The Big Question: Can States Tax Central Operations? Insights from the P&H HC Judgement

The author is Mahi Agrawal, second year student at Hidayatullah National Law University, Raipur

Abstract:

This blog breaks down the recent judgement given by the Punjab & Haryana High Court in Union of India v. Punjab State Electricity Board & Ors. At the core, the judgement emphasizes the constitutionally mandated financial boundaries between the state and central governments, protecting federal operations from direct taxation by states. The case revolves around Article 287 of the Indian Constitution, which exempts certain central Government activities from state-imposed taxes on electricity consumption. Further, this ruling brings attention to practical issues in enforcing such exemptions, as seen in disputes over accountability and administrative coordination. This blog examines the nuances of these challenges and explores how improved state-central collaboration and clear procedural guidelines could prevent similar disputes in the future, helping to maintain a balanced federal structure.

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The Indian Central Government runs various essential public operations- like defense facilities and railway services, both of which rely heavily on substantial electricity resources. Consider this scenario- the State Government in the region where these services are located imposes a tax on this electricity usage. Such a tax would introduce an uneven and additional financial burden, even though these essential operations are government owned. This could potentially strain government resources and impact service delivery. 

This was the exact situation in Union of India v. Punjab State Electricity Board & Ors., where the Punjab & Haryana High Court ruled that states cannot tax electricity consumed by the Central Government. The case arose when the Military Engineering Service (“MES”), responsible for managing electricity within a cantonment area, was charged an octroi duty of INR 4,57,342 by the Punjab State Electricity Board (“PSEB”) for electricity used between 2000 and 2007. The MES argued that under Article 287 of the Indian Constitution, the State wasn’t allowed to levy this tax on electricity consumed by a Central Government body. The Court conceded, ruling that Article 287 explicitly protects the Central Government from such state-imposed taxes. The judgement led to the order for a refund, making it clear that the MES should have never been taxed on its electricity use in the first place.

Why Must States Exempt Certain Taxes, and Why Does It Matter?

The Indian Constitution establishes a careful balance of powers in a federal structure, enabling both the Centre and the States to legislate within their respective domains. This balance extends to the realm of taxation, where the authority to levy taxes is granted to both, subject to constitutional limitations. While States enjoy exclusive powers to legislate on matters in the State List, these powers are constrained by provisions like Articles 13, 248, and those in Part XII, which impose critical checks. Among these limitations, Articles 285 to 287 stand out for their role in regulating State taxation powers to avoid friction with national interests. 

Article 287 of the Indian Constitution is designed to ensure that government operations critical to national functions, such as military or railways, aren’t burdened by additional financial demands from state authorities. It states as follows:

“...No law of a State shall impose, or authorize the imposition of, a tax on the consumption or sale of electricity (whether produced by a Government or other persons) which is. -

(a) consumed by the Government of India, or sold to the Government of India for consumption by that Government; or...”

If every state could tax the electricity used by, say, the defense forces or railway services- there would be added costs and complexities that would disrupt these operations. Article 287 essentially helps avoid such scenarios by creating a tax-free zone for essential government functions. Article 288 further restricts the states from imposing taxes on water or electricity when these resources are stored, generated, consumed, distributed, or sold by an authority established by an existing law or by Parliament. The case of State of A.P. v. National Thermal Power Corporation Ltd. and Ors. (2002) illustrates how different interpretations may arise regarding these provisions, not just between states but also within the organs of a particular State. In this case, the states of Andhra Pradesh and Madhya Pradesh argued that Articles 287 and 288 exclusively govern electricity taxation, excluding the application of other constitutional provisions like Entry 54, which addresses “goods”, or Entry 92-A, which deals with inter-state trade. The Supreme Court rejected this reasoning, holding that Articles 287 and 288 are context-specific and do not comprehensively govern electricity taxation. Instead, they provide exemptions in specific circumstances, leaving room for other provisions to apply. The Court also clarified that taxation of electricity sold or consumed outside state boundaries fall under Entry 54, and may also invoke Entry 92-1 of List I, enabling central regulation of inter-state trade. Thus, it is evident that states may differ in their reliance on Articles 287 and 288 or in their willingness to apply broader entries like 53, 54, or 92-A to expand or limit their taxation powers. This potential for varied interpretations necessitates judicial intervention to resolve conflicts and ensure a consistent application of constitutional principles. 

The Indian legislature has always stood by the idea that taxation should not impede critical functions, as it would result in inefficient costs passed onto essential services and, ultimately, the public. This principle finds further expression in provisions like Articles 285 and 289 of the Indian Constitution, which exempt Union property from State taxes and prohibit the Union from taxing State property or income, respectively. These exemptions preserve a smooth functioning of government entities while reducing the financial burden on services that directly affect the populace.

Article 285 exempts Union properties from all state taxes, thereby preserving the central government’s financial autonomy. The Supreme Court in State of West Bengal v. Union of India (1963) reiterated that the Indian Constitution is not strictly federal, as it grants states limited sovereignty over local matters while empowering the Union with broader authority to maintain national economic, industrial, and commercial unity, including property regulation. The Court even noted that, beyond being exempt from state taxes, the Union also has the authority to acquire state-owned property through legislation if needed.

In the subsequent case of New Delhi Municipal Committee v. State of Punjab (1997), the Supreme Court labelled the exemption under Article 285 as “absolute” and “empathetic in terms”, unlike Article 289. Article 289 provides a reciprocal exemption, stating that the Union cannot tax state properties or income, except when the State operates a trade or business. Article 289(1) provides a qualified exemption. This qualification is explained in clause 289 (2). If a law exists under clause (2), it limits the scope of the exemption in clause (1) to the extent specified in that law. While these two articles provide immunity from direct property taxation, the Supreme Court has recognized certain exemptions in this regard. In Mineral Area Development Authority v. Steel Authority of India (2024) , the Court clarified that while states may impose taxes on activities like mining under Entry 50 of List II, such taxes should not directly target Union property. This separation allows states to levy taxes on private entities operating on Union land, without infringing upon the Union’s immunity. Parliament’s oversight also ensures uniformity in mineral taxation across states. For instance, through the Mines and Minerals (Development and Regulation) Act, 1957, Parliament has set standards that prevent state-imposed taxes from interfering with national economic activities. Thus, it is well established that while the states may regulate and tax activities within their territory, direct taxation on Union property remains constitutionally restricted.

Practical Challenges in Enforcing These Tax Exemptions

In many instances, enforcing the tax exemptions under Articles 285, 287, 288, and 289 brings practical complications, particularly when different state departments have conflicting roles. For instance, in the above-mentioned case of Punjab State Electricity Board, the PSEB levied the octroi, claiming it was required to remit the tax to the local municipal body. It argued that it was merely following contractual obligations and forwarded the entire collected tax to the municipal body. So, when MES asked for a refund, each department started “passing the buck”- PSEB blamed the municipal body, and vice versa. This left MEB stuck in this bureaucratic loop with no clarity on who was responsible for the refund. Such situations illustrate common issues with tax exemptions, including administrative delays and disputes over responsibility. The primary challenges in this context are:

1. Who is Accountable? Each state entity might interpret tax exemption scope differently, leading to confusion about who is responsible for refunds or the exemption process.

2. Administrative Delays. Tax exemption cases often require coordination among multiple state bodies, particularly where refunds are due. For instance, state and municipal bodies may need to collaborate to process refunds, yet a lack of standardized procedures slows the process, adding administrative burdens to central agencies.

3. Legal Disputes and Compliance Issues. Conflicting interpretations of these articles often to lead to legal disputes over what constitutes exempt property or income. Courts frequently intervene to clarify such issues, which delay the resolution of tax exemption claims. Ensuring compliance with exemption provisions also requires rigorous verification to prevent fraud and misuse, as some entities may falsely claim exemptions or use exempt properties for non-exempt purposes.

It is also noteworthy that the states in India rely heavily on financial assistance from the Union due to limited taxation powers, which often make their own resources insufficient. They receive a share of certain Union taxes, such as those on non-agricultural income and property succession, along with grants-in-aid under Article 275. However, tax exemptions for central government operations further potentially strain state finances by causing revenue losses. Although exact data on the revenue loss caused by these exemptions is not publicly available, it is worth exploring their impact on state finances more thoroughly. The GST revenue-sharing model already illustrates the tension between States’ calls for greater fiscal autonomy and the Union’s emphasis on centralized policymaking. To address these concerns, compensating States for revenue foregone or reevaluating tax exemptions to reflect state-specific needs could be considered. A reassessment of these provisions, informed by data, might support a more balanced approach that aligns state and national priorities, contributing to a stronger and more collaborative federal structure.

How Can State-Central Coordination Improve?

Improving coordination between state and central is key to ensuring smooth enforcement of tax exemptions under the said articles. Standardized, clear guidelines on exemption eligibility, refund procedures, and accountability could prevent departments from misinterpreting roles, thereby reducing disputes and delays. India might consider adapting a model inspired by Australia’s Intergovernmental Agreement on Federal Financial Relations, which coordinates tax and financial relations between the Australian federal government and states. While the agreement primarily manages financial transfers rather than specific tax exemptions on properties, it does provide a structured framework that helps prevent intergovernmental disputes and ensures coordinated financial operations across different levels of government. India could create a centralized digital portal for exemption applications accessible to both state and central entities, integrated with a database of eligible properties and exemptions. Moreover, such a structured model could ensure a clear accountability mechanism for refunds, with specific agencies designated accountable for timely processing and disbursement of refunds, backed by set timelines.

Conclusion

Understanding why states must refrain from imposing certain taxes is crucial, especially as India’s economy grows more integrated. In an age where infrastructure, digital services, and energy requirements transcend state boundaries, maintaining these exemptions allows for smoother governance and sustained growth without bureaucratic or financial hindrances. For instance, if states were to impose taxes on digital or logistics networks crucial for national development, it would disrupt these sectors’ efficiency, potentially affecting citizens across all states.

Thus, a structured, consultative approach to tax exemptions could benefit both states and the central government, perhaps through clear-cut guidelines on exemptions and a centralized system for managing refunds. Ultimately, in a federal system like India’s, tax exemptions are significant in ensuring that vital services remain efficient, affordable, and accessible to all its citizens.