Can Tax Credit Be Denied For An Illegal Transaction? Appellate Tribunal Answers

A recent Mumbai tax tribunal order on central VAT credit has stirred up the debate on the legitimacy of taxing an illegal transaction. The order further raises the question of whether credit can be claimed for an illegal transaction on which tax has already been paid.

According to a recent order by the Customs, Excise and Service Tax Appellate Tribunal, the illegality of the underlying transaction cannot be a ground to reject the central value-added tax credit. The tax authorities are expected to allow the credit, as long as they have received the tax from the service provider on that transaction, the order said.

This order, that refers to a dispute in the erstwhile indirect tax regime, could have implications under the GST law as well, according to experts.

"The precedent can be applied universally to both service tax and (the) GST," according to Asish Abraham, partner at Lakshmikumaran and Sridharan Attorneys. According to him, the precedents established on central VAT credit would be equally applicable for claiming input tax credit under the Goods and Services Tax Act.

In this case, ICICI Lombard General Insurance Co. was denied credit against certain payments to automobile dealers. The company had entered into an arrangement with automobile dealers for the sale of its insurance products. The dealer was compensated with a commission for the service, on which it had paid tax.

This qualified the insurance company for a central VAT credit. However, despite complete payment of service tax, the authorities refused to grant credit to the insurance company, alleging illegality in the arrangement. According to them, commission for such a service is illegal according to the provisions of the Insurance Act , as no one—except a registered insurance agent—can facilitate the sale of insurance contracts.

However, according to the insurance company, this argument was irrelevant as the authorities had already accepted tax for the alleged illegal transaction.

The tribunal agreed with the insurance company's reasoning and held that arguments of illegality are not maintainable in a case where the government had undisputedly received tax from the automotive dealers. The availment of Cenvat credit follows the statute, the court said.

This is, however, an exceptional case and cannot be construed as a general rule, according to Rajat Bose, partner at Shardul Amarchand Mangaldas and Co.

According to him, Cenvat Credit Rules dictate that a service recipient can avail tax credit for the services as long as they are availed for business purposes. To him, a business purpose has to be legal to be eligible for credit.

However, according to Abraham, as the law stands, the legality of a transaction is not an essential condition to avail credit unlike in income tax, where expenditures can be disallowed for any expenses in contravention of law. To him, the provision and receipt of services are sufficient to qualify for Cenvat credit.

Sanjeev Sachdeva, partner at Luthra and Luthra Law Offices, held a similar view.

As long as service tax was paid for the service and all necessary documents prescribed under the Cenvat Credit Rules are undisputed, the authority cannot reject credit for the same, he said.