Indirect Tax Alert - Credit Note issued by Manufacturer to Dealer for ‘Warranty’ replacement is ‘valuable consideration’ for ‘Sale’, liable to Sales Tax/VAT

Historical Background

• Delhi High Court¹ had earlier observed that in the case of the sale of a car with a warranty to replace defective parts free of cost, the consideration of the defective part that might be replaced was included in the price charged for the sale of a car. Thus, sales tax is not leviable on the free-of-cost replacement of defective parts.
• Madhya Pradesh High Court² had held that when a dealer replaces defective parts by either procuring the same from the manufacturer or claims reimbursement on the same, it is neither a sale of those parts by the dealer to the customer nor the manufacturer. Hence, the same will not fall within the definition of the term ‘sale’.
• Kerala High Court³ had held that the transaction whereby the dealer replaces defective parts during the warranty period which is reimbursed by the manufacturer by issuing Credit Notes (CN) cannot be treated as a sale.
• However, Supreme Court⁴ held as follows:
  • Apex Court distinguished the factual position before it with the facts in Prem Nath Motors (supra).
  • The nature of the transaction between the dealer and the manufacturer in Prem Motors (supra) and Geo Motors (supra) was lost sight of. Accordingly, the aforesaid rulings were overruled by the Supreme Court.
  • It was held that when the spare parts are replaced under warranty by the dealer for which, consideration is paid by the manufacturer by way of CN, the transaction will be leviable to sales tax.

Facts of the case

• Basis the aforesaid rulings, a series of 34 appeals arising from the orders passed by various High Courts (viz., Karnataka, Rajasthan, Allahabad, Madhya Pradesh, Bombay, Andhra Pradesh, Kerala and Gujarat) were filed before the Supreme Court.
• While the facts in respect of each of the 34 Appeals pending before the Supreme Court is different, for ease of reference, the facts in one of the appeals are reproduced below:
  • M/s. Marudhar Motors (Taxpayer or dealer), a dealer of Tata vehicles entered into a dealership agreement with Tata Motors Ltd. (manufacturer), the dealer would replace the spare parts to the customer under the manufacturer’s warranty.
  • Generally, the manufacturer sells vehicles and spare parts to the dealer by charging CST against ‘C’ Forms for onward sale to the customers on payment of applicable sales tax.
  • However, in case of warranty claims on account of defective spare parts, such parts are replaced on a free-of-cost basis as follows:
    • The dealer replaces such defective parts with a new part/ vehicle in his stock, purchased from the manufacturer.
    • Subsequently, such defective parts are returned to the manufacturer for verification.
    • Upon verifying that the spare parts received from the dealer are defective, the manufacturer issues CN, thereby crediting the dealer’s running account.
  • Pursuant to the decision of the Supreme Court in Mohd. Ekram Khan (supra), the Tax Authorities invoked assessment/ reassessment proceedings under Sections 28 and 30 of the Rajasthan Sales Tax Act, 1994 (RST Act) respectively, for FY 2000-01 to 2005-06.
  • Taxpayer filed appeals before the First Appellate Authority which upheld the levy of sales tax. However, the imposition of interest and penalty was set aside.
  • Subsequently, the Taxpayer filed 6 appeals before the Second Appellate Authority i.e., Rajasthan Tax Board (RTB) challenging the levy of tax as determined by the aforesaid order. Concurrently, the Tax Authorities filed 6 appeals challenging the order which set aside levy of interest and penalty before the RTB.
  • Upon hearing both parties, RTB distinguished the facts from Mohd. Ekram Khan (supra) and consequently, set aside the imposition of tax.
  • Against the aforesaid order, the Tax Authorities filed revision petitions before the Rajasthan High Court, which affirmed the order passed by the RTB.
  • Aggrieved by the above, the Tax Authorities filed an appeal before the Supreme Court.
• The Division Bench (two judges) of the Supreme Court, vide order dated 5 December 2019, referred the matter to a Bench comprising of three judges to determine whether CN issued by a manufacturer to a dealer as a recompense to replace defective part is liable to sales tax.

Contentions of the Taxpayer

• All transfers are not sales as the term ‘sale’ has a definitive connotation in the Sales tax laws and tax is not leviable on all transfers which may happen by means of transactions other than sale such as gift, barter, or exchange.
• The transaction in the present case cannot be treated as a taxable sale on account of the following:
  • Spare parts are supplied to the customers by the dealers completely free of charge as replacement of goods already sold.
  • A new spare part is installed in the customer’s vehicle and the defective part is removed.
  • The substance of the transaction is the discharge of a warranty obligation. As the spare parts are deducted from the dealer’s stock, credit is rightfully provided by the manufacturer to the dealer.
  • Any dealer of the manufacturer can be approached for discharging such warranty obligation.
  • The Tax Authorities have wrongly assumed that the supply of such spare parts is a sale made by the dealer to the manufacturer albeit the title is transferred to the customer.
• Replacement of defective parts during the warranty period does not constitute a ‘sale’. Instead, a warranty is a stipulation collateral to the main purpose of the contract. Further, the enforcement of a contractual right for getting a free replacement in exchange for a defective part cannot be treated as a purchase-sale transaction.
• A CN is issued by the manufacturer as an acknowledgement of the diminution in the original sale price. CN is not a sale price or valuable consideration as the character of credit is not towards the price of the newly replaced part, but a credit that embodies the diminution of the price already paid for the car.

Contentions of the Tax Authorities

• The presence of a manufacturer’s/ dealer’s warranty on the car sold by the dealer does not make any difference as to whether the transaction of replacement of defective goods satisfies the element of sale or not.
• The dealership agreement is on a principal-to-principal basis. The ingredients of a sale transaction are completed when the new spare parts are transferred to the customer and payment (by way of CN) is received from the manufacturer.
• The performance of warranty obligation is determined through actual damage to the defective part. Hence, the same cannot be said to be totally accounted for and debited in the manufacturer’s taxable turnover of sales and purchases.
• All the elements of the sale are complete because there is a seller (the dealer) and a buyer (the manufacturer), valuable consideration is paid by the manufacturer in the form of CN and the transfer of property in goods is taking place to the nominee of the buyer i.e., the customer.

Observations of the Supreme Court

• In respect of the replacement of defective spare parts, the following scenarios can emerge:
  • Scenario I: The manufacturer may either manufacture the spare parts or procure the same from the open market and subsequently, supplies them to the dealer for onward installation in the customer’s vehicle. Thereafter, the dealer returns the defective spare parts to the manufacturer. In this case, no compensation is paid by the manufacturer to the dealer.
  • Scenario II: Here, the dealer either procures the goods from the open market or uses the goods from his existing stock and undertakes the replacement of defective parts. Subsequently, the dealer returns the defective spare parts to the manufacturer. Thereafter, on verifying that the spare part is defective, the manufacturer recompenses the dealer for the spare parts replaced from its inventory.
• In both the scenarios above, it is observed that –
  • The dealer acts pursuant to a warranty which he is bound to honour along with the manufacturer vis-à-vis the customer.
  • The dealer is acting as an intermediary/ agent of the manufacturer as the warranty emanates from the manufacturer to the customer through the dealer.
  • Thus, as an intermediary, the dealer has to act on behalf of the manufacturer.
• The issue in the present case is whether the second scenario will amount to a sale in the sense that the dealer is liable to pay sales tax on the CN received from the manufacturer.
• In order to constitute a ‘sale’, all the following elements must be present:
  • There must be an agreement between the parties for transferring the title to the goods.
  • The parties are competent to enter into the agreement.
  • The agreement is for valuable consideration.
  • The property in goods passes on to the buyer.
• To examine whether the transaction at Scenario II is covered under the ambit of the term ‘sale’, it is important to examine whether any consideration is received by the dealer and whether any transfer of property in goods exists, which is as under:
  • Existence of consideration:
    • The manufacturer is liable to replace the defective parts to the customer in terms of the warranty obligations.
    • Generally, when the dealer invests in spare parts, he is entitled to sell the same and earn profit/ return on his investment. However, by using such spare parts for discharging the manufacturer’s warranty obligations, the dealer neither ‘sells’ such parts to the customer nor receives any consideration from the customer.
    • However, to recompense the dealer for the above, the manufacturer (after receiving and verifying the defective spare parts) issues a CN for the spare parts which are not sold to the customer and provided to the customer free of cost in terms of the manufacturer’s warranty obligations.
    • Thus, the reason for the issuance of CN by the manufacturer is to reimburse the dealer for the costs which cannot be recovered from the customer while discharging the manufacturer’s warranty obligations.
    • The amount shown in the account of the dealer as CN is nothing but the price received by the dealer for the sale of spare parts. Merely because the dealer is acting as an intermediary or on behalf of the manufacturer for discharging warranty obligations and is recompensed by way of CN, the same cannot escape sales tax liability.
    • A CN issued by a manufacturer in favour of a dealer is a valuable consideration within the meaning of the definition of ‘sale’ under the Central Sales Tax Act, 1956 (CST Act) and the respective State enactments.
  • Transfer of property in goods:
    • There does not exist any transfer of property between the manufacturer and the dealer when spare parts are used from the stock of the dealer for replacing the defective parts.
    • However, there is a transfer of property in goods between the dealer and the customer on behalf of the manufacturer under a warranty, for which, the consideration is paid by the manufacturer by way of CN (as highlighted above).

Thus, there is a transfer of property in spare parts from the dealer to the customer for which, the manufacturer pays consideration by way of CN. The consideration received from the manufacturer is leviable to sales tax and the person who pays the valuable consideration in a sale transaction is irrelevant as long as it is paid.

• All CN received by the dealer are not indicative of the value of the spare parts supplied to the customer under warranty, and in some cases (such as under the agency contract), it may pertain to a rendition of services which can attract Service tax liability, depending on the terms and conditions of the agency.
• However, as long as the CN is issued for the spare parts used by a dealer, it becomes a ‘sale’ transaction under the CST Act or respective State enactments.

Ruling of the Supreme Court

• The decision in Mohd. Ekram Khan (supra) applies to a situation where a manufacturer issues a CN to a dealer acting under a warranty given by the manufacturer in the following circumstances:
  • The dealer replaces a defective part of the automobile with a spare part maintained in the stock of the dealer.
  • The dealer purchases the spare part from the open market.

The value of CN issued in the aforesaid circumstances is treated as ‘consideration’ for the sale of spare parts, and hence, is liable to sales tax.

• However, the decision in Mohd. Ekram Khan (supra) will not apply in the case wherein the dealer receives spare parts from the manufacturer for replacing the defective part.

BDO India Comments

The aforesaid ruling distinguishes the different methods of replacements by a dealer under warranty provided by the manufacturer and thereby providing for divergent treatment with respect to each method. The ruling also upholds the settled principle that consideration for the sale of goods may flow from a third party (in this case, the manufacturer).

The aforesaid ruling is likely to have substantial implications for the ongoing sales tax/ VAT assessments especially for the automobile industry, electronics industry, etc. However, the aforesaid ruling will not apply to cases where the dealer is engaged in providing services to the manufacturer and not engaged in supplying goods wherein the dealer could be liable to discharge applicable Service tax.

[M/s. Tata Motors Ltd. and Ors. Vs Deputy Commissioner of Commercial Taxes (SPL) and Anr. [TS-227-SC-2023-VAT], dated 15 May 2023]

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