Territorial non-taxability and proportionate credit reversal defeated Rule 6 demand under the Cenvat Credit Rules.

Services rendered in Jammu and Kashmir were outside the service tax levy because the Finance Act, 1994 did not extend to that territory, and they were not treated as exempted services for Rule 6 of the Cenvat Credit Rules, 2004. The separate-account requirement under Rule 6(2) therefore did not apply on that basis. Where the assessee had already reversed proportionate Cenvat credit attributable to the disputed common input services, the percentage-based demand of 5%/6%/7% under Rule 6 was not sustainable, because proportionate reversal achieved the rule's object and the higher liability could not be imposed mechanically.

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Issues: (i) Whether services rendered in Jammu and Kashmir could be treated as exempted services for the purpose of Rule 6 of the Cenvat Credit Rules, 2004. (ii) Whether the demand of 5% / 6% / 7% under Rule 6 was sustainable despite reversal of proportionate Cenvat credit attributable to the disputed services.

Issue (i): Whether services rendered in Jammu and Kashmir could be treated as exempted services for the purpose of Rule 6 of the Cenvat Credit Rules, 2004.

Analysis: Services supplied in Jammu and Kashmir were outside the levy of service tax because the Finance Act, 1994 did not extend to that territory. A service that is not subject to levy of tax is not, for that reason alone, an exempted service within the meaning of the Cenvat Credit Rules. The separate-account requirement under Rule 6(2) applies where a provider renders taxable services and exempted services, not where part of the output consists of services that are simply non-taxable by reason of territorial exclusion. The legal fiction sought to be applied by the Revenue was therefore unsustainable.

Conclusion: The services rendered in Jammu and Kashmir were not exempted services, and Rule 6 could not be invoked on that basis.

Issue (ii): Whether the demand of 5% / 6% / 7% under Rule 6 was sustainable despite reversal of proportionate Cenvat credit attributable to the disputed services.

Analysis: The assessee had already reversed the proportionate credit relatable to the disputed common input services. Compliance with the proportionate reversal mechanism under Rule 6(3)(ii) read with Rule 6(3A) met the object of preventing retention of credit attributable to exempted output. In such a situation, the higher amount prescribed under the percentage-based demand provision could not be mechanically imposed, and the Rules did not provide for automatic application of that option merely because no election was made at an earlier stage.

Conclusion: The percentage-based demand under Rule 6 was not sustainable after proportionate reversal of credit.

Final Conclusion: The impugned demand was unsustainable and the departmental appeal failed, leaving the assessee's relief intact.

Ratio Decidendi: Services that are outside the territorial levy of service tax are not automatically exempted services under Rule 6 of the Cenvat Credit Rules, 2004, and where proportionate credit attributable to common input services is reversed, the percentage-based demand under Rule 6 cannot be imposed mechanically.

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