Understanding Composite Supply

 

Under GST law, the concept of “composite supply” is still an area of interpretation even though the government has issued clarifications and FAQs as unique underlying facts of each case needs to be examined. One such scenario relates to the Reagent Rental Contract (“RRC”) which is commonly entered into by the medical device companies with hospitals, laboratories etc.

Under this model, the medical instruments are provided by the companies without any consideration for a specified period to the end customers such as hospital, laboratories etc., who in return agrees to purchase a minimum quantity of reagents/consumable during the contract period at agreed prices. Also, the reagents are procured through their authorised distributor channels.

The modus operandi of the transaction under this model is that the movement of the medical instruments are done on the basis of a delivery challan and the reagents/consumables are supplied at specified prices by way of issuing a tax invoice at applicable rate of GST.

With the market players extensively operating under such business model and the GST regime still being in its evolving phase, the tax implications arising on such transactions is yet to attain uniformity. As we understand that, in case businesses perceives any doubts, they can opt to approach the Authority of Advance Ruling to determine the tax consequences of the particular transaction.

In one such instance, the above transaction was examined by the Kerala Advance Ruling Authority (‘Kerala AAR’) in the case of M/s Abbott Healthcare (P.) Ltd. (“company”) [TS-538- AAR-2018-NT], wherein it was held that above transaction of placing the medical instruments to unrelated customers like hospitals/laboratories for their use without any consideration, in the backdrop of an agreement containing minimum purchase obligation of products like reagents/consumables for a specified period constituted “composite supply”.

Aggrieved by the above ruling the company filed an appeal before the Appellate Authority for Advance Ruling (AAAR) [TS-917-AAAR-2018-NT] who rejected the appeal of the company and hence a writ was filed before the Kerala High Court [TS-4-HC-2020(KER)-NT].

In the ensuing part of this article, effort has been made to highlight the key aspects pronounced by Hon’ble High Court of Kerala.

Brief Facts of the Case

The petitioner is a company engaged in the sale of pharmaceutical products, diagnostic kits etc. It has executed Reagent supply and Instrument use agreements with hospitals and laboratories;

The medical instruments would be provided to the customer without any consideration basis and to be placed at his premises;

The stipulation attached to the such arrangement is that the end customer will purchase minimum agreed quantity of reagents/consumables at agreed prices, through its distributors, barring which, the petitioner was entitled to recover the deficit amount;

The supply of reagents etc. are done by the distributors to the hospital/laboratories are on a principal to principal basis by issuing a tax invoice after levying applicable GST @5%.

Further, it has been highlighted that the value of instruments in comparison to the total turnover of supply of reagents/consumables over the contract period, accounted to around 20% of the turnover of reagents etc.

When a consignment of instruments was being transported to a laboratory without any consideration, the same was seized by tax officer on the ground that the goods were not accompanied with a tax invoice but were being transported under a delivery challan.

The question raised before the Advance ruling authority (AAR) was whether provision of medical instruments by company to unrelated parties ie hospitals and laboratories constitutes a “ supply” or whether it constitutes “ movement of goods otherwise than by way of supply” as per GST Act.

The AAR held that placement of medical instruments to unrelated customers like hospitals/laboratories for their use without any consideration, in the backdrop of an agreement containing minimum purchase obligation of products like reagents/consumables for a specified period constituted “composite supply”. The Appellate Authority for Advance Ruling (AAAR) rejected the appeal of the company and hence a writ was filed before the Kerala High Court.

The Kerala High Court Decision

Context

The High Court stated that the AAR had opined that the company had made two supplies, namely of medical instruments and of reagents/consumables to be used along with the instruments. Since the instruments supplied had no utility to the customer unless he also bought the reagents/consumables, the supply of the instruments and reagents/consumables had to be seen as naturally bundled to form a composite supply. The AAR went on to observe that the

supply of instrument was to be treated as principal supply, in the composite supply, and accordingly, that the reagents etc had to taxed at a higher rate applicable to the instrument supplied. As regards valuation of the said supply, the AAR found that in terms of the agreement, the company had, in fact, supplied the medical instrument for deferred consideration since, according to it, the minimum purchase obligation in respect of reagents etc, under the agreement, ensured that the overall price realized from customer subsumed within it, the rent for the instrument as well. This was more so because, the agreement between the parties clearly stipulated that if the required quantity of reagents was not purchased by the customer, it was obliged to pay to the company the deficient amount. The aforesaid findings of AAR were upheld by the AAAR.

Observations

Jurisdiction – The AAR was required to give a ruling on whether the placement of medical instruments at the customer premises constitutes a ‘ supply’ under GST Act. Rather than that the AAR actually gave a finding that provision of medical instruments to customers constituted a ‘composite supply’. Its this finding, was wholly without jurisdiction. The AAR went beyond the terms of reference. As a consequence, the AAR did not go into the real issue of whether placing the instruments per se constituted a taxable supply under the GST Act.

Nature of supply and valuation thereof – The High Court held that the concept of enhancement of utility of the instrument through the supply of reagents/consumables, while relevant for the purposes of valuation of supply of instruments, cannot be imported into the concept of composite supply under GST Act. While clubbing of two independent supplies may be resorted to for the purposes of valuation of each of those supplies, there is no scope of clubbing of two independent supplies so as to notionally alter the very nature of each of those supplies as the existed in fact, at the relevant point in time.

Composite Supply – Since the counsel for the company urged the High Court to give a definitive view on the transaction being a composite supply, the High Court proceeded to examine the transaction.

It will be apt at this stage to reproduce the definition of “ composite supply” under the GST Act:

“ a supply made by a taxable person to a recipient consisting of two or more taxable supplies of goods or services or both, or any combination thereof, which are naturally bundled and supplied in conjunction with each other in the ordinary course of business, one of which is the principal supply”.

The High Court held that in order for the supply to be composite, it has to be made by one taxable person. In the instant case, the instrument is provided by company and the supply of reagents/consumables by the distributors who purchase it from the company on a principal to principal basis. Although it could be argued that there is a relationship between the said persons that influences the valuation of the supply, the same does not take away from the fact that the supplies are, in reality made by two different taxable persons. Indeed supplies by two separate suppliers could not be treated as principal and ancillary supplies.

The High Court also held that composite supply must take into account supplies as effected at a given point in time on “ as is where is “ basis.

Next Steps – The writ petition was allowed by quashing the orders of AAR and AAAR and remanding the matter back for fresh order to be passed on the basis of observations in this judgment.

Key Takeaways from the Decision

Jurisdiction – The AAR/AAAR must only address the question raised by the applicant. Nature of supply and valuation thereof – It is important to understand the difference between nature of supply and valuation thereof.

Composite Supply – If there are two taxable persons involved in a transaction, it cannot partake the nature of a composite supply. Also, the composite supply must take into account supplies as effected at a given point in time on “ as is where is “ basis.

Reagent Rental Contract

It is important to mention that recently there has been a Karnataka AAR in the case ofM/s Randox Laboratories India Private Limited [TS-1025-AAR-2019-NT] on facts which are identical to the facts of the case of M/s Abbott Healthcare Pvt. Ltd. The Karnataka AAR held that there will be no tax implication arising on medical instrument provided to the hospital where no consideration was received, as the same is outside the purview of supply under GST. Conclusion

It is interesting to note that the Hon’ble High Court has remanded the matter back to Kerala AAR for fresh consideration based on the observations made in the judgment.

Unless challenged in the higher fora, the said order would provide major relief to the medical device industry, which might have faced a major impact in case the of supply under RRC model, as the entire supply would have resulted in levy of tax @ 18% (taking instruments as a principal supply) instead of 5%/12% as applicable on the supply of reagents.

Now, it would be interesting to see how the outcome of the matter after the observations made by the High Court of Kerala, whether the same would concur with the ruling pronounced by the Karnataka AAR as in the case of M/s Randox Laboratories India Private Limited or would lead to another round of litigation

A favorable ruling may result in putting rest to a lot of future litigations on the said matter.