Complicacies in VAT on Works Contract

VAT on Works Contract in Rajasthan and Complicacies in tax computation.  

Introduction

Works contract is a contract for carrying out some work for a lump sum consideration. The transfer of property in the goods involved in the execution of the works contract is taxable as deemed sale under State VAT Act. The value of works contract is composed off ‘Material Value’, ‘Labour Value’, ‘incidental services’ and ‘profit margin’. The tax under vat is levied on the value of goods in which property is transferred or say tax is levied only on the ‘Material Value’ component of the works contract. The Material Value is further composed off different category of goods, exempted as well as  taxable goods. Now question is how to determine the value of each component of the works contract and then how to split the total value of goods used in the works contract in different tariff groups i.e. exempted, 5%, 14% etc., according to their classifications as per vat schedule? Since the value of works contract is indivisible various issues are involved in offering the tax liability. There have been confusions and litigations over the years regarding computation of taxable turnover and computation of tax liability thereon and also how it is different than Normal sale? All these issues have been discussed in later part of this article.

What is Works Contract (Deemed Sale)  and How it is different than Normal Sale?

Under Rajasthan Value Added Tax Act 2003 the “Works Contract” has been defined under section 2(44). According to this section “Works Contract” means a contract for carrying out any work which includes assembling, construction, building, altering, manufacturing, processing, fabricating, erection, installation, fitting out, improvement, repair or commissioning of any movable or immovable property;

As per Section 2(35)  RVAT Act 2003 “Sale” includes – ‘transfer of property in goods (whether as goods or in some other form) involved in the execution of works contract’; and such transfer, delivery or supply shall be deemed to be a sale and the word “purchase” or “buy” shall be construed accordingly;

To understand the meaning of Works Contract we shall have to differentiate Normal Sale & Works Contract. The works contracts are not normal sales. In the normal sale there is a transfer of property in definite or ascertained goods. Goods is sold “chattel quo chattel” . The character/identity of goods remains same before and after the delivery of the goods. However, in works contracts it is not so. In WC the goods before the delivery are in different form/shape/character and after execution of the works contracts it comes or transforms into different form/shape/character. For example, before the Construction (works contract) commences, the goods like cement, steel, sand etc. are lying at the site of construction of building but after construction a building (immovable goods) comes to an existence. Thus, in case of indivisible works contract what is ultimately delivered to the awarder is not in the same form in which it was originally purchased by the contractor. The Contractor neither sold steel, cement, sand etc. to the awarder nor he sold the building, then the question arises, what has been sold by him? The answer is that, the value of material or goods consumed in the works contract in which property is transferred to the awarder has been considered to be a “Deemed Sale” under works contract.  This is the difference between the ` Normal” sale and the “deemed sale”.

Basic Difference in Normal Sale & Deemed sale under Works Contract:

“In a contract of sale, the main object is the transfer of Property and delivery of the possession of Chattel as a Chattel to the buyer, whereas it is not so in WC, it is a contract of Works & Labour” (Hindustan Aeronautics Ltd. 55-STC 314-SC).

“If the thing to be delivered has any individual existence before the delivery as the property of the party who is to deliver it, then it is a sale. If the main object of the work undertaken is not the transfer of a Chattel qua Chattel, the contract is one for work and labour” (Hindustan Shipyard – 119 STC 533-SC).

“The activity is a sale or works contract depends upon the facts, the terms and conditions and the intention of the parties” (Mekenzis Ltd.-165 STC-58 SC). In normal practice, we can identify many indivisible/composite works contracts namely construction of a Building, erection of Plant & Machinery, Processing jobs, Job works, Repair jobs, Electrical Fittings, Annual maintenance Contracts (AMCs). Installation of Elevators, Air Conditioners, Repairs of Vehicles, Re-trending of old tyres, Customized Printing Jobs, Electro Plating, electro-galvanizing, anodizing etc. We would discuss later, the levy of Sales Tax/VAT on such activities which are indivisible works contracts.

Brief History or back ground of Works Contract/Deemed Sale

Before the 46th  Amendment to the Constitution of India, the States were allowed to tax only on the sales covered under the sale of goods Act i.e. ‘Normal Sale’ and not the indivisible works contracts. The Supreme Court confirmed this legal status in its land mark judgment in the case of Gammon & Dunkerely (9 STC 353 SC). Due to this legal status, the states were denied to  levy Sales Tax on the indivisible works contracts and such contractors were outside the clutches of sales tax laws.

To remove this anomaly finally,  46th  amendment was made to the Constitution of India on 2nd  February, 1983 and  a sub-article (29-4) was added - “(b) a tax on the transfer of property in goods (whether as goods or in some other form) involved in the execution of a works contract”.

After the said 46th  amendment to the Constitution, the indivisible works contract was brought at par with a contract which is divisible into one for supply of goods and one for service and labour and the States were empowered to levy Sales Tax  on that portion of  Works Contract  which relates to supply of material as if it was a sale, called as “Deemed sale” involved in the execution of works contract. Due to the said amendment the concept of `Deemed Sale’ was introduced.

After the said amendment to the Constitution certain States namely Maharashtra & Delhi had come out with separate `Works Contract’ Acts. The other states incorporated separate provisions in the State Act to levy Sales Tax on the deemed sales in the works contracts. Now in Vat System all VAT States have incorporated provisions of `Works Contracts’ in their respective VAT Act and now there is no WCT Act in force. The advantage to the Contractors under VAT system is that the Contractors like manufacturers can avail set off or Credit of VAT paid to the local vendors, which was not available in the Pre-VAT Regime but in Rajasthan set off of Tax Paid material was allowed and tax was imposed only on URD purchases.

Methods for computation or valuation of  taxable turnover under Works Contract-

In VAT System there is a uniformity in all States in respect of provisions relating to works contract. All States have provided three options for computation of Taxable Turnover under works contract. The three options are as under:

1. Exemption Fee Method: commonly known as Composition Method

2. VAT Method-1 : Actual Deduction Labour and Service Method

3. VAT Method -2 : Standard Deduction Method

Although all States have provided above three options but  many States have not provided or prescribed the complete procedure for items to be deducted from total value of works contract for computing the material value of the works contract and also not laid down the rules for splitting the material value into different tariff groups according to the classification of goods, however the High Courts and the Supreme Court have suggested methods on “How to arrive at a material value from the total Contract Price”. (Gannon Dunkerly’s SC Judgement 1993) (88 STC 204). Now we discuss each option one by one as under;

Option 1- Exemption Fee/ Composition Method (Under RVAT Act 2003)

Considering the complexity in computation of taxable turnover as well as tax liability on works contract and in order to grant relief to the dealers from lengthy process of record keeping, filing of quarterly returns and proving the deductions with evidence during the assessment proceedings the State Govt. has announced a simplified scheme to tax the works contract known as Exemption Fees Scheme vide Notification No. F.12(63)FD/Tax-2005/80 dated 11.08.2006 and amended from time to time and now it has been replaced by Notification No. F.12(101)FD/Tax/2011-59 dt. 13.08.13. It is also known as Composition Scheme. It is a scheme which causes minimum inconvenience to the contractor as well as to the department in computing and assessing the taxable figure.

What is the Exemption Fees Method

Under this Scheme the State Government has notified  different rate of Exemption Fee for different category of works contract according to the nature of work. The contactor has to simply pay the Exemption Fee, on the total value of the works contract without any deduction, at the rate which is applicable to its works contract and as mentioned in the Exemption Certificate. The rate of Exemption Fee is varying from .25% to 3%. It can be explained with an example that a contractor has been awarded a works contract for a total value of Rs. 2 crore for construction of Building. The rate of EC on this work is 3% as per notification, therefore the tax liability of contractor under this scheme shall be 6 lakhs being 3% of 2 crore.

Major Features of Exemption Fees Scheme in Rajasthan VAT

1. EC fee is payable at a flat rate or fixed rate, on Total Value of works contract, decided at the time of issue of Exemption Certificate.

2. No deduction is available from total value.

3. No set off or credit of input tax available.

4. Only one annual return is required to be filed.

5. No record of material purchased and consumed is required to be maintained.

6. Once option is exercised no exit route is available.

Procedural aspects for availing this scheme

1. The Contractor has to exercise option of EC fee within 60 days of the Work Order in WT-1.

2. AO will grant Exemption Certificate in WT-2 within 21 days of application.

3. Separate application is required for separate Work Order.

4. If value of Work Order is enhanced or increased then revised EC application in WT-4 has to be filed within 60 days of communication regarding enhancement.

5. If application is late, then following late fee is payable:

Rs. 1000/-  : if application is filed within one year of work order

Rs. 5000/-  : if application is filed between one year to two year

From the date of work order

6. No application can be filed after two year from the date of work order.

7. Rate of Exemption Fee shall be specified in EC certificate and the rate of EC Fee will be that rate which is prevailing on the date of submission of application.

What will be the Status of Sub-Contractor

As per rule 22(2A) of Rajasthan VAT Rules 2006, if the main contractor has obtained Exemption Certificate in respect of his work and thereafter if he sub-lets whole or part of the work to a sub-contractor, then the sub-contractor shall not be liable to pay tax on such work or he is not required to opt for this scheme as the turnover of such contract will not be included in the taxable turnover of the sub-contractor.

VAT METHOD-1 (deduction of actual labour and services method)

In VAT method, the taxable turnover of the contractor is calculated by deducting value of labour and services involved in execution of works contract from the Gross Payment. The resulting value is the “Material Value” on which VAT is levied. From this VAT, the contractor can claim  input tax credit of goods purchased by him and pay the balance liability in cash.

How  to calculate the value of Taxable Turnover or  Material Value

Rule 22 of RVAT Rule 2006 provides for determination of taxable turnover. Sub-Rule (1) of Rule 22 provides that for determining the taxable turnover for levying tax under section 4(1) of the Act following amount shall be deducted from turnover:

a. on which no tax is leviable under this Act;

b. which has been exempted from tax;

c. & (d)  *******     not relevant here.

Sub Rule (2) of Rule 22 provides that apart from deductions provided in sub rule (1), the amount of labour shall also be deducted from the total value of the contract.

Although the provisions of RVAT Act and Rules provides that certain items on which tax cannot be imposed should be deducted from the total turnover to derive the value of taxable turnover but it does not provide clear cut guidelines to identify the items which are not liable to tax and which are to be deducted from the total value of the contract for arriving at the Material Vale or taxable value. Therefore guidance can be taken from the principles laid down by Supreme Court in Gannon Dunkerley and Company Vs State of Rajasthan and Larsen & Turbo Vs Union of India and Others ((1993)  88 STC 204)  regarding the items which are to be deducted from the total value of works contract for calculating the taxable turnover or the material value. The principles laid down by these verdicts are thoroughly followed while assessing the VAT on contractors if the contractors have not taken the Exemption Scheme route.

Method specified by by SC in Gannon Dunkerley & Company and L & T’s case

In this judgment Hon’ble SC has suggested that following deductions are to be made from the gross value of  works contracts to derive the Taxable Turnover or Material Value.

Total Value of Works Contract   xxxxxxxxx

Less: Prescribed Deductions

(i) Labour Charges for execution of Works Contract    xxxxxxxxx

(ii) Amount paid to sub- contractor for labour and services.  xxxxxxxxx

(iii) Charges for planning and designing and architect’s fees  xxxxxxxxx

(iv) Charges paid for obtaining on hire or otherwise the equipments or machinery used for execution of works contract. xxxxxxxxx

(v) Cost of consumables used in execution of works contract in which property does not pass to the contractee, such as water, electricity, fuel etc. xxxxxxxxx.

(vi) Cost of establishment to the extent it relates to supply of labour and services. overhead expenses of the head office and branch office including rents, salary, electricity, telephone charges, etc. and interest charges to bank and financial institutions; xxxxxxxxx

(vii) Other similar expenses relating to supply of labour and services. xxxxxxxxx

(viii) Profits earned by the  contractor to the extent it relates to supply of labour and services. xxxxxxxxx                                                                                   

Balance = Taxable Turnover/material Vale   xxxxxxxxx

At What rate the Tax will be levied on the Taxable Turnover

After arriving at the value of taxable turnover as above, the question which arises is, that, at what rate tax will be charged ?. There is no single rate prescribed for this purpose. The rate of tax will be the same rate which was applicable on the corresponding input good. For this purpose  we shall have to split the taxable turnover into different tariff category on the basis of input composition e.g. exempted goods, 5% taxable goods and 14% taxable goods category etc.,. Now the question arises how it will be splitted ? It may be splitted in the same proportion in which the  purchase value of each tariff group bears to the total purchase value. Or it may be splitted into the ratio worked out on the basis of material composition as per G-Schedule. After splitting the taxable turnover or the taxable material value tax shall be charged on the value of each group at the same rate to which it’s input category correspond in the vat Schedules. Although the State Government has powers to notify different rate of tax than the tax rate of input category  but in the absence of any such notification the tax will be charged at the rate which correspond to the input category because it is a deemed sale of those items only.

Now let us take an example to understand the manner in which the taxable turnover is computed and the manner in which the taxable turnover is splitted into different group according to different tariff category and the manner in which the tax liability is computed.

Case Study

Draft Works Account of a Contractor

Details of Input Tax & TDS

Category of Goods                        Purchase Value      Input

Taxable at 5%                                   725000                   36250

Taxable at 14%                                 575000                   80500

Total Input                                        116750

TDS deducted @ 3%                           75000

Calculation of Taxable Turnover

Now the Taxable Turnover will be bifurcated into turnover of different tariff category in the same ratio in which goods of different tariff category purchased bears to the total purchases. After splitting the taxable turnover into different tariff category, out put tax will be calculated  and from output tax the contractor will claim credit of input tax  and TDS  and the result will be the tax payable or refundable. .

Less: Input Tax Credit & TDS Credit (116750+75000)-  191750

Refundable to the contractor- 3452  

The above example is just for simple understanding of the concept; however the computation of tax liability will vary depending upon the facts and circumstances of each case, and there will be many  practical difficulties in this method which may be listed as below:

Practical difficulties in this Method

a. In this method the contractor is required to maintain complete books of account, site wise stock register etc.

b. The practical scenario is not so easy. In an unorganized sector it is very difficult to obtain the relevant details.

c. Since the vat invoices are raised progressively, vat liability has also to be discharged on progressive basis.

d. Identification of material transferred in each sale invoice is required. It is a very difficult task if the stock inventory is not maintained in order.

e. Bifurcation of material in which property is transferred and in which property is not transferred is very difficult.

f. The situation will be more difficult when the contractor has 10-12 work orders for different works.

g. The contractor will have to prove all the expenses for which deduction is claimed with proof and evidence. It is not so that whatever has been written in books of account will be accepted by the AO.

h. There will be problem in splitting the cost of establishment that how much is attributable to labour or service and how much is attributable to supply of material.

i. Again the splitting of taxable turnover or Material value into different tariff category is also  much difficult task.  

j. If the 100% goods are not purchased on the basis of purchase invoice then the split ratio worked out on the basis of purchase invoice will be wrong and will give wrong results.

k. If the contractor claims that whatever purchases recorded in the books of account are 100%, how the AO will rely on this statement to split the Material Value of works contract in different tariff category.

l. In the above example the taxable turnover or the material value of taxable turnover has been determined on the basis of deduction method or say by deducting the amounts on which tax cannot be imposed. It may also be computed directly taking the basis of purchase value and by adding margin therein. E.g. the purchase cost of material is Rs. 13.80 lakhs, by adding margin at the rate of 18.50% in this, the sale value of material will come to Rs. 16.34 lakhs which is same with the value worked out on deduction method basis. But the problem will be in proving the purchase cost of the materials, whether it is correct or not. There may be  possibility that the contractor may book excessive purchase of exempted goods, 5% taxable goods and may book lesser purchase of 14% taxable goods. The contractor will have to prove that the purchases booked under each group is correct with G-Schedule and other evidences.

m. In this situation contractor will have to sit with the engineer and list out the material used in the works contract in each work order as per G-Schedule, quantify each item of material in terms of value and put them into different group of tariff category in which they fall such as exempted, 5% taxable, 14% taxable etc.. and then work out the ratio of their composition in total value of material. If there are more than one work order then do this process for all work orders and then work out the average ratio in which the exempted goods was used, 5% taxable goods was used and 14% taxable goods was used.

n. Contractor will have to sit with the site engineer to bifurcate the purchases of goods into transferable and non transferable goods. For example-  wooden material purchased and used for shuttering activity are not transferred to the client and are booked as ‘consumables, store and spares’.   

VAT Method- 2 (Standard Deduction Method) Cases Where Proper Books of Accounts are not kept by Contractor

In the above calculation, it is presumed that the contractor performing the works contract is maintaining proper books of accounts and other relevant records and he can prove the genuineness of the deductions claimed from the gross turnover before the assessing authority with the inherent difficulties mentioned above.

But when contractor does not maintain proper books of accounts or the books of accounts produced by him cannot be said to be reliable, the legislature can prescribe some arithmetic formula by which a certain percentage is specified for deduction of labour and service which is to be deducted from the value of gross contracts for determining the taxable turnover of the contractor.

In Rajasthan VAT Rules, Explanation to Rule 22(2) deals with such situation. It provides that “Where the amount of labour is not determinable from the accounts of the contractor, or is considered to be unreasonably high in view of the nature of the contract, the deduction towards labour charges shall be allowed by the assessing authority according to the limits laid down in Column 3 for the type of contract specified in Column 2 of the table appended hereto;”

In this Rule the Legislature has prescribed  percentage of labour deduction only for different category of works contract which varies from 15% to 30%. It has not prescribed any formula for deduction of service charges. However, the deduction of labour provided in sub-rule (2) of Rule 22 is apart from the deductions provided in sub-rule (1). Clause (a) and (b) of Sub-rule (1) of Rule 22 provides for deduction of amount on (a) which no tax is leviable under the act and (b) which has been exempted from tax. Both these clause very well covers the service charges also. Although the State Government has not prescribed any percentage of deduction in this regard but a reasonable amount of deduction should be allowed for eight items as suggested by the Supreme Court in the case of Gannon Dunkerley and Company Vs State of Rajasthan and Larsen( 1993 88 STC 204). 

Sum up: To sum up it can be said that the material value involved in the execution of works contract in which property is transferred is a deemed sale under the VAT Act., and there are three methods in almost all States to determine the value of taxable turnover or material value. One Method is Exemption Fee Method which is very simple method in which a flat rate of exemption fee is paid on the total value of works contract and no input tax credit is allowed and the contractor is dispensed with the requirement of going through lengthy process of record keeping and quarterly returns. Other two methods are VAT Method where the tax is levied only on the material value of the works contract in which property is transferred and the contractor is allowed to take input tax credit in respect of goods purchased within the state from registered dealers of the state. Now which option is to be exercised will depend on the complexity of the issues involved and facts of the case.