The issue of taxability of works contracts under VAT and Service Tax is something which has confronted assessees leading to frequent referrals to Courts over the years. While the issue of taxability under Sales Tax has led to referrals over the last 50 years or so, the issue with regard to service tax is a more recent one. But often the issue of taxability centers around the basic nature of contracts and the valuation methodology that should be adopted under both Sales Tax/VAT and Service Tax. While the valuation issue has been sought to be sorted out through amendments in law bringing about provisions for specifying deemed value for taxation in the absence of evidence of actual costs being incurred in terms of labour and materials used for works contract execution, the issue of basic nature of contract is something which has seen enough confusion of late.
This issue has been sought to be clarified by the Supreme Court in the context of construction services by real estate developers in M/s Larsen & Toubro Limited & Another Vs State of Karnataka & Another (2013 (9) TMI 853 – Supreme Court) where the earlier decision in K. Raheja Development Corporation Vs State of Karnataka (2005 (5) TMI 7 – Supreme Court) was followed and now in the latest decision of the Constitution Bench of the Supreme Court in M/s Kone Elevator India (P) Ltd Vs State of Tamil Nadu & Others (2014 TIOL 57 SC-CT-CB), in the context of supply, erection, commissioning and installation of lifts where the Court has held that the same amounts to works contract rather than sale of lifts. This has been done overruling the earlier decision given in Kone Elevators (India) Ltd Vs State of Andhra Pradesh (2005 (2) TMI 519 – Supreme Court of India).
This once again leads us to the basic question and that is understanding the circumstances in which a contract could be regarded as one of works contract as distinguished from one of sale.
Earlier decisions
If one refers the decision of the Supreme Court in Gannon Dunkerely & Co. (Madras) Ltd Vs The State of Madras (1958 (04) TMI 42 – Supreme Court of India), the distinction between a contract for sale and one for works contract is evident. The Court held thus – “It has been already stated that, both under the common law and the statute law relating to sale of goods in England and in India, to constitute a transaction of sale there should be an agreement, express or implied, relating to goods to be completed by passing of title in those goods. It is of the essence of this concept that both the agreement and the sale should relate to the same subject matter.
Where the goods delivered under the contract are not the goods contracted for, the purchaser has got a right to reject them, or to accept them and claim damages for breach of warranty. Under the law, therefore, there cannot be an agreement relating to one kind of property and a sale as regards another.
We are accordingly of opinion that on the true interpretation of the expression "sale of goods" there must be an agreement between the parties for the sale of the very goods in which eventually property passes. In a building contract, the agreement between the parties is that the contractor should construct a building according to the specifications contained in the agreement, and in consideration therefor receive payment as provided therein”
The Court also went on further to analyse the timing and manner of the transfer of the property in goods used in construction by referring to some of the decisions of the English Courts as follows –
“The nature and incidents of works contracts have been the subject of consideration in numerous decisions of the English Courts, and there is a detailed consideration of the points now under discussion, in so far as building contracts are concerned, in Hudson on Building Contracts, 7th Edition, pages 386-389 and as regards chattels, in Benjamin on Sale, 8th Edition, pages 156-168 and 352-355. It is therefore sufficient to refer to the more important of the cases cited before us.
In Tripp v. Armitage, Bennett, a builder, had entered into an agreement with certain trustees to build a hotel. The agreement provided inter alia that the articles which were to be used for the structure had to be approved by the trustees. Subsequently, Bennett became bankrupt, and the dispute was between his assignees in bankruptcy, and the trustees as regards title to certain wooden sash-frames which had been approved on behalf of the trustees but had not yet been fitted in the building. The trustees claimed them on the ground that property therein had passed to them when once they had approved the same. In negativing this contention, Lord Abinger, C.B., observed:
"..............this is not a contract for the sale and purchase of goods as movable chattels; it is a contract to make up materials, and to fix them; and until they are fixed, by the nature of the contract, the property will not pass."”
“In Seath v. Moore, the facts were similar to those in Tripp v. Armitage. A firm of Engineers, A. Campbell & Son, had entered into five agreements with the appellants, T.B. Seath and Co., who were ship- builders to supply engines, boilers and machinery required for vessels to be built by them. Before the completion of the contracts, A. Campbell and Son became bankrupt, and the dispute was as regards the title to machinery and other articles which were in the possession of the insolvents at the time of their bankruptcy but which had been made for the purpose of being fitted into the ships of the appellants. It was held by the House of Lords approving Tripp v. Armitage (1839) 4 M. & W. 687; 150 E.R. 1597 that there had been no sale of the machinery and parts as such, and that therefore they vested in the assignee. For the appellant, reliance is placed on the following observations of Lord Watson at page 380:
"The English decisions to which I have referred appear to me to establish the principle that, where it appears to be the intention, or in other words the agreement, of the parties to a contract for building a ship, that at a particular stage of its construction, the vessel, so far as then finished, shall be appropriated to the contract of sale, the property of the vessel as soon as it has reached that stage of completion will pass to the purchaser, and subsequent additions made to the chattel thus vested in the purchaser will, accessione, become his property." It is to be noted that even in this passage the title to the parts is held to pass not under any contract but on the principle of accretion.”
In Hindustan Shipyard Ltd Vs State of Andhra Pradesh (2000 (7) TMI 864 – Supreme Court of India), the Court held an arrangement for building and delivering a ship as amounting to sale of ship concluding thus - “The delivery of the ship must be preceded by trial run or runs to the satisfaction of the owner. All the machinery, materials, equipment, appurtenances, spare parts and outfit required for the construction of the vessel are to be purchased by the builder out of its own funds. Neither any of the said things nor the hull is provided by the owner and in none of these the property vests in the owner. It is not a case where the builder is utilising in building the ship, the machinery, equipment, spares and material, etc., belonging to the owner, whosoever might have paid for the same. The builder has thereafter to exert and invest its own skill and labour to build the ship. Not only the owner does not supply or make available any of the said things or the hull of the ship the owner does not also pay for any of the said things or the hull separately.”
In Sentinel Rolling Shutters & Engineering Co. Pvt Ltd Vs The Commissioner of Sales Tax (1978 (9) TMI 157 – Supreme Court of India), the Court held a contract for fabrication, supply, erection and installation of rolling shutters as works contract and not sale of shutters concluding thus – “The rolling shutter comes into existence as a unit when the component parts are fixed In position on the premises and it becomes the property of the customer as soon as it comes into being. There is no transfer of property in the rolling shutter by the manufacturer to the customer as a chattel. It is essentially a transaction for fabricating component parts and fixing them on the premises so as to constitute a rolling shutter. The contract is thus clearly and indisputably a contract for work and labour and not a contract for sale.”
In Richardson & Cruddas Ltd Vs The State of Madras (1967 (5) TMI 61 – Supreme Court of India), a contract for fabrication and installation of bottle cooling equipment by fabricating different parts of the unit according to special requirements of the customer in his premises, was held to be works contract. A reference was made to Halsbury's Laws of England, Volume 34, page 6, in paragraph 3, where it was observed thus –
"A contract of sale of goods must be distinguished from a contract for work and labour. The distinction is often a fine one. A contract of sale is a contract whose main object is the transfer of the property in, and the delivery of the possession of, a chattel as a chattel to the buyer. Where the main object of work undertaken by the payee of the price is not the transfer of a chatter qua chattel, the contract is one for work and labour. The test is whether or not the work and labour bestowed end in anything that can properly become the subject of sale; neither the ownership of the materials, nor the value of the skill and labour as compared with the value of the materials, is conclusive, although such matters may be taken into consideration in determining, in the circumstances of a particular case, whether the contract is in substance one for work and labour or one for the sale of a chattel."
This was also followed in Variety Body Builders Vs State of Gujarat (1976 (4) TMI 190 – Supreme Court of India), where building of railway coaches on under-frames supplied by railways was held to amount to works contract and not sale.
In Nanu Ram Vs State of Rajasthan (1969 (7) TMI 95 – Supreme Court of India), the Court relied on an earlier decision in State of Rajasthan Vs Man Industrial Corporation Ltd (1969 (2) TMI 130 – Supreme Court of India) to hold that where the primary undertaking of the contractor was not merely to supply the windows but to fix the windows and if the windows were not properly fixed the contract could not be completed, the view of the High Court that it was only upon the fixing of the window-leaves and when the window-leaves had become a part of the building construction that the property in the goods had passed under the terms of the contract, had to be accepted.” In other words, the contract would be a works contract.
In the context of contracts for construction of buildings in India, in Builders Association of India & Others Vs UOI & Others (1989 (03) TMI 356 – Supreme Court of India), the Court followed what was laid down earlier in Gannon Dunkerley’s case though it further discussed the concept of transfer of property in goods involved in construction of building as follows –
“Ordinarily unless there is a contract to the contrary in the case of a works contract the property in the goods used in the construction of a building passes to the owner of the land on which the building is constructed, when the goods or materials used are incorporated in the building. The contractor becomes liable to pay the sales tax ordinarily when the goods or materials are so used in the construction of the building and it is not necessary to wait till the final bill is prepared for the entire work. In Hudson's Building Contracts (8th edition) at page 362 it is stated thus:
"The well-known rule is that the property in all materials and fittings, once incorporated in or affixed to a building, will pass to the freeholder-quicquid plantatur solo, solo cedit. The employer under a building contract may not necessarily be the freeholder, but may be a lessee or licensee, or even have no interest in the land at all, as in the case of a sub-contract. But once the builder has affixed materials, the property in them passes from him, and at least as against him they become the absolute property of his employer, whatever the latter's tenure of or title to the land.
The builder has no right to detach them from the soil or building, even though the building owner may himself be entitled to sever them as against some other person-e.g., as tenant's fixtures. Nor can the builder reclaim them if they have been subsequently severed from the soil by the building owner or anyone else. The principle was shortly and clearly stated by Blackburn, J., in Appleby v. Myers [1867] LR 2 CP 651 at p. 659: 'Materials worked by one into the property of another become part of that property. This is equally true, whether it be fixed or movable property. Bricks built into a wall become part of the house; thread stitched into a coat which is under repair, or planks and nails and pitch worked into a ship under repair, become part of the coat or the ship.””
The aforesaid concept of transfer of property in goods involved in works contract execution would be vital and would require review especially in a scenario where the construction work gets sub-contracted in whole or in part to another contractor by the main contractor or a Developer. The issue of vesting of materials is something which has posed problems to Courts. While they have traditionally dealt with cases of transfer of property in goods from a single contractor to the end user who often happened to be the owner of the land, we also have scenarios where work is sub-contracted and one has to deal with issues of ownership of materials brought in by the sub-contractor more so where there is no privity of contract between such sub-contractor and the end customer.
If we go purely by the concept of quicquid plantatur solo, solo cedit i.e. the Latin principle which says “whatever is fixed to the soil belongs to the soil”, the vesting of materials should be with the end customer even in the absence of privity of contract between the sub-contractor and the said end customer. However, this very aspect needs judicial review considering the fact that there would be issues with regard to ownership of materials as well as taxing of transfer of property in goods involved in works contract execution in the hands of the main contractor/developer who has privity of contract with the end customer but where construction work is sub-contracted to another contractor.
In Larsen & Toubro Ltd & Others Vs State of Andhra Pradesh & Others (2008 (08) TMI 21 – Supreme Court), the Court relied on the principle of accretion dealt with in Builders Association of India case to hold the view that “once the work is assigned by the contract to its sub-contractor(s), main contractor ceases to execute the works contract because property passes by accretion and there is no property in goods with the contractor which is capable of a retransfer, whether as goods or in some other form.” Therefore, the main contractor was held not to be liable to VAT on the turnover of the sub-contractor u/s 4 of the Andhra Pradesh Value Added Tax Act 2005. It however remains a fact that the concept of “employer” referred to by the Honorable Supreme Court in Builders’ Association of India case by quoting Hudson’s Building Contracts was not discussed in Larsen & Toubro Ltd’s case at all along with the principle of quicquid plantatur solo, solo cedit which if it had been done, could have thrown more light on the concept of “employer” and vesting of materials.
In K. Raheja Development Corporation Vs State of Karnataka (2005 (5) TMI 7 – Supreme Court of India) the Supreme Court had in fact gone on to hold the view that certain contracts could be regarded as works contracts even if they specifically were not classified as such. It held that undertaking to build as developers for the prospective purchasers on payment of price in various instalments after entering into sale agreements with purchasers, would amount to a works contract. This decision has been followed and approved in M/s Larsen & Toubro Limited & Another Vs State of Karnataka & Another (2013 (9) TMI 853 Supreme Court). Here, the Court relying on the earlier decision in Bharat Sanchar Nigam Ltd Vs UOI (2006 (3) TMI 1 Supreme Court) also held that in a composite transaction covered by clauses of Article 366 (29A) of the Constitution of India (which would also cover a works contract), the dominant nature test would not be applicable and that the sale element of those contracts could be separated and subjected to sales tax.
In M/s Kone Elevator India (P) Ltd Vs State of Tamil Nadu & Others (2014 TIOL 57 SC-CT-CB), the Honorable Supreme Court in its judgement delivered on 6th of May 2014 has reviewed the position regarding manufacture, supply and installation of lifts to see whether such contracts are to be regarded as one of sale or as one of works contract. The need for this arose as a result of differing views being taken across various States with regard to concept of works contract and sale by both assessees as well as Revenue Authorities when it came to a question of classifying supply and installation contracts. This followed the earlier decision in Kone Elevators (India) Ltd Vs State of Andhra Pradesh (2005 (2) TMI 519 – Supreme Court of India) where the contract pertaining to lifts was held to be a sale contract as well as contradictory decisions with regard to concept of works contract in the context of building contracts as well as some of the decisions indicated earlier in this article.
The Court has consequently held that the principal logic applied, i.e., the incidental facet of labour and service, in the earlier decision is not correct and that a composite contract for supply and installation of lifts would have to be treated as a works contract. The Court observed thus with regard to the process of installing lifts – “Individually manufactured goods such as lift car, motors, ropes, rails, etc. are the components of the lift which are eventually installed at the site for the lift to operate in the building. In constitutional terms, it is transfer either in goods or some other form. In fact, after the goods are assembled and installed with skill and labour at the site, it becomes a permanent fixture of the building.”
It further went on to add that if there are two contracts, namely, purchase of the components of the lift from a dealer, it would be a contract for sale and similarly, if separate contract is entered into for installation, that would be a contract for labour and service. But, once there is a composite contract for supply and installation, it has to be treated as a works contract, for it is not a sale of goods/chattel simpliciter. It is not chattel sold as chattel or, for that matter, a chattel being attached to another chattel. Therefore, it would not be appropriate to term it as a contract for sale on the bedrock that the components are brought to the site, i.e., building, and prepared for delivery.
The conclusion, as had been reached in the earlier decision of Kone Elevators (India) Ltd Vs State of Andhra Pradesh (2005 (2) TMI 519 – Supreme Court of India) was found to be based on the bedrock of incidental service for delivery. It was found not to be legally correct to make such a distinction in respect of lift, for the contract itself profoundly spoke of obligation to supply goods and materials as well as installation of the lift which obviously conveyed performance of labour and service. Hence, the fundamental characteristics of works contract were found to be satisfied. Thus analysed, the conclusion was that the decision rendered in the aforesaid case by the Three Member Bench did not correctly lay down the law and it had to be, accordingly, overruled.
In delivering its verdict, the Court has also relied on the decision in Larsen & Toubro Limited & Another Vs State of Karnataka & Another (2013 (9) TMI 853 Supreme Court), to reiterate the position that “the dominant nature test” or “overwhelming component test” or “the degree of labour and service test” are really not applicable. If the contract is a composite one which falls under the definition of works contracts as engrafted under clause (29A)(b) of Article 366 of the Constitution, the incidental part as regards labour and service pales into total insignificance for the purpose of determining the nature of the contract.
Assessees who have adopted the stance that such contracts are one of sale rather than works contracts would be better advised to review the position as there is a risk of increased Departmental scrutiny moving forward not just under VAT but also under Service Tax on account of contracts being regarded as works contracts. Pending assessment cases including those under litigation would also need review going by the concluding paragraph in the said decision.
By CA Srikantha Rao T
CAclubindia
