Taxability of Pagadi under the GST Regime
[Pranjal Agarwal is a third-year student at National Law Institute University, Bhopal.]
On May 2, 2018, the Ministry of Finance (India) released a circular clarifying the applicability of the Central Goods and Services Tax Act, 2017 (Act) on the transfer of tenancy rights by payment of a tenancy premium or pagadi.
The term pagadi is well heard of while dealing with the real estate sector of the financial capital of the country, Mumbai. The system can be traced back to the colonial rule over India, under which the property was made non-transferable. The owner would allow the tenant to acquire tenancy rights against an additional payment to the nominal rent called the pagadi.
Similar to a standard agreement of lease, the landlord may be the owner of the property but the possession of the same lies with tenant, and the tenant is responsible to pay periodic rent to the landlord as long as he occupies the property. However, it is interesting to note that under this system, the tenant is said to acquire the status of a ‘part owner’ of the property (and not that of the land), in furtherance of which he has the option to sell the tenancy right of the said property. Under such an arrangement, the tenant has to share a percentage of the proceeds with the owner of the land as provided in their tenancy agreement. Alternatively, to get the property vacated, the landlord has to pay the tenant the prevailing tenancy premium. While the system is prevalent in multiple states of India, explicit codification of the same is provided for under section 56 of the Maharashtra Rent Control Act, 1999.
A similar practice is followed in the Republic of Korea, wherein it is customary that an outgoing tenant of a commercial building receives a premium from a new tenant at the time of transferring his or her leasehold right. The rationale is that the outgoing tenant of a commercial building invests in the property for his/her business by way of installation of facilities and by getting customers habituated to the location. In consideration for enjoyment or utilization of the value addition to the property, the new tenant pays a premium to the outgoing tenant. To protect this customary right, it was given legal status by an amendment to the Commercial Building Lease Protection Act on May 13, 2015, which essentially prohibits the owner from disturbing a tenant's recovery of the premium by any means.
The circular released by the Ministry of Finance acknowledges the prevalence of ambiguity regarding two aspects of the pagadi system under the Goods and Services Tax (GST) regime viz. the taxability of consideration for transfer of tenancy rights by an owner to an incoming tenant, which is in the form of a tenancy premium, and the taxability of the part of this consideration that may accrue to the outgoing tenant (if any) for surrendering tenancy rights.
Prior to the Act, the transfer of tenancy rights was considered to be a service to a tenant against consideration in the form of tenancy premium which was taxable under the Finance Act, 1994 (Service Tax). The circular clarifies that even under the GST regime, the tenancy premium remains taxable. Under section 9(1) of the Act, a Central GST shall be levied on all intra-state supplies of services. The activity of transfer of tenancy rights against consideration in the form of tenancy premium is a supply of service, thereby liable to GST. This is because it is accorded the status of a lease or renting of property by the circular, and para 2(1) of schedule II of the Act explicitly states any lease or tenancy to occupy land to be treated as a supply of service.
Further, there are certain exceptions to the scope of supply of services as mentioned in schedule III of the Act, but the circular clarifies that the transfer of tenancy rights cannot be treated as a sale of land or building under para 5 of the said schedule and, therefore, the consideration for the same shall attract the levy of GST. However, the nature of use of such a property is to be perused. Under notification No. 12/2017 - Central Tax (Rate) released by the Ministry of Finance, “services by way of renting of residential dwelling for use as residence” are exempted from intra-state tax. Hence, the acquisition of tenancy rights in a residential dwelling for residential use by payment of a tenancy premium or/and periodic rent is exempted from the applicability of the Central GST.
The circular further clarifies the taxability of the second aspect of the pagadi system wherein the outgoing tenant may receive a part/portion of consideration in the form of tenancy premium for the services provided by him by way of surrendering the tenancy rights. The circular categorically states that such part/portion of consideration shall also be liable to GST.
In conclusion, the circular plays a momentous role in ensuring the taxability of the historic practice of pagadi under the Act and the codification of the system thereof.