassionate evolution of legal principles, thereby rendering each case a precedent confined to its own factual setting. The same is the case with the Northern Operating[34] decision which premises the conclusion so deep on the factual paradigm that it would give little trouble to ingenuine lawyers in identifying factors which would distinguish its application. In another sense, such decisions also dilute (if not obviate) the precarious tax certainty which is craved upon not just by the stakeholders but judiciary alike,[35] rendering the outcome of the lis rests more on the subjective assessment of facts instead of an objective implementation of the legal standards.


Tarun Jain, Advocate, Supreme Court of India; LLM (Taxation), London School of Economics

[1] 2022 SCC OnLine SC 658.

[2] See generally, Larsen & Toubro Ltd. v. State of Karnataka, (2014) 1 SCC 708 : (2014) 303 ELT 3 wherein the Supreme Court acknowledged existence of certain decisions which tested the substance of the contract (in order to ascertain whether they were exigible to sales tax) to opine that such decisions have lost precedential value in view of a constitutional amendment.

[3] For illustration, in Great Eastern Shipping Co. Ltd. v. State of Karnataka, (2020) 3 SCC 354 : (2020) 32 GSTL 3 the Supreme Court referred to the “substance” test in order to determine the true nature of the lease of the ship where the transaction was characterised as a time charter agreement.

[4] For illustration, see CCE v. Hari Chand Shri Gopal, (2011) 1 SCC 236 : (2010) 260 ELT 3.

[5] 2022 SCC OnLine SC 658.

[6] The relevant clauses of the agreements, as reproduced in the Supreme Court’s decision.

[7] (2007) 7 SCC 1.

[8] (2009) 15 SCC 1.

[9] For illustration, see Chandna Impex (P) Ltd. v. Commissioner of Customs, (2011) 7 SCC 289 : (2011) 269 ELT 433; Nicholas Piramal India Ltd. v. CCE, (2010) 14 SCC 635 : (2010) 260 ELT 338; CCE v. Sai Mirra Innopharma (P) Ltd., 2015 SCC OnLine SC 1398 : (2015) 326 ELT 633.

[10] 2022 SCC OnLine SC 658.

[11] 2022 SCC OnLine SC 658.

[12] “[i]t is doubtful whether without the comfort of this assurance, they would agree to the secondment”.

[13] (2004) 8 SCC 173, 184 : (2004) 172 ELT 289. This decision was subsequently approved by a five-Judge Bench of the Supreme Court in CCE v. Grasim Industries Ltd., (2018) 7 SCC 233 : (2018) 360 ELT 769.

[14] Relying upon Union of India v. Playworld Electronics (P) Ltd., (1989) 3 SCC 181.

[15] (2004) 8 SCC 173 : (2004) 172 ELT 289.

[16] (2013) 15 SCC 1 :  (2014) 302 ELT 3.

[17] 1940 SCC OnLine PC 29 .

[18] Such as, A.V. Fernandez v. State of Kerala, AIR 1957 SC 657, Partington v. Attorney General, (1869) 4 HL 100.

[19] (2014 ) 7 SCC 1 : (2014) 304 ELT 161.

[20] State of A.P. v. Kone Elevators (India) Ltd., (2005) 3 SCC 389 :  (2005) 181 ELT 156.

[21] (2006) 3 SCC 1.

[22] (2003) 3 SCC 239 : (2004) 170 ELT 385.

[23] “The terminology employed to describe an activity as sale or service is not conclusive in itself. By calling sale as service or vice versa, the substance of the transaction will not get altered. The question has to be determined, by discerning the substance of the transaction in the context of the contract between the parties or in a case of statutory contract in the light of the relevant provisions of the Act and the Rules.” (2003) 3 SCC 239 : (2004) 170 ELT 385.

[24] For illustration, see Commr. of Customs v. Pundrick Ravindra Trivedi, (2015) 16 SCC 702 : (2015) 322 ELT 812, following Commr. of Customs v. Phoenix International Ltd., (2007) 10 SCC 114 : (2007) 216 ELT 503.

[25] 2022 SCC OnLine SC 658.

[26] (1921) 1 KB 64 that “[i]n a taxing Act one has to look merely at what is clearly said. There is no room for any intendment. There is no equity about a tax. There is no presumption as to a tax. Nothing is to be read in, nothing is to be implied. One can only look fairly at the language used”. Cited with approval inter alia in Ranbaxy Laboratories Ltd. v. Union of India, (2011) 10 SCC 292; CCE v. Acer India Ltd., (2004) 8 SCC 173.

[27] 1936 AC 1 that “every man is entitled if he can to order his affairs so that the tax attaching under the appropriate Acts is less than it otherwise would be”.

[28] CIT v. Sarabhai Holdings (P) Ltd., (2009) 1 SCC 28 : (2008) 307 ITR 89.

[29] For illustration, see Aruna Group of Estates v. State of Madras, 1961 SCC OnLine Mad 252 : (1965) 55 ITR 642 wherein it has been inter alia observed that “[a]voidance of tax is not tax evasion and it carries no ignominy with it for it is sound law and, certainly, not bad morality for anybody to so arrange his affairs as to reduce the brunt of taxation to a minimum”. See also CIT v. Sri Abhayananda Rath Family Benefit Trust, 2002 SCC OnLine Ori 307 : (2002) 255 ITR 436.

[30] For illustration, see CIT v. Calcutta Discount Co. Ltd., (1974) 3 SCC 260 : (1973) 91 ITR 8, CIT v. A. Raman & Co., AIR 1968 SC 49 :  (1968) 67 ITR 11.

[31] (1985) 3 SCC 230 : (1985) 154 ITR 148.

[32] For illustration, see Union of India v. Azadi Bachao Andolan, (2004) 10 SCC 1 : (2003) 263 ITR 706; CIT v. Walfort Share and Stock Brokers (P) Ltd., (2010) 8 SCC 137 : (2010) 326 ITR 1.

[33] Income Tax Act, 1961, Ch. X-A.

[34] 2022 SCC OnLine SC 658.

[35] For illustration, see Vodafone International Holdings BV v. Union of India, (2012) 6 SCC 613 : (2012) 341 ITR 1.

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