Is fair market value fitting for valuation of services?

Fair market value (FMV) is generally understood as the price for which a specified asset or property would be sold in the market and that a knowledgeable, willing, and unpressured buyer would pay to a seller. As a concept, FMV has been widely used for a long time across many areas of law to determine the value of assets for payment of taxes, excise duty, insurance claims, etc.

However, it is interesting to note that it was only in 2012 – the year when the service tax law was comprehensively revamped with the introduction of a negative list approach to taxation of services – that the concept of FMV was introduced for the purpose of payment of service tax in relation to specified services of construction, works contract and supply of food by restaurants and caterers.

The Service Tax (Determination of Value) (Second Amendment) Rules, 2012, and abatement Notification No. 26/2012, provided that while determining the value for the payment of service tax for the services of construction, works contract and supply of food by restaurants and caterers, the FMV of any goods provided by the service recipient to the service provider during the course of provision of such service should form part of the amount for discharging the service tax.

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The FMV of such goods is to be determined in accordance with generally accepted accounting principles. In other words, for the first time, it was statutorily provided that “gross amount” for the purposes of payment of service tax would include the FMV of supplies/goods made available by service receiver to the service provider while providing the specified services of construction, works contract and supply of food by restaurants and caterers.

Debate before recognition

The statutory recognition of FMV for the payment of service tax under specified services was preceded by a bitter history of litigation related to the erstwhile taxable services of erection commissioning, works contract, etc. The tax authorities contended that the “gross amount charged” ought to be read as inclusive of all components which are loaded in the taxable service including the raw materials supplied free by the principal. This argument was based on the authorities’ belief that the scheme of valuation under section 67 of the Finance Act, 1994, and abatement notifications in 2004, 2005 and 2006 mandate such inclusion.

The issue was further complicated by conflicting decisions of the Bangalore and Ahmedabad service tax tribunals. The issue was finally referred for adjudication to the larger bench of the Delhi tribunal in M/s Bhayana Builders (P) Ltd v CST, Delhi (2013). Examining the service tax scheme in terms of the valuation provisions under section 67 of the act, the larger bench held that “value of goods and materials supplied free of cost by a service recipient to the service provider, being neither monetary or non-monetary consideration paid by or flowing from the service recipient, accruing to the benefit of service provider, would be outside the taxable value or the gross amount charged, within the meaning of the expression in Section 67 of the Act”. Hence, free supplies ought not to be included for the purpose of computing the “gross amount” under the abatement notifications as it has no legal sanctity under section 67.

However, it is imperative to note that though the concept of FMV has been introduced under the Service Tax Valuation Rules and abatement Notification No. 26/2012, section 67 – the substantive provision dealing with the valuation under the act within which the rules are issued – remained unchanged. Hence, it can be argued that the ratio of Bhayana Builders, insofar as it held that the scheme of section 67 does not allow the inclusion of “free supplies” in the definition of “gross amount” for the payment of service tax, holds true.

Challenges with concept

Moreover, as FMV has been vaguely defined to mean value as per generally accepted accounting principles, there is no uniform criterion for fixing the FMV of goods/materials and it is left to the parties to justify that their declared value of goods is the “fair market value” of such goods. The vagueness in the definition of FMV allows enough leverage to tax officers to question the correctness of the value of goods for the payment of service tax.

It is equally relevant to note that FMV as a concept clearly ignores the commercial freedom of a service receiver to make goods and materials available to its service provider with the ultimate objective of reducing the cost of services which it ultimately has to bear.

It is undisputable that the concept of FMV for valuation of services raises several unanswered questions in relation to its validity and its application. However, it is certain that in its current form, the concept of FMV has the potential to lead to another round of litigation.

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Kumar Visalaksh is an associate partner and Rahul Khurana is an associate manager at Economic Laws Practice. This article is intended for informational purposes and does not constitute a legal opinion or advice.