Service Tax on Director Remuneration – Applicability & Planning

While it is alien to associate the service tax component with salary for the assessee, we need to realise that it might not be the case with the Revenue. In fact, we have seen quite a few notices / orders being slapped on assessees demanding why service tax should not be levied on directors’ salaries under the reverse charge mechanism. Therefore, although the issue might appear quite simple, if the assessee is unable to prove its case beyond doubt, it may be end up paying a fat tax along with interest and penalty on the directors’ remuneration.

A preliminary reading of Section 65B (44) of the Finance Act, 1994, which defines the crucial term ‘service’, squarely excludes provision of service by an employee to the employer in the course of or in relation to employment. Nevertheless, the learned Revenue officials are not ready to buy this argument and wisely quote Rule 2(d)(i)(EE) of the Service Tax Rules, 1994 and Notification No.30/2012-S.T. dated June 20, 2012 (as amended) to prove point-blank that any service provided by a director to the company is subject to tax under the reverse charge mechanism. It is also understandable that any person, be it corporate or Government, who is slapped with steep targets, is bound to leave no stone unturned to meet it.

Definition of whole-time director

To rebut the Revenue’s stand, let us understand the definition of the term “whole-time director” in Section 2(94) of the Companies Act, 2013, which reads as follows: “whole-time director includes a director in the whole-time employment of the company”. This definition amply clarifies that a director can be an employee of the company. Further, one can also refer the judgment in Ramaben A. Thanawala vs Jyoti Ltd. And Ors. [AIR 1958 Bom 214, (1957) 59 BOMLR 67] decided by the Hon'ble Bombay High Court: “…. it seems to us that the expression "whole-time director" must refer to a director who spends his whole time in the management of the company in the same sense as a managing director does”. The aforementioned definition and citation clearly bring out the element of employment in whole-time directorship.

Contract of service vs. Contract for service

One has to understand the distinction between employee and independent service provider like independent contractor, consultant, advisor and the like. In the case of an employee, there is a 'contract of service', while in the case of independent service provider, there is a 'contract for service'. The distinction between these terms has been upheld by a full bench of the Supreme Court in Indian Medical Association vs. V.P. Shantha [1956 AIR 550, 1995 SCC (6) 65]:

 “A `contract for services' implies a contract whereby one party undertakes to render services e.g. professional or technical services, to or for another in the performance of which he is not subject to detailed direction and control but exercises professional or technical skill and uses his own knowledge and discretion. [See: Oxford Companion to Law, P. 1134]. A `contract of service' implies relationship of master and servant and involves an obligation to obey orders in the work to be performed and as to its mode and manner of performance.” [emphasis provided by us]

In the case of a company and its working directors, the company maintains its ultimate control through the Board which has the authority to direct the mode and manner of performance of the working directors. This is also substantiated vide Section 2(53) of the Companies Act, 2013 which reads that: “manager means an individual who, subject to the superintendence, control and direction of the Board of Directors, has the management of the whole, or substantially the whole, of the affairs of a company, and includes a director or any other person occupying the position of a manager, by whatever name called, whether under a contract of service or not;”

In view of the above, the contract for appointment of the whole-time / executive director is a 'contract of service' amounting to employment.

Act prevails over Rules and Notifications

It is a well-settled position in law that the Act would prevail over the Rules or Notifications thereunder. When the activity of employment itself is excluded from the definition of “service” under the Finance Act, 1994, there is no question of taxability of such service under Service Tax Rules, 1994 or Notification No.30/2012-S.T. (under any charge mechanism, whether forward or reverse or joint).

Differential approach cannot be adopted by the two branches of Ministry of Finance on the same subject matter

If salary is paid to the whole-director, it is imperative that Form No. 16 (viz., certificate for tax deducted at source from salaries) would have been issued under the Income Tax Act, 1961. When the amount paid is considered as salary by the Income Tax Department (a branch of the Ministry of Finance), the same amount cannot be considered otherwise by the Service Tax Department (which is another branch of the same ministry). This stand is fortified by the judgment of Hon'ble CESTAT, Mumbai in Rent Works India Pvt. Ltd. v. Commissioner of Central Excise, Mumbai-V [2016 (43) S.T.R. 634 (Tri.-Mumbai)], where it was held that:

“7. … If an amount paid by the appellant to Shri Alan Van Niekerk is considered as salary by the Income Tax Department, a branch of Ministry of Finance, Department of Revenue, it cannot be held by the Service Tax Department, another branch of the Ministry of Finance, Department of Revenue, as amount paid for consultancy charges and taxable under the Finance Act. The same department of Government of India cannot take different stand on the amount paid to the very same person and treat it differently. In our considered view, the amount which is paid to Mr. Alan Van Niekerk, in the circumstances of this case as brought out herein above, has to be treated as salary to the director and the salary is not to be considered as to fall under the category of ‘Management Consultancy Services’ and liable for Service Tax.

 8. In view of the foregoing and in the facts and circumstances of the case, we hold that the impugned order is unsustainable and liable to be set aside and we do so. …” [emphasis provided by us]

MCA circular provides clarity

The Ministry of Corporate Affairs (MCA), while guiding the companies registered under the Companies Act on the issue of managerial remuneration, records with utmost clarity as follows (vide General Circular No. 24/2012 dated August 9, 2012):

“The Finance Act 2012 has introduced Service Tax which is applicable to anyone who provides a Service not covered under the negative/exempted list and if the value of the annual revenue is more than Rs. 10 lakh. The Non-Whole Time Directors of the Company are presently not covered under the exempted list and as such, the sitting fee/commission payable to them by the company is liable to Service Tax.”

Without any need for further explanation, the aforementioned MCA Circular makes it amply clear that only in respect of payments made to non-whole time directors (who are not director employees of the company working regularly for the company), service tax liability arises to the companies.

Basic steps to safeguard the assessee’s interest

In view of the above arguments, whole-time directors can be termed as employees, consequent to which their salaries would not attract service tax in view of the provisions of Section 65B(44)(b) of the Finance Act, 1994. Therefore, if the directors do not have compelling reasons to be non-whole time directors, it is advisable to appoint them as whole-time directors at least in the forthcoming year and pay them remuneration in the form of salary without attracting the service tax liability.

Importantly, it should be recorded in no unclear terms in the Board resolution that the directors are being appointed as whole-time directors and that they are entitled to ‘salary’. Further, it is advisable to document a simple offer letter from the Board to the director(s) being appointed, setting forth the terms of appointment, their duties / responsibilities and the salaries. Also, promptly covering such payments under Form No. 16 (viz., certificate for tax deducted at source from salaries) issued under the Income Tax Act, 1961 would save a lot of trouble for the assesses, since it would be hard for the Revenue to prove that two wings of the Ministry of Finance (viz., Central Board of Direct Taxes and the Central Board of Excise and Customs) can treat the same transaction conflictingly.