The Supreme Court Has Not Upheld Any Entry Tax Legislation

The Supreme Court recently delivered a landmark judgement relating to the constitutional validity of entry taxes. By way of 7-2 majority, the apex court upheld the constitutionality of entry taxes, but not unconditionally. It leaves open, many circumstances where such legislation can be challenged. So while it closes a long chapter on a contentious area of law, it may have just laid the foundation for potentially another wave of litigation. In this article, we will review the background to this issue, the salient points emerging from the judgement and the way forward from here on for industry.

Background

Part XIII of the Constitution covers ‘Trade, Commerce and Intercourse within the Territory of India’. It was introduced to protect free trade between the States to ensure India remains a single market. Article 301 provides for such freedom of trade and commerce and reads as:

The Parliament is permitted to impose such restrictions on freedom of trade, commerce and intercourse as may be required in public interest under Articles 302. However, Article 303 prohibits creation of restrictions that have a result of giving preference to any one State over another except in situations arising from scarcity of goods in any part of India. The power of the States to impose restrictions on trade and commerce is enshrined in Article 304, which reads as follows:

Article 304(a) allows the States to impose non-discriminatory taxes on goods imported from other States vis-à-vis similar goods manufactured or produced in the importing State. Article 304(b) allows the States to impose reasonable restrictions on the freedom of trade or commerce as may be required in public interest.

The Constitution provides powers to the States to impose tax on entry of goods into a local area for specified purposes. This power is derived from Article 246 read with Entry 52 of List II to the Seventh Schedule of the Constitution. Entry 52 reads as below:

The States, exercising their powers under Entry 52, have been enacting different forms of entry tax laws. These entry tax laws and other taxes on movement of vehicles have been the subject matter of several challenges as being violative of Part XIII of the Constitution from an early stage. The scope of Article 301 was examined by a five judge bench of Supreme Court in Atiabari Tea Co. Ltd. v. State of Assam, where a tax was levied on transport of sugar in the state of Assam. The tax was held to be unconstitutional on the ground that it had a direct and immediate effect of impeding the free movement of goods. The law laid down in Atiabari (supra) was further clarified by a seven judge bench in the Automobile Transport v State of Rajasthan case, where motor vehicles tax was challenged. In this case, the Supreme Court carved out a class of taxes, known as compensatory taxes, which was held to be not in violation of Article 301. According to the court, such taxes were regulatory in nature - for provision and use of trade facilities - and could not qualify as restrictions. However, with time, from 1964 till 2003, divergent views emerged in High Courts and the Supreme Court regarding the understanding and application of what constitutes a compensatory tax.

Decision Of The Supreme Court

Considering the diverging views emerging from the law laid down by the Supreme Court in different cases in respect of entry taxes, the issues were referred to a nine judge bench of the Supreme Court for resolution. In this case, the Supreme Court formulated the questions for determination and heard the Counsels for the different assessees, the Centre and the States. Finally, loosely in the form of a seven to two majority held that entry tax legislations are not subject to Article 301 and are not unconstitutional subject to fulfilling certain conditions.

Rejection Of Compensatory Tax

One of the key problems faced by the Supreme Court in various cases was the application of the concept called ‘compensatory tax’. The problem with ‘compensatory tax’, right from the beginning, was that it situated itself between what was clearly understood to be a ‘fee’ and a ‘tax’. ‘Fee’ is imposed by the State for providing a service or as a payment for a special benefit or privilege. ‘Tax’, on the other hand, is levied as a general measure for a common burden. It is not linked to any particular purpose or service. In the earlier cases, the Supreme Court found that in the case of entry taxes, though these were in the nature of taxes, these additionally also contained a nexus with the provision of facilities provided in the local area. Thus, a category of taxes called ‘compensatory tax’ was carved out to protect certain entry taxes.

While ‘compensatory taxes’ were simple in concept, they proved extremely difficult in application. This concept led to several inconsistencies and uncertainties in the formulation and application of legal standards. In the present case, the Supreme Court was all but unanimous in declaring that ‘compensatory tax’ had no juristic basis and was liable to be rejected.

Article 301 Does Not Limit Taxing Power

Article 301 provides that trade or commerce throughout India would be free. The issue that arose from Article 301 was whether this article limited the power of the Parliament or the States from enacting tax laws that impede trade or commerce in India. The Supreme Court had previously founded a legal standard of any law, including tax law, that had the direct and immediate effect of impeding trade or commerce as being violative of Article 301 and hence liable to be struck down as being unconstitutional. Thus, Article 301 was an important hurdle that tax laws were required to cross.

The Supreme Court, in this case, held that Article 301 does not apply to tax laws. It is probably the most important decision taken in this case. The majority analysed various provisions in the Constitution that limited the power of tax and found that in all such provisions there was a specific reference to tax. The majority concluded that if the framers intended to impose limitations on tax laws in Article 301, they would have clearly spelt it in the Article.

There is a strong dissent in the minority on this issue. The minority held that Articles 304 and 306 which use the term ‘tax’ are exceptions to Article 301. These articles can only be exceptions if the main article included tax within its ambit. The minority also observed that Article 302 and 303 use the phrase “any law” to include both fiscal and other laws. They further held that taxes can have the effect of impeding movement or freedom of trade and commerce and hence would be covered under the term “restrictions” in Articles 302 and 304(b). All these indicated that Part XIII covered tax legislations as per minority. However, as strong the dissent may be, the Supreme Court’s view now is that Article 301 does not place any fetter on tax laws.

Scope Of Article 304 (a) And 304(b)

Apart from Article 301, Article 304 clearly restricts the States from imposing tax laws in certain scenarios. Article 304 is split into two parts. While Article 304(a) clearly stops the States from legislating tax laws that are discriminatory, Article 304(b) requires States to impose only reasonable restrictions on trade or commerce without any reference to tax laws. The issue that arose before the Supreme Court was whether tax laws legislated by the States would need to overcome only Article 304(a) or both Article 304(a) and 304(b).

Both the majority and the minority agreed that Article 304(a) and 304(b) are disjunct and need not be read together even though a conjunctive “and” was used between them. However, on the application of Article 304(a) and 304(b) the majority and the minority diverged.

The majority held tax laws are limited only by Article 304(a) and not Article 304(b). Accordingly, the majority held that entry taxes must be tested on the edifice of discrimination under Article 304(a) and Article 14. They held that taxes should not be equal in form but also in effect and burden. The minority held that in addition to Article 304(a), Article 304(b) also applies to tax laws. The minority also opined that non-tax restrictions found in tax laws should be tested under Article 304(b). However, the law as laid down by the Supreme Court is that Article 304(a) is the only hurdle for entry tax laws to overcome in order to be valid.

What Remains Of The 30,000 Crore Tax Problem

The first thing that businesses should note is that the Supreme Court has not upheld any entry tax legislations. Importantly, while the standards for when an entry tax legislation is violative of the Constitution have been laid down by the Supreme Court in this case, the judgment does not uphold or strike down any of the specific entry tax legislations. Instead, the judgment details several instances of discrimination where legislations may fall foul of the Constitution and has left it to the individual High Court Benches to decide on a case to case basis. It therefore recognizes that there are still entry tax legislations that may be struck down.

What is discriminatory has been discussed and there lies any potential solution to the Rs 30,000 cr problem.

First, the Supreme Court unanimously has held that it is not enough if the rate of tax on imported goods is that same as that levied on locally produced goods. It was also imperative that the tax burden, which is a net effect of abatements, set-offs and credits also must be equalized. In other words, it is not the form of tax but the burden of tax that must be equalized.

Second, the court has held that it is not necessary that entry tax on imported goods must be imposed to countervail the entry tax on locally produced goods, moving within the state. Even VAT and other tax levies suffered by locally produced goods can be countered through the imposition of entry tax. This is because the essence of Article 304(a) is to create a level playing field between imported goods and locally manufactured goods.

Third, the court opined that exemptions which are granted only to locally manufactured goods and not to imported goods will have to be scrutinized under the lens of Article 304(a). If the exemptions are intended to create a hostile environment for imported goods and not for any other reason, then such exemptions will be discriminatory. However, if the exemptions are for encouraging the growth and development of certain backward regions in a state and are granted for a limited period of time, such exemptions will be valid. To this extent, such exemptions have been carved out of Article 304(a).

Fourth, the court held that entry tax can be levied on imported goods, even if identical or similar goods are not manufactured within the State. This is because according to the majority, there can be no discrimination if a class of local goods does not exist. However, this view is not subscribed to by Hon. J. Bobde and Hon. J. Bhushan. They have clearly held that if certain goods are not produced or manufactured within a state, then no entry tax can be levied on import of such goods from outside the state. However, as per the majority, such entry taxes are likely to not be in violation of the Constitution.

The guidance provided by the Supreme Court is not exhaustive and are to be developed on a case to case basis by the individual benches of the High Courts. There are several issues left open. For example, what is the scope of local area for the purpose of levy of entry tax; what is the scope of entry tax vis a vis imported goods. What however clearly emerges is that we have not seen the last of entry tax challenges in the Supreme Court. The strategy of the business will need to be re-aligned on the basis of the Supreme Court judgment. But discrimination under Article 304(a) and Article 14 present strong planks for reviewing the entry tax legislations again readying businesses for a new wave of litigation that could span several years.

MP Devnath is an executive partner and Charanya Lakshmikumaran is a principal associate at law firm Lakshmikumaran & Sridharan

The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.