WHAT IS WORKS CONTRACT TAX? PLEASE EXPLAIN..
P SHENOY
(Practicing C.A.)
(35 Points)
Replied 31 October 2010
1. Composite Contracts — Introduction :
A composite contract is one which has constituent elements but the customer is interested
in the final outcome of the contract. In such a contract, the constituent elements
are so integrally connected and interdependent with each other that it is not feasible
to look at the elements in isolation. Such composite contracts may also include
minor elements which are incidental and ancillary to the main objective of the contract.
Such elements of a composite contract are to be treated as means of attaining the
ultimate object of the contract. For example, in a turnkey contract for design engineering,
procurement, construction, installation and commissioning of a power plant, the
individual element of engineering cannot be viewed in isolation of the procurement,
construction, installation and commissioning. In a lighter vein, one can say that
the icing on the cake cannot be viewed separately from the cake itself !
1.1 Works Contracts — Species of Composite Contracts :
Composite contracts involving both the supply of materials and
rendering of services (in reasonably dominant proportions) are known as works contracts.
A turnkey contract of the nature referred to above is a good example of a works
contract. In a works contract, there is a transfer of materials from the contractor
to the employer/contractee, however, the said transfer is not by means of sale.
In a works contract, the contractor agrees to perform some work
on the client’s property (may be moveable or immoveable). The performance of work
also involves the use of some materials of the contractor. As the contractor uses
these materials to perform the work, the materials get attached to the property
of the client in such a fashion that such contractor’s materials can no longer be
removed without substantial damage either to the contractor’s materials or the contractee’s
property. Since the property which is the subject matter of the work belongs to
the client, the ownership of the materials so attached on the property passes on
to the client albeit in an indirect fashion.
1.2 Accretion :
Consider the case of a building contractor who constructs a
building on the land of the client using his owned bricks, sand, cement, etc. Till
the stage he applies the cement on the land and lays a brick on it, the cement and
brick belongs to the contractor. But once the cement paste and the brick are applied
on the land, these ingredients fasten themselves to the land. It is then not possible
or viable to remove the cement or brick from the land (without fundamental damage).
Since the land belongs to the contractee, the ownership in the cement and brick
gets transferred to the contractee by inference and not by way of sale. This process
of the contractor’s materials getting embedded in the client’s immoveable property
is referred to as the transfer of ownership in goods through the process of accretion.
1.3 Accession :
Consider another example of a garage undertaking to paint the
car of its client. Similar to the earlier example, till the stage the garage applies
the paint on the car, the paint belong to the garage. But once the paint is applied
on the car, the liquid paint gets attached on the metal of the car. It is then not
possible to remove the paint without fundamental damage. Since the car belongs to
the client, the ownership in the paint also gets transferred to the client by inference.
This process of the contractor’s materials getting embedded in the client’s moveable
property is referred to as the transfer of ownership in goods through the process
of accession.
1.4 Blending :
One more situation of works contract could be a case where multiple
moveable products owned by the contractor are ‘blended’ together to create a new
moveable product which is non-marketable in nature. Consider the case of a printer
who uses paper and ink to print cheque books for its client bank.
In this case, the transaction cannot constitute a sale because
cheque books are not marketable and there-fore are not goods. However, the properties
in the paper and the ink have passed on to the bank the moment the printer blended
these two moveable products. Thus, there is a transfer of the ownership in goods
through the process of blending.
2. Nature of Indirect Taxes and applicability to Composite
Contracts :
At this juncture, it may be relevant to broadly classify the
indirect taxes based on the nature of the taxes. At one end of the spectrum are
duties on goods like customs duties and excise duties which are levied on specified
activities i.e., the activity of import/export of goods or the manufacture
of goods. Since the levy of duty is on an activity and not on a transaction, it
is apparent that the duty is attracted irrespective of whether the product constitutes
an end in itself or a means to an end.
At the other end of the spectrum are taxes like sales tax (VAT)
and service tax which are levied on specified transactions i.e., the transaction
of sale of goods or the provision of services. Since the levy of the tax is on a
transaction, one has to look at a transaction. A transaction is the cake itself
(i.e., the end) and not the icing on the cake (i.e., the means to
an end). This therefore suggests that for taxing the transaction, one looks at the
tax implications on the cake and not on the icing !
3. Composite Contracts — Judicial Thinking :
Before proceeding any further, it may be relevant to look at
the judicial thought process on this aspect.
In a landmark case
1 pertaining to sales tax, the Supreme Court held that a building
contract is one entire and indivisible contract; there is no sale of goods as a
separate contract. A series of judgments of the High Courts and the Supreme Court
followed this case taking the same view.
In another situation, the contract provided for progressive
release of payments dependent on the stage of execution of a particular component.
The Supreme Court2 observed that in an indivisible, composite contract, it is not
possible to vivisect the same. The Court accepted the commercial practice in spreading
the contractual payments over the entire period of the execution of the contract
and held that progressive release of payments would not have any bearing on the
nature of the contract.
In a case3 pertaining to income tax, an Indian company entered
into separate contracts with the foreign company for purchase of equipment and for
supervision of erection, start-up, putting into commission, etc. of the equipment.
The A.P. High Court held that the terms of the separate agreements clearly showed
that it was one and the same transaction. One could not be read in isolation of
the other. The considerations for services in connection with the supervision of
erection, start-up, putting into commission, etc. were part of the payment of the
sale price of the equipment. Thus, in spite of two separate contracts, the High
Court considered these as part of single sale transaction.
In a landmark judgment4 pertaining to service tax, the Department
tried to levy service tax on the drawing, designing and commissioning activities,
for which separate amounts were indicated in the price break-up in the turnkey contract.
Negating such attempt, the Tribunal held that the contract between Daelim and IOCL
was a works contract on turnkey basis. It cannot be vivisected for subjecting a
part of the contract price to service tax.
From each of the above decisions, it is amply clear that the
judiciary has consistently looked at composite contracts as a whole and has not
permitted a vivisection of such composite contracts.
4. Constitutional Amendment &
On the basis of recommendation of the Law Commission, the Parliament
passed 46th Constitutional Amendment, introducing a legal fiction by defining ‘tax
on the sale or purchase of goods’ in Article 366(29A) to include certain types of
deemed sales. Thus, the following non-sale transactions were brought within the
service tax net :
(a) Non-voluntary transfer of goods for consideration
(b) Transfer of property in goods involved in the execution
of works contract
(c) Delivery of goods on hire-purchase or instalment payments
(d) Transfer of right to use goods
(e) Supply of goods by unincorporated association or body to
members for consideration
(f) Supply of food or beverage by way of or as part of service.
With respect to works contracts, one of the deemed sales, in
view of the above amendment, sales tax/VAT could be levied on the value of the supply
portion of the contract. Thus, there is a sale of the goods supplied in the execution
of works contract for the limited purpose of sales tax/VAT. In this sense, through
legal fiction, an indivisible composite contract becomes divisible. However, the
Supreme Court
5 has held that the 46th Constitutional amendment is valid only
for those entries in the three lists in the Seventh Schedule where the expression
‘tax on the sale or purchase of goods’ appears. Effectively, the amendment is applicable
only with respect to sales tax/VAT law and not for any other law. This amendment
has not brought any change in the normal legal meaning of ‘sale’. Therefore, for
purposes outside sale tax/VAT, the concept of indivisible composite contract continues
to be valid. Further, the Supreme Court6, held that even after the 46th Constitutional
amendment it is not permissible to split composite transactions except in the case
of works contracts and supply of food and beverages as part of the service in restaurants
and hotels for sales tax/VAT. In other words, the principles enunciated in Gannon
Dunkerley & Co. case, survives for purposes other than tax on these two deemed sales
introduced by the Constitutional amendment.
5. Implications under Service Tax — before 1-6-2007 :
The above discussion brings to light a question regarding the
applicability of service tax provisions to composite contracts. Over a period of
time, there has been a gradual expansion in the scope of taxable services. Some
relevant service categories are listed in the table below :
Category of Service Effective
date
Consulting Engineering Services 7-7-1997
Erection, Commissioning & Installation Services 1-7-2003
Construction Services 10-9-2004
Construction of Residential Complex Services 16-6-2005
Works Contract Services 1-6-2007
Right from the time the category for taxing consulting engineering
services was brought into the Statute, there were constant attempts to levy service
tax on the ‘consulting’ element of the composite contracts. While the 46th Constitutional
Amendment permits the States to levy tax on transfer of goods involved in the execution
of a works contract, no specific authorisation is available to the Centre for artificially
vivisecting such contracts for the purpose of levy of service tax and hence the
Courts have consistently held that composite contracts cannot be made liable for
service tax7 under the category of consulting engineering services.
Since 2003, the Legislature has gradually expanded the scope
of taxable services to cover various activities involving performance of work. From
an industry perspective, such performance of work could be either on a stand-alone
basis or as an element of a composite contract. While there were no doubts on the
coverage of activity done on a stand-alone basis (‘labour job’), there was uncertainty
on the coverage of the activity done as a component of a composite ‘works contract’.
The Department interpretation at that stage was to argue on
the principle of aspect theory and suggest that the levy of service tax was, in
principle, in order. To address the issue of valuation and cascading impact of taxes,
the Department provided the following alternatives :
1. Discharge of service tax on the full value of the contract
with corresponding credit of duties/taxes paid on inputs and input services
2. Discharge of service tax on the value of the service component
(by identification and reduction of the value of the goods sold) with corresponding
credit of taxes paid on input services
3. Discharge of service tax on a presumptive value of the service
component (i.e., 33% of the gross value of the contract) with no credit of
taxes paid on inputs/input services.
Notwithstanding the abovementioned options, can it be argued
that there really is no authority to levy a service tax at all in the absence of
a specific constitutional amendment ? After all, even for levy of sales tax, a Constitutional
amendment was required and it has already been held that the Constitutional amendment
has only restricted applicability vis-à-vis sales tax laws
8.
The answers to the above questions could be debatable and would
depend on whether one treats a works contract as a whole as constituting an activity
and therefore a service (View 1) or one looks at works contract as independent of
both goods and services (View 2).
In case View 1 is adopted, the levy of service tax can be said
to be effective from the date the respective category for execution was introduced,
say construction service. All the three alternate options for discharging the tax
liability would ensure that there is no cascading effect. In case View 2 is adopted,
the levy of service tax would actually require a Constitutional amendment.
Before the dust could settle down on the said controversy, the
judiciary was flooded with a plethora of cases wherein the Department’s attempt
to tax the services embedded in a composite contract was challenged. In fact, the
Bangalore Tribunal went ahead and held that a composite contract cannot be vivisected
to levy a tax on the erection, commissioning and installation component of the said
composite contract
9.
6. Implications under Service Tax — from 1-6-2007 :
In order to overcome the above controversy and specifically
provide for a mechanism to tax the service component of a works contract, a new
category of service was introduced with effect from 1-6-2007 to tax specified works
contracts.
However, as highlighted earlier, in case a view is taken that
the service component is embedded within a composite contract, the composite contract
cannot be vivisected merely by insertion of a taxable category of service. Hence
the levy of service tax under the category of ‘Works Contracts Services’ can be
constitutionally challenged.
If one holds the conservative view that the entire composite
contract is a service, there was really no need for the introduction of the category
of ‘Works Contracts Services’, since the basic categories were wide enough to cover
the impugned transactions. In either of the situations, the introduction of the
category of ‘Works Contracts Services’ becomes redundant. The law cannot be interpreted
to bring about redundancy in any of the provisions.
Therefore it can be strongly argued that the levy of service
tax is not constitutionally valid even after the introduction of works contract
services as a category, since the Legislature does not have the authority to vivisect
a composite contract.
7. Non-Vivisection
While there is a strong legal justification to challenge the
applicability of service tax on works contracts, a business needs to evaluate the
position taken from a practical perspective. Being an indirect tax, any aggressive
position taken can result in an opportunity cost (since the tax would have been
recovered from the client in the case of a conservative position). Further, the
availability of CENVAT Credit to both the service provider and service recipient
(in many cases), effectively results in no additional cost on account of adoption
of a conservative position. Thus, one may reconcile the position to accept the levy
of service tax under the category of ‘Works Contract Services’ with effect from
1-6-2007.
— Practical Ramifications :
With the introduction of a new category to tax only specified
works contracts, it can be argued that the Legislature accepts the principle that
the works contracts could not be taxed under the basic category itself and therefore
the new category was created. Therefore, no service tax was payable in the past
periods in cases where works contract tax was payable. This view has already found
favour with the judiciary
10. Thus, one can safeguard the liability for the past periods.
8. Conclusion :
The article tries to explain in a nutshell the theory of non-vivisection
of composite contracts and its ramifications vis-à-vis levy of service tax
on works contracts. It does not deal with the issues concerned with valuation and
claim of credit, since they are secondary to the basic issue of levy of service
tax itself.
The article also does not deal with the tax implications of
other types of composite contracts wherein, say, multiple services are bundled.
Over a period of time, the law will evolve. It appears that a long-term solution
could be to have an integrated Goods and Service Tax with a comprehensive cover-age
of all supplies of goods and services. Till the time such a GST regime is evolved,
these issues will continue to present uncertainty for the industry.
It is a challenge to both the profession and the business to
confront and comply with uncertainty.
1 State of Madras v. Gannon Dunkerley & Co. (Madras) Ltd.,
(1958) 9 STC 353 (SC).
2 Sentinel Rolling Shutters and Engg. Co. (P) Ltd. v. CST,
(1978) 4 SCC 260.
3 CIT v. Sundwiger Empg & Co., (2003) 262 ITR 110 (AP).
4 Daelim Industrial Co. v. CCE, 2003 (155) ELT 457 (Tri-Del) as approved by the
SC.
5 Geo Miller & Co. (P) Ltd. v. State of M.P., (2004)
5 SCC 209.
6 Bharat Sanchar Nigam Limited v. UOI, 2006 (3) SCC 1.
7 Daelim Industrial Company Limited v. Commissioner of Central Excise, 170 ELT A181
(SC); CCE & C, Vadodara v. L & T Ltd., 2006 TIOL 490 CESTAT Mum. — to cite a few.
8 Geo Miller & Co. v. State of MP, 5 SCC 209 (SC) &
BSNL v. Union of India, 3 SCC 1 (SC).
9 Blue Star Ltd. v. CCE, Hyderabad-II 2007 TIOL 38 CESTAT Bang.
10 L & T v. Commissioner of Central Excise, 2007 (7) STR 224 (Ahmd. Trib.)
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