It is true that the revenue collected through taxes enables the government to work towards public welfare, public health, infrastructure development, and national security. However, under the Indian Constitution, the power to levy and collect taxes is not unlimited. Recently, the Karnataka High Court, in the case of Dhariwal Industries and Others vs. Government of India and Others, delivered a significant judgment declaring the capacity-based cess imposed on pan masala and tobacco companies unconstitutional.

In its far-reaching judgment, a single-judge bench headed by Justice M. Nagaprasanna made it clear that determining cess solely on the presumed capacity of machines, instead of actual production, is arbitrary and vague and directly violates Article 14 of the Constitution, which guarantees the right to equality, and Article 19(1)(g), which protects the freedom to carry on trade and business.

The judgment has not only brought relief from the uncertain financial burden running into billions of rupees that was hanging over pan masala manufacturing units across the country, but has also reaffirmed the principle of taxation based on actual and verifiable realities under Indian tax law.

The High Court observed that the argument of tax collection and administrative convenience cannot take precedence over the constitutional right to equality.

It is worth noting that a special cess was imposed on pan masala manufacturers under the Health Security se National Security Cess Act, 2025 (HSNS Act) and the Rules framed thereunder in 2026. The primary objectives behind the cess were to generate resources for public health, raise revenue for national security priorities, and curb tax evasion.

However, the rules introduced an extremely rigid capacity-based assessment mechanism. Under this system, if a manufacturer possessed a machine capable of packing 500 pouches per minute, the tax authorities effectively assumed that the machine would operate at 100% capacity, continuously for 24 hours a day and 365 days a year.

Instead of determining the cess on the basis of actual production, it was calculated on the estimated or prescribed production capacity of the machines used in manufacturing. This created severe financial difficulties for pan masala manufacturers because even when actual production was substantially lower or operations remained shut, manufacturers were still required to pay cess based on the maximum capacity of their machines.

Clearly, when tax is imposed on production capacity many times higher than actual output, small and medium-sized manufacturing units can be pushed towards financial distress and even closure.

Distressed by this situation, several manufacturers, including Dhariwal Industries, challenged the provisions before the Karnataka High Court. The manufacturers argued before the court that no manufacturing unit could realistically operate at its theoretical maximum capacity because of power cuts, machine maintenance, shortage of raw materials, labour absenteeism, and other operational factors.

In response, the Central Government argued before the court that this was not an ordinary GST levy but a specific cess enacted by Parliament, for which the Centre had full legislative authority. The government’s principal argument was that the pan masala and tobacco sector had a higher possibility of tax evasion through undeclared production and that machine-capacity-based taxation was the only effective administrative mechanism to address the issue.

The Karnataka High Court acknowledged that Parliament does possess the legislative power to impose a cess or tax. However, it held that the manner and mechanism through which the cess was being calculated and collected did not satisfy the constitutional test under Article 14.

Article 14 of the Indian Constitution not only ensures equal treatment for persons who are similarly situated, but also recognises that persons who are differently situated cannot be treated identically in a manner that creates unfairness.

The High Court found that the cess framework placed machines with substantially different production capacities and speeds within the same tax category. For example, machines operating at 65 pouches per minute, 100 pouches per minute, and 500 pouches per minute could be classified within the same category and subjected to the same rate of cess.

The court made it clear that placing a small-capacity manufacturing unit and a large industrial facility on the same footing can amount to arbitrary and unreasonable treatment.

The High Court also rejected the government’s argument that tracking actual production and preventing tax evasion in industries such as pan masala is extremely complicated and that estimating tax on the basis of machine capacity is therefore a practical solution.

The court observed that merely because monitoring and verification may be difficult or challenging for the administration, the government cannot ignore ground realities and impose an estimated or arbitrary taxation mechanism.

Administrative convenience cannot come at the cost of constitutional equality.

If tax authorities do not have adequate mechanisms for inspection or production tracking, taxpayers cannot be penalised by forcing them to pay an unreasonable amount of tax on production that never actually took place. This observation establishes an extremely important principle for Indian tax jurisprudence.

The 15-Day Shutdown Condition

The rules also provided that manufacturers would qualify for exemption or abatement from the cess only if their machines remained completely shut down continuously for at least 15 days.

The High Court found this 15-day shutdown condition to be excessively harsh, impractical, and arbitrary.

The first reason is that machines in any manufacturing unit may remain shut for two, five, or ten days because of technical failures, power outages, shortage of raw materials, labour strikes, or sudden decline in demand.

The second issue was the disproportionate financial burden created by the provision. If a manufacturing unit remained shut for 12 days, it would fail to meet the 15-day threshold and could therefore remain liable for the entire capacity-based cess, despite having recorded zero or negligible production during that period.

The court highlighted that such a mechanism ignores the practical realities of manufacturing and places an unreasonable financial burden on manufacturers.

Small and Medium Manufacturers Most Affected

The most damaging impact of the capacity-based taxation system falls on small and medium-sized pan masala manufacturers.

Under the principle of proportionality, the tax burden should bear a reasonable relationship to the actual capacity and earnings of a business. When cess is calculated on potential or presumed capacity, the production cost of smaller manufacturers can increase disproportionately compared with larger manufacturers.

For example, if a small manufacturer’s machine is operating at only 30% capacity because of technical problems, but the manufacturer is still required to pay cess based on 100% capacity, the resulting tax liability could become disproportionately high compared with the unit’s actual turnover and profits.

As a result, smaller units could be pushed towards closure.

Technology Can Provide a Better Solution

In its judgment, the High Court acknowledged that preventing tax evasion is a legitimate and necessary objective of the government. It also recognised that unauthorised production and the cash economy present genuine challenges in the pan masala industry.

However, the court made it clear that the means adopted to achieve such an objective must also be lawful and constitutionally valid.

Instead of imposing tax on presumed capacity, the government can adopt modern, technology-driven tracking systems that are transparent and verifiable.

These could include blockchain- or QR-code-based digital supply-chain tracking, smart data loggers installed in machines to record production in real time, and AI-based analytics to identify unusual production patterns.

Such technological measures can provide accurate information about actual production, helping curb tax evasion while ensuring that legitimate manufacturers and low-capacity units are not subjected to an unfair tax burden.

Unreasonable Taxation Can Encourage the Parallel Market

The government must also recognise that when tax rates on a product become excessively high, complicated, or unreasonable, they can encourage illegal trade and parallel black markets.

When compliance costs for legitimate manufacturers become so high that conducting business becomes economically difficult, unauthorised manufacturing can receive an unintended boost. This can ultimately result in even greater revenue losses for the government.

The Dhariwal Industries judgment therefore provides an important direction for the Indian taxation system, particularly in the area of indirect taxation.

The message for the government is clear: Parliament has the power to impose taxes and cesses, but the policies and mechanisms created for their implementation must be transparent, fair, reasonable, and constitutionally sustainable.

The Central Government remains free to create a new and more scientific taxation framework in accordance with Article 14, provided that it relies on certified and verifiable actual data instead of presumed production capacity.

For the industry, the message is equally important. While the judgment provides protection against arbitrary taxation mechanisms, manufacturers must also recognise that tax compliance and transparency remain essential. Going forward, businesses will need to be prepared to adopt more digital, transparent, and traceable systems.

A Potential Turning Point for the Industry

Overall, the Karnataka High Court’s judgment represents an important development in India’s constitutional tax jurisprudence.

The decision underlines a fundamental democratic principle: even when the objective is legitimate, the means adopted to achieve it must also be constitutionally valid.

Generating resources for public health and preventing tax evasion are undoubtedly important and legitimate objectives. However, these objectives cannot be used to justify a taxation system designed primarily for administrative convenience that ignores differences between businesses and imposes disproportionate burdens on smaller enterprises.

The case has made it clear that taxation in India must operate on the principles of constitutional fairness and proportionality rather than administrative convenience.

However, the government has challenged the single-judge bench’s decision, and the matter is scheduled to be heard on 17 September. The industry will be hoping that the Division Bench also upholds the judgment.

If the Division Bench, like the single judge, rejects the approach of treating the presumed capacity of machines as equivalent to actual production, it will undoubtedly prove to be a major turning point for the pan masala and tobacco industry.

Such a decision would bring an end to the uncertainty surrounding arbitrary tax demands and financial liabilities faced by manufacturers and could pave the way for taxation based on actual production or sales.

Most importantly, MSMEs and small manufacturing units are likely to receive the greatest protection from such a framework.