Madras HC Quashes Tax Demand For Lack Of Clear Valuation In Revenue-sharing Model

BRIEF FACTS OF THE CASE

• The Petitioner, engaged in the business of providing diagnostic and healthcare-related services through laboratories and testing centers. The Petitioner entered into a Franchise Agreement with M/s. Pranav Labs, under which the franchisee was permitted to conduct diagnostic tests using the petitioner's branding, infrastructure, and diagnostic equipment.
• The agreement was based on a revenue-sharing model: in the case of government-referred patients, a fixed amount of ₹235 per sample was charged, of which ₹141 was payable to the franchisee and ₹94 was retained by the petitioner, while in the case of private patients, the revenue from "standard tests" was shared in the ratio of 31.20:68.80 and for other tests in the ratio of 50:50.
• In practice, the franchisee collected samples, performed testing using the Petitioner equipment, and transmitted the results to the Petitioner, who in turn generated the final diagnostic report for delivery to the patient. Thus, the petitioner retained control over brand quality and the issuance of final reports, while the franchisee performed the preliminary functions of sample collection and analysis.
• A Show Cause Notice was issued, alleging that the petitioner had rendered taxable services in the nature of both franchise services and supply of tangible goods services by providing equipment to the franchisee without transferring possession. This culminated in Order-in-Original confirming the entire demand of service tax with interest and equal penalty, while dropping the levy of late fee.
• The Petitioner filed writ petition before the Hon'ble Madras High Court and the issue under consideration was whether the activities carried out by the petitioner under the franchise arrangement, particularly the supply of diagnostic equipment and the revenue adjustments under the agreement, amounted to taxable services.

KEY OBSERVATIONS OF THE HON'BLE MADRAS HIGH COURT

• The Court noted at the outset that the franchise arrangement involved two distinct services . One was franchise service, for which tax had already been paid. The other was supply of diagnostic equipment by the petitioner to the franchisee, which constituted supply of tangible goods service under Section 66B read with Section 66D of the Finance Act after 01.07.2012. However, the franchise agreement did not separately quantify the consideration for supply of such equipment, and the charges were in effect subsumed in the revenuesharing arrangement. The adjudicating authority had confirmed the demand without properly determining the taxable value as required by Section 67 of the Finance Act, 1994 read with Rule 3 of the Service Tax (Determination of Value) Rules, 2006. Instead, the order merely referred to CBEC's Education Guide and to certain judicial decisions without addressing the precise valuation exercise required by law. The Court held that this omission was a fatal flaw because the foundation of any tax demand lies in a proper determination of value, and without such determination, the demand could not be sustained.
• Further, the Court observed that the show cause notice itself was vague and had not disclosed the methodology for computing the taxable value of the alleged services. Since the notice was deficient in this respect, the subsequent confirmation of demand was equally unsustainable. Consequently, the Court quashed the impugned order and remitted the matter back to the adjudicating authority with a direction to issue a corrigendum to the show cause notice clarifying the valuation method and thereafter pass fresh orders within 30 days in accordance with law.
• The coverage of services within health care services has always been an area of dispute, where taxpayers have in many instances categorized all services connected to healthcare services as the main services. Hospital and pathology labs today operate under various operation and management models. A thorough evaluation of the nature of services being performed under a contract and the manner of sharing the revenue becomes critical in determining the actual category under which such activities would get classified and taxed. In the present case, the Court draws a clear distinction between healthcare services, which enjoy exemption under Notification No. 25/2012-ST, and supply of diagnostic equipment under a franchise arrangement, which has been held to be taxable as a supply of tangible goods service post 01.07.2012. The Court has clarified that multiple taxable services can coexist under a single contractual arrangement, and it is essential to determine the nature of each activity to conclude on the true nature of these services.
• The Court, however, has reaffirmed the principle that in the absence of an appropriate and defined consideration, no tax liability can be confirmed. The Court insisted on strict compliance with valuation provisions under Section 67 of the Finance Act, 1994 and the Service Tax (Determination of Value) Rules, 2006 and stated that tax liability cannot be imposed on broad assumptions or revenue-sharing figures without properly identifying and quantifying the consideration attributable to the taxable service.

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