The class-based exclusivity test the Supreme Court used for state undertaking levies.

Two licences, one question: When is a state undertaking's fee truly 'exclusive'?

Kerala State Beverages Manufacturing & Marketing Corporation Ltd. (KSBC) is not your average liquor company. It is a wholly state-owned enterprise, the sole wholesale distributor of Indian Made Foreign Liquor (IMFL) in Kerala, and the operator of a chain of retail outlets. In the assessment year 2015-16, the tax department disallowed deductions for levies it had paid — gallonage fee, licence fees, shop rental, and a surcharge on sales tax. The weapon the department used was Section 40(a)(iib) of the Income Tax Act, 1961, a provision inserted in 2013 specifically to prevent state governments from shifting profits of their undertakings into consolidated funds to avoid Union taxation. The stakes were enormous: the entire tax treatment of state-owned enterprises across India hung in the balance.

The story of the levies

KSBC operates under two primary licence categories under the Kerala Abkari Act, 1902. An FL-9 licence permits it to manufacture and sell IMFL in bulk. An FL-1 licence permits it to run retail outlets. For both, it pays a gallonage fee (under Section 18A of the Abkari Act), a licence fee, and a shop rental (called kist). On top of that, it pays a surcharge on sales tax under the Kerala Surcharge on Taxes Act, 1957, and a turnover tax under the Kerala General Sales Tax Act, 1963.

The procedural journey was a long one. For AY 2014-15, the Deputy Commissioner of Income Tax, Circle 2(1), Thiruvananthapuram, completed an assessment under Section 143(3) allowing the deductions. But the Principal Commissioner of Income Tax, Thiruvananthapuram, stepped in under Section 263, setting aside that assessment as erroneous and prejudicial to the revenue, specifically holding that the surcharge on sales tax and turnover tax should have been disallowed under Section 40(a)(iib). For AY 2015-16, the Assistant Commissioner of Income Tax, Circle 1(1), Thiruvananthapuram, disallowed the levies. The Commissioner of Income Tax (Appeals) and the Income Tax Appellate Tribunal, Cochin Bench, both upheld the disallowance. The High Court of Kerala at Ernakulam then delivered a split verdict on 30 April 2020: it upheld the disallowance for FL-9 licence fees but allowed it for FL-1 fees (since another state entity, the Kerala State Civil Supplies Corporation, also held an FL-1 licence, breaking the exclusivity). It also ruled that the surcharge on sales tax and turnover tax were not covered by Section 40(a)(iib). Both sides appealed to the Supreme Court.

What each side argued

KSBC, represented by its learned Counsel, argued that Section 40(a)(iib) only disallows fees or charges levied exclusively on state government undertakings. Since the FL-1 licence was also held by another state entity, the levy was not exclusive to KSBC, and therefore the deduction should be allowed. On the surcharge and turnover tax, KSBC argued that these were taxes, not fees or charges, and thus fell outside the scope of the provision entirely.

The Revenue, represented by the learned Additional Solicitor General, countered that the exclusivity under Section 40(a)(iib) must be viewed from the nature of the undertaking, not the number of licensees. The provision was designed to catch all levies that are imposed only on state undertakings, regardless of how many of them exist. On the surcharge, the Revenue relied on the Supreme Court's recent decision in Jalkal Vibhag Nagar Nigam v. Pradeshiya Industrial and Investment Corporation (2021 SCC OnLine SC 960), arguing that the distinction between tax and fee had been substantially effaced, and that surcharge on sales tax should therefore be treated as a fee or charge under Section 40(a)(iib).

What the Supreme Court did

The two-judge Bench of Justice R. Subhash Reddy (author) and Justice Hrishikesh Roy delivered a nuanced judgment on 3 January 2022. They dismissed KSBC's appeal regarding the gallonage fee, licence fee, and shop rental for both FL-9 and FL-1 licences. They allowed the Revenue's appeals to the extent that FL-1 licence fees also attract Section 40(a)(iib). But they upheld the High Court's finding that surcharge on sales tax and turnover tax are not covered by the provision. The matter was remanded to the Assessing Officer for fresh computation consistent with this judgment.

The doctrine that mattered: exclusivity by nature, not by number

The core of the judgment is the interpretation of the word 'exclusively' in Section 40(a)(iib)(A). The provision disallows any sum paid on account of any fee or charge levied exclusively on a state government undertaking. The Revenue had argued that because only state undertakings could hold FL-1 licences, the levy was exclusive to state undertakings as a class. KSBC argued that since two different state entities held FL-1 licences, the levy was not exclusive to any one of them.

The Supreme Court rejected KSBC's argument. It held that the aspect of 'exclusivity' under Section 40(a)(iib) is to be viewed from the nature of the undertaking on which the levy is imposed, not on the number of undertakings on which it is imposed. In other words, if a levy is imposed only on state government undertakings — regardless of whether there is one or a hundred of them — it is exclusive within the meaning of the provision. The Bench observed that to hold otherwise would allow state governments to defeat the provision by simply issuing licences to multiple state undertakings and then contending that exclusivity is lost. This, the Court said, must be guarded against.

On the surcharge and turnover tax, the Court took a different view. It relied on two precedents: C.I.T. v. K. Srinivasan (1972) 4 SCC 526, which held that surcharge is used to increase rates of income tax and is part of the tax itself, and Sarojini Tea Co. Ltd. v. Collector, Dibrugarh (1992) 2 SCC 156, which held that surcharge on land revenue is enhancement of land revenue and part of it, not a distinct levy. Applying this logic, the Court held that a surcharge on sales tax is nothing but an enhancement of the sales tax itself, and such taxes are outside the scope and ambit of Section 40(a)(iib)(A) and (B). The Jalkal Vibhag case was distinguished on its facts. The same reasoning applied to turnover tax.

THE PLAY: When challenging a disallowance under Section 40(a)(iib), do not argue that exclusivity is broken merely because multiple state undertakings hold the same licence. Argue instead that the levy is a tax or surcharge, not a fee or charge — that is the only escape route the Supreme Court has left open.

Why this matters in practice

For advocates, this judgment settles a critical interpretive question. The 'exclusivity' test under Section 40(a)(iib) is now a class-based test, not a licensee-count test. If a levy is imposed only on state government undertakings as a class, it is exclusive, regardless of how many of them exist. This means that state-owned enterprises cannot avoid the provision by pointing to other state entities that also pay the same levy.

For CFOs and founders of state-owned enterprises, the practical takeaway is this: every fee, charge, or levy imposed on you under state law must be scrutinised for its nature. If it is a fee or charge imposed exclusively on state undertakings, it is likely disallowable. But if it is a tax or a surcharge on a tax, it is not. The distinction between a fee and a tax, though blurred in some contexts, remains alive for the purposes of Section 40(a)(iib).

The judgment also contains a warning for state governments. The obiter dicta in the judgment suggests that courts should be alert to structured arrangements designed to circumvent Section 40(a)(iib) through licence fragmentation. If a state creates multiple undertakings to hold different licences, the courts will look at the substance of the arrangement, not the form.

The bottom line

For any state-owned enterprise paying levies under state law, the Supreme Court has drawn a bright line: fees and charges imposed exclusively on state undertakings are disallowable under Section 40(a)(iib), but taxes and surcharges on taxes are not — and the exclusivity test is determined by the class of the undertaking, not the number of licensees.