Experts CornerTarun Jain (Tax Practitioner)

Introduction

The very fact that a tax is recognised as a transaction tax on a conceptual basis implies that there must be a transaction to begin with in order to levy such a tax. Admittedly goods and services tax (GST), introduced in India in 2017, is one such tax. It is hinged upon the existence of a supply which has been legislatively defined to essentially refer to a transaction between two persons. A key element for the levy of GST is existence of “consideration”. Albeit there are certain circumstances in which consideration is not necessary and by way of a legal fiction is “deemed” to exist. In all other cases, however, consideration must flow from the recipient of the supply to the supplier in order for the transaction to be exigible to tax. Thus is introduced within the GST realm an important aspect of the law of contract, the “privity of consideration” doctrine. This post examines the nuances of the doctrine to explore its interplay under the GST law and explore its increasing application to address intricate issues which may arise owing to the peculiarities of “consideration”.

Privity of consideration: Not a sine qua non for a valid contract unlike privity of contract

Under the law of contract, privity between parties to the contract (i.e. privity of contract) is a necessity. “It is an elementary principle of English law known as the ‘doctrine of privity’ that contractual rights and duties only affect the parties to a contract, and this principle is the distinguishing feature between the law of contract and the law of property.”1 The same legal position exists under the Contract Act, 1872 (ICA). Pollock & Mulla, describing this doctrine, state “a contract cannot confer rights or impose obligations arising under it on any person except the parties to it. No one but the parties to a contract can be entitled under it or bound by it. This principle is known as that of privity of contract”.2

By contrast, privity of consideration is not a requirement for valid contract. This is on account of the definition of “consideration” set out in Section 2(d) of the ICA which permits the consideration for a contract to flow from a third party. It states that “when, at the desire of the promisor, the promisee or any other person has done or abstained from doing, or does or abstains from doing, or promises to do or to abstain from doing, something, such act or abstinence or promise is called a consideration for the promise”. In other words, for a contract to come into existence, it is not necessary that the consideration for the contract must necessarily come from the parties to the contract; the consideration can flow even from any other person. This aspect was resounded by the Delhi High Court, inter alia observing that “in India, whereas privity of contract is a must to create a jural relationship, privity of consideration is not essential and pertaining to a contract, consideration may flow to a contracting party from a third party, but at the instance of the other contracting party.”3

Even though there has been a proposal to amend this legal position,4 nonetheless “under the Act, the consideration for an agreement may proceed from a third party, but it does not follow that the third party can sue on the agreement”.5

Privity of consideration under GST laws: Exploring the interplay

The relevance of the aforesaid discussion under the law of contracts qua transaction taxes is brought out from the following consequences flowing from the privity doctrine:6

“The doctrine has two aspects. The first aspect is that no one but the parties to the contract are entitled under it. Contracting parties may confer rights or benefits upon a third party in the form of a promise to pay, or to perform a service, or a promise not to sue (at all or in circumstances covered by an exclusion or a limitation clause). But a third party on whom such right or benefit is conferred by contract can neither sue under it nor can rely on defences based on the contract.

The second aspect of the doctrine is that parties to a contract cannot impose liabilities on a third party. A person cannot be subject to the burden of a contract to which he is not a party. It is the counterpart of the proposition that a third person cannot acquire rights under a contract. This rule, for example also bars a person from being bound by an exemption clause contained in a contract to which it is not a party, so that a contract between A and B cannot impose a liability upon C.”

For our purpose, this summation of the legal position brings forth two aspects which may be relevant for transaction tax perspective. First, a contract between A and B can cause a benefit to flow from A to C. Second, in a contract between X and Y, the consideration to X can flow from Z (upon insistence of Y) even though Z is not a party to the contract. Let us exemplify these aspects in form of illustrations.

Illustration 1-A. A, a philanthropist executes a contract with B, a renowned NGO. Under the contract, B will carry out free evening teaching classes in identified areas to all daily wagers and their children, who are collectively referred as C. In turn, A shall compensate B for carrying out the teaching activity.

Having noted the contract law propositions, let us transpose them in transaction tax domain. For this purpose, it is imperative to take note of the legal provisions of the GST laws. The provisions of the Central Goods and Services Tax Act, 2017 (CGST Act) carry specific stipulations to this end. Section 2 of the CGST Act inter alia defines a “recipient” and “supplier” in the following terms:

(93) “recipient” of supply of goods or services or both, means — (a) where a consideration is payable for the supply of goods or services or both, the person who is liable to pay that consideration; (b) where no consideration is payable for the supply of goods, the person to whom the goods are delivered or made available, or to whom possession or use of the goods is given or made available; and (c) where no consideration is payable for the supply of a service, the person to whom the service is rendered, and any reference to a person to whom a supply is made shall be construed as a reference to the recipient of the supply and shall include an agent acting as such on behalf of the recipient in relation to the goods or services or both supplied;

* * *

(105) “supplier” in relation to any goods or services or both, shall mean the person supplying the said goods or services or both and shall include an agent acting as such on behalf of such supplier in relation to the goods or services or both supplied.

Let us apply the aforesaid statutory stipulations in the illustration. Theoretically, there can be two versions on its treatment under the GST law. The first version supports the view that there is only one supply in this situation. The second version, however, moots two supplies in this illustration.

  • In the first version, A will be the recipient, as A is liable to pay for the service which B is supplying and accordingly B will be the supplier. In this version, C is a third party to the contract and thus at best a beneficiary.

  • However, second version opines that there are two supplies; the first supply being between A and B and the second supply being occasioned when B undertakes teaching to C. Accordingly to this version, B is the supplier in both supplies. However, the recipient is A (who pays for the supply) in the first supply. In the second supply C is the recipient in terms of Section 2(93)(c) of the CGST Act, which specifically identifies “where no consideration is payable for the supply of a service, the person to whom the service is rendered” is construed as the recipient of the service.

The dichotomy in the two versions under the GST law is best reconciled when the privity of consideration doctrine from contract law perspective is introduced in this scenario. The doctrine of privity of consideration clearly demystifies that there is only one contract in this situation where only A and B are the parties to the contract. The doctrine of privity of consideration is clearly able to delineate that C, even though it gets benefit from the contract between A and B, is at best a third party and thus only a beneficiary which reveals that there is no second supply.

Illustration 1-B. Let us take another illustration on similar lines. Here, P is a pauper litigant. Q is a legal aid society which empanels counsels willing to act pro bono of which R is a member. In view of P approaching Q, R represents P before the court for which R is compensated by Q.

Even in this illustration, theoretically, there can be two versions on its treatment under the GST law. The first version supports the view that there is only one supply in this situation. The second version, however, moots two supplies in this illustration.

  • In the first version, R is the service provider (of legal services) and Q is the service recipient as Q is the person liable to pay for the service which R is supplying. In this version ,P is a third party to the contract, thus, at best a beneficiary.

  • However, second version opines that there are two supplies; the first supply being between R and Q and the second supply being occasioned when R undertakes to represent P. Accordingly to this version, R is the supplier in both supplies. However, the recipient is Q (who pays for the supply) in the first supply. In the second supply P is the recipient in terms of Section 2(93)(c) of the CGST Act, similar to Illustration 1-A.

Similar to Illustration 1-A, the dichotomy amongst the two versions under the GST law in this illustration is best reconciled by the doctrine of privity of consideration. Here R has agreed to represent P on account of the contract between R and Q in terms of which Q has recommended and paid for R to represent P. Thus, the contract is between R and Q and the doctrine of privity of consideration explains why R is representing P in this situation and there is no independent transaction between R and P and there is no separate supply by R to P.

Admittedly both the above illustrations are qua philanthropic activities. However, that fact alone does not take them out of the purview of tax legislations as it is now virtually well established that mere absence of profit motive is not sufficient to ward-off tax liability.7 In any case, there is nothing in these illustrations which cannot accommodate purely commercial transactions, and thus the relevance of doctrine of privity of consideration cannot be overemphasised in the realm of GST law.

Illustration 2. X is a start-up entity which has launched a new product. X is desirous of having a wide user base for its product. X contracts with Y, a marketing company, to make the product popular by getting at least 10,000 users sign up on X‘s website and order one product each. Y would charge marketing fee from X if Y is successful in this assignment. Through intensive marketing, Y is able to successfully get the requisite number of users sign up on X’s website and order the products. These users are collectively referred to as Z. Thus, Y charges the marketing fee from X.

Even though it may be fairly obvious as to who is the supplier and who is the recipient in this illustration from a GST perspective, the doctrine of privity of consideration nonetheless confirms the analysis. By applying the doctrine of privity of consideration, it is clear that the contract is between X and Y where the consideration to X flows from Z (through activities of Y) even though Z is not a party to the contract. Thus, X is the recipient and Y is the supplier. This is so, notwithstanding the conspicuous absence of “consideration” element in the definition of “supplier” under the CGST Act.

The aforesaid illustration has a real life parallel. In the year 2016, owing to demonetisation being announced by the Government, there were difficulties for certain users to carry the cash required to be paid, for crossing a toll bridge. In order to obviate such difficulties, the Ministry permitted users to cross the bridge without making any payment during a particular period. In lieu of the loss suffered by the toll operator on this account, the Ministry compensated the toll operator. The services by way of toll were specifically exempt under the service tax law. However, when the payments were made by the Ministry to the toll operator, certain tax officers sought to levy service tax on the payment made by the Ministry to the toll operator, on the premise that the payments represented an independent service by the toll operator to the Ministry. To address the issue, the Tax Board issued a circular8 clarifying that the activity carried out by the toll operator (i.e. allowing use of the road) remained the same and it was only because the toll operator received the consideration from the Ministry that it permitted the users to use the road without payment of the toll by them. Thus, there was no change in the contract (between the toll operator and user of road) and only the flow of consideration changed. Inter alia the following conclusions were drawn in the circular:

“The service that is provided by toll operators is that of access to a road or bridge, toll charges being merely a consideration for that service. On Ministry of Road Transport and Highways of India (MoRTH)/National Highways Authority of India (NHAI’s) instructions, for the period 8-11-2016 to 1-12-2016 this service of access to a road/bridge was continued to be provided without collection of consideration from the actual user of service. Consideration came from the project authority. The fact that for this period, for the same service, consideration came from a person other than the actual user of service, does not mean that the service has changed.”

Thus, even though the circular did not make specific reference to the doctrine of privity of consideration, it nonetheless gave effect to it in practice by (a) acknowledging that consideration can flow from a third person which is not a party to the contract; and (b) accepting that flow of consideration from a third party does not change the nature of transaction between the parties to a contract. The logic underlying this circular has been extended even to GST laws,9 which clearly reveals the importance of appreciating the finer nuance of doctrine in transaction tax space, including GST.

Conclusion

The aforesaid analysis has multiple implications. First, it reveals how tax law does not operate in isolation. Instead, the contours of tax law are intrinsically interwoven with many other laws, including the law of contract. Second, there can be innate difficulties in applying the tax law on a literal paradigm, which difficulties can be smoothened by taking recourse to relevant doctrines under other laws. Third, in the specific context of the privity of consideration paradigm, the discussion clearly highlights that under GST, determining the existence of a transaction on the basis of the flow of consideration may not reveal the correct legal position given the explicit recognition of third-party consideration under the Indian law. In such view of the matter, the doctrine of privity of consideration may be gainfully employed to decipher the real contracting parties (which often gets clouded when the appraisal is from the perspective of consideration flow), and thus GST can be levied on the correct transaction instead of chasing artificial constructs. The invocation of the substance of this doctrine, as illustrated by the circular, vindicates this analysis.


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

1. P.S. Atiyah, Atiyah’s Introduction to the Law of Contracts, (3rd Edn., 1981) p. 265, as quoted in P. Ramanatha Aiyar’s, Advanced Law Lexicon, (5th Edn., 2017) p. 4077. The same Lexicon also quotes G.H. Treitel, The Law of Contract, (8th Edn., 1991) p. 538 to state “the doctrine of privity means that a person cannot acquire rights or be subject to liabilities arising under a contract to which he is not a party. It does not mean that a contract between A and B cannot affect the legal rights of C indirectly”.

2. Pollock & Mulla, Indian Contract & Specific Relief Act, (12th Edn., 2010) p. 102. Elaborating further, the authors state that the “doctrine of privity may involve any (or more) of the four questions: (i) can a person enforce a contract to which he is not a party? (ii) can a person set up a defence based on the terms of a contract to which he is not a party in order to answer a claim brought by a person who is a party to the relevant contract? (iii) can a contracting party set up a defence based on the terms of his own contract in order to answer a claim brought by a person who is not a party to the relevant contract? (iv) can a contracting party enforce his own contract against a person who is not a party to the relevant contract?”

3. Paam Antibiotics Ltd. v. Sudesh Madhok, 2011 SCC Online Del 4911: (2012) 186 DLT 652. See also, Krishna Devloor v. N. Madhavi, 2013 SCC Online AP 160: AIR 2013 AP 138: which inter alia explains this legal position in the following terms; “Mere payment of money by one individual to another, does not, by itself, bring about the transaction of a particular description. It is only when there exists unity of opinion, or what is commonly known in the realm of contracts, as consensus ad idem, that it can be treated as a consideration of the contract of a particular description. The money can certainly constitute the consideration, in a given transaction. However, it is only when it is paid by one, to another, with a specific understanding, that it is the consideration for a contract, that the contract can be said to have come into existence. The money paid for one purpose, cannot be treated as consideration for another. Even if a person pays the amount to another, with an idea that it is the consideration for purchase of an item of property, law would recognise such event, if only the person who paid the amount establishes that the one, who received it, was also of the same idea and understanding.”

4. See, 13th Report of the Law Commission of India (1958). In Para 16, the Law Commission had noted the following:

“That a rigid adherence to the doctrine of privity is bound to cause hardship is obvious. The present state of law in India is not quite uncertain and the particular exceptions which have been acknowledged by case law and statutes do not cover all cases of hardship and thus enhance the bewilderment of the layman. As we anticipated in our Report on the Specific Relief Act, the better course would be to adopt a general exception to cover all cases of contracts conferring benefit upon third parties and dispense with the particular instances where the rule of privity should not apply. We consider the recommendations of the Law Revision Committee best suited for the purpose, and recommend that a separate section be incorporated on the lines thereof.”

5. Pollock & Mulla, Indian Contract and Specific Relief Act, (12th Edn., 2010) p. 103. For English law on the subject, see Dunlop Pneumatic Tyre Co. v. Selfridge & Co., 1915 AC 847 inter alia observing that “My Lords, in the law of England certain principles are fundamental. One is that only a person who is a party to a contract can sue on it. Our law knows nothing of a jus quaesitum tertio arising by way of contract. Such a right may be conferred by way of property, as, for example, under a trust, but it cannot be conferred on a stranger to a contract as a right to enforce the contract in personam. A second principle is that if a person with whom a contract not under seal has been made is to be able to enforce it consideration must have been given by him to the promisor or to some other person at the promisor’s request. These two principles are not recognised in the same fashion by the jurisprudence of certain continental countries or of Scotland, but here they are well established. A third proposition is that a principal not named in the contract may sue upon it if the promisee really contracted as his agent. But again, in order to entitle him so to sue, he must have given consideration either personally or through the promisee, acting as his agent in giving it.” (per Viscount Haldane L.C.) See also, Scruttons Ltd. v. Midland Silicons Ltd. 1962 AC 446: (1962) 2 WLR 186: (1962) 1 All ER 1, etc.

6. Pollock & Mulla, Indian Contract and Specific Relief Act, (12th Edn., 2010) p. 106.

7. See generally, State of T.N. v. Port of Madras, (1999) 4 SCC 630. In any case, in a transaction tax (unlike income tax), there would ordinarily be no difference between commercial activities and non-profit driven activities.

8. Circular No. 212/2/2019-Service Tax dated 21-5-2019.

9. Refer, Circular No. 178/10/2022-GST dated 3-8-2022, relevant at Paras 8-8.1.