VOL II GOODS AND SERVICE TAX ONE STOP SOLUTION TO … · 6/3/2018 · Services Tax’ can act as a panacea for the long standing issue. INTRODUCTION The authority to levy tax is

VOL. II GOODS AND SERVICE TAX: ONE STOP SOLUTION TO PRESENT

TAX REGIME?

2015

[68]

WORKS CONTRACT AND TAX REGIME: WILL ‘GOODS AND SERVICE TAX’ SOLVE THE

PARADOX

- Ankush Thakur & Mehul Bansal*

ABSTRACT

The taxation of composite contracts has always been a complex area and Works

Contract, specifically, is highly debated of all composite contracts. Works Contract taxation

have been the bone of contention in various issues and is a significant task both before the

Legislature as well as the Courts. The clear demarcation of areas in regards the applicability

of Sales tax (VAT) and Service tax is a distant goal, even today. This Article endeavours to

bring to the fore the present status of taxation of works contract and its judicial developments

comprehensively. Further, this article places stress upon cascading effect that taxation in

works contract brings and attempts to give broad idea as how new regime of ‘Goods and

Services Tax’ can act as a panacea for the long standing issue.

INTRODUCTION

The authority to levy tax is derived from the Constitution of India1 and the power to

levy such taxes is allocated between Centre and States2. It assures that the federal principle of

our constitution is upheld and practiced religiously. In taxation laws, it is very pivotal to

understand as what exactly is taxable and who has the right to tax. The Constitution of India

under Schedule VII has divided the subject matter relating to taxation into three lists, which

are, Union List, State List and Concurrent List.

Taxation is mainly divided into two forms, that is, Direct Taxation and Indirect

Taxation. The Direct taxation is primarily governed by the Central government whereas

indirect taxation is a subject matter for both Union and State governments. To be more

specific, under Indirect taxation; Excise Duty, Service Tax etc. are levied by Central

government whereas Value Added Tax (hereinafter VAT), Entry taxes etc. are left to the

State Government.

A composite contract means a contract involving transactions wherein the element of

* Students, Rajiv Gandhi National University of Law, Punjab. 1 The Constitution of India 1950, art 265. 2 The Constitution of India 1950, art 246 read with Schedule VII.

VOL. II INDIAN JOURNAL OF TAX LAW 2015

[69]

provision of ‘service’ and the element of ‘sale’ in which various parts/elements are so

inextricably linked that it becomes impossible to demarcate and hence, constitute a one

composition contract. There are certain areas/events where the product/project is subject to

taxes both by Union and State. Works Contract, Catering Contract and Hire and Purchase

Contracts are common examples of such composite contracts. This article mainly focuses

upon Works Contract and its Tax implications. Works Contracts are subject to both Service

tax and VAT and lack of clarity as to right to levy tax by Union or States makes it more

complex and overlapping. This cannot be changed as because works contract has both an

element of “Sale of goods” and “Service”.

WHAT IS A WORKS CONTRACT?

Works Contract has been defined by both Central and State legislations. Works

contract is a contract which involves both “Sale of goods” and “Service” component. Initially

we shall focus on the definition given by Central Legislation [Service Tax: Finance Act,

1994].

Section 65B (54) of the Finance Act, 1994 (as effective from July 1, 2012) defines

Works Contract as:

“‘Works contract’ means a contract wherein transfer of property in goods

involved in the execution of such contract is leviable to tax as sale of goods and such

contract is for the purpose of carrying out construction, erection, commissioning,

installation, completion, fitting out, repair, maintenance, renovation, alteration of any

movable or immovable property or for carrying out any other similar activity or a part

thereof in relation to such property”.

The definition provided in Service tax law is exhaustive and end with words “any

other similar activity”. Therefore the last line certainly has wide implication and makes it

prone to litigation. “Works Contract” as per Section 2 (ja) of “Central Sales Act, 1956” is

defined as follows:

“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”.


TAX REGIME?

2015

[70]

Apart from Central Legislations, “Works Contract” has also been defined by various

state legislatures in order to conform to VAT provisions applicable in respective states. To

quote one such definition, reliance shall be made upon “Maharashtra Value Added Tax,

2002”. “Works Contract” as per Explanation (b) (ii) to Section 2 (24) of Maharashtra Value

Added Tax is defined as:

“‘Works Contract’ includes an agreement for carrying out for cash, deferred

payment or other valuable consideration, the building, construction, manufacturing,

processing, fabrication, erection, installation, fitting out, improvement, modification,

repair, or commissioning of any movable or immovable property”.

The definitions of works contract under Service tax and state VAT differs to a certain

extent. A works contract is an indivisible contract and thus it is not possible to exactly

demarcate between the ‘Service’ portion and ‘Sale of goods’ portion. Typically, a contract for

sale of goods would attract State VAT and a contract for pure service would attract service

tax. But, Works contract attract both State VAT (on Sale of goods element) and also Service

tax (on Service element). Thus, it makes difficult to determine who has the right to tax.

Works Contract being a complex issue was subject to various interpretations.

Therefore, to bring uniformity, reliance is made upon various judicial interpretation of the

Apex court. Some key judicial developments are noted below:

Supreme Court in the case of Hindustan Aeronautics v. State of Karnataka 3 has

confirmed the difference between sale of goods and works contract:

“In a contract for sale, the main object is transfer of property and delivery of

possession of chattel as a chattel to the buyer, where it is not so, it is contract of works

and labour”.

Also in the case of Hindustan Shipyard v/s State of Andhra Pradesh4 it was brought to

the fore that:

“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

3 Hindustan Aeronautics v. State of Karnataka (1984) 55 STC 314 (SC). 4 Hindustan Shipyard v. State of Andhra Pradesh (2009) 119 STC 533 (SC).


[71]

work undertaken is not the transfer of a Chattel qua Chattel, the contract is one for

work and labour”.

Works contracts are mainly related to building contract, construction, erection,

installation, turnkey projects etc. A similar case was reported to include a matter related to

building construction. To further bring more clarity to the concept of works contract, it was

judicially interpretation by the Supreme Court in the landmark case of State of Madras v.

Gannon Dunkerly,5 it held:

“That building contract is one, entire and indivisible contract and there is no

sale of goods as understood by law. That the property in construction material gets

progressively transferred as and when these are incorporated in works contract. But the

customer is only interested in taking over completely constructed building, which is

immovable property. There is no understanding by him to purchase the construction

material”.

To overcome Gannon Dunkerly, a provision (29A) was inserted in Article 366 of the

Constitution of India which expanded the meaning of “tax on sale and purchase or sale of

goods”.

Under the state sales tax laws, before the 46th amendment to the Constitution of

India6, the sales tax was applicable only on the sales covered under Sales of goods Act

(Normal Sale). These indivisible contracts were not covered under state sales tax Acts since

works contract were not normal sales. The Supreme Court confirmed its legal status in its

landmark judgment in the case of Gannon Dunkerly.7 Due to this legal status the states were

denied the levy of sales tax on the indivisible works contract. Therefore, such contractors

were outside the clutches of State sales tax laws.

Therefore, to overcome such situation, 46th constitutional amendment was brought

which further added clause 29A to Article 366 of the Constitution of India. It expanded the

definition of the term “sale” to include six transactions which are not sale under common law

parlance but are “deemed sales”. Though, there are plethora of cases to be referred in regard

to Works Contract but some significant judicial constructions in the last decade are discussed

ahead.

5 State of Madras v. Gannon Dunkerly (1958) 9 STC 353 (SC). 6 The Constitution (46th Amendment) Act 1982, § 4 (w.e.f.02.02.1983). 7 Supra note 5.


TAX REGIME?

2015

[72]

Raheja Developers v. State of Karnataka8 was a significant progress in the area of

works contract at the time when VAT regime was unfolding in almost all states of the

country. The legal position laid down by Raheja Developers9 was affirmed in the recent

judgment of Supreme Court in the matter of Larsen and Toubro Ltd v State of Karnataka10.

The Supreme Court of India in the case of Raheja Developers,11 held that:

“The definition of the term “works contract” in the said Act is an inclusive

definition. It is a wide definition which includes “any agreement” for carrying out

building or construction activity for cash, deferred payment or other valuable

consideration. It must be clarified that if the agreement is entered into after the flat or

unit is already constructed, then there would be no works contract. But so long as the

agreement is entered into before the construction is complete it would be a works

contract. Value addition made to goods transferred after agreement is entered into with

flat purchaser can only be made chargeable to tax by State Government.”

Almost a decade later, a similar matter pertaining to Flat Developers came up before

the Apex court and demanded to lay strict legal position of works contract and span of 46th

Constitutional Amendment. It was then in the case of “Larsen and Toubro”12 that the Court

held:

“…the term ‘works contract’ in Article 366(29A) (b) is amply wide and cannot

be confined to a particular understanding of term or to a particular form. Once

characteristics or elements of works contract are satisfied in a contract then

irrespective of additional obligations, such contract would be covered by term ‘works

contract’. Term “works contract” in Article 366(29A) (b) takes within its fold all genre

of works contract and is not restricted to one specie of contract to provide for labour

and services.”

Also, while stating the ingredients of Works Contract, it specifically asserted:

“For sustaining levy of tax on goods deemed to have been sold in execution of a

8 Raheja Developers v. State of Karnataka (2005) 5 SCC 162. 9 Id. 10 Larson and Toubro Ltd. v. State of Karnataka (2014) 1 SCC 708. 11 Supra note 8. 12 Supra note 10.


[73]

works contract, three conditions must be fulfilled: there must be a works contract,

goods should have been involved in execution of a works contract and property in those

goods must be transferred to a third party either as goods or in some other form. Single

and indivisible contract, now by Forty-Sixth Amendment has been brought on par with

a contract containing two separate agreements and States have now power to levy sales

tax on value of material in execution of works contract”.

TAXATION IN CASES OF WORKS CONTRACT

This Article aims to elaborate over taxation scheme of works contract. As discussed

above, Works contract include both “Sale of Goods” element and “Service” element.

Therefore, both Central government and State government are capable of levying tax on such

projects. To simplify, endeavour is made to explain the taxation aspect both from Service tax

and state VAT viewpoint.

TAXATION OF ‘WORKS CONTRACT’ FROM SERVICE TAX VIEWPOINT

Service tax law has grown most significantly over the last decade and has spread its

wings to almost every sector. In India, we have no separate statute for administration of

service tax and still draws it power Finance Act, 1994. Certainly, area of “Works Contract”

has become more complex and blurred after advent of service tax. These multiple taxes have

added to the disgust of developers, investors and the like. Before we delve into the

complexity of works contract and service tax, it is important to understand what a service is.

Section 65B of Finance Act, 1994 (as effective from July 1, 2012), defines “Service”

as follows:

‘Service’ means any activity carried out by one person for another for consideration,

and includes ‘declared service’, but shall not include:

(a) An activity which constitutes merely,:

(i) a transfer of title in goods or immovable property, by way of sale, gift

or in any other manner; or,

(ii) such transfer, delivery or supply of any goods which is deemed to be

sale within the meaning of clause 29 of Article 366 of the Constitution; or,

(iii) a transaction in money or actionable claim.

(b) A provision of service by an employee to the employer in the course of or in


TAX REGIME?

2015

[74]

relation to his employment.

(c) Fees taken in any court or tribunal established under any law for time being in

force.

Regarding applicability of the service tax on such “Works Contract”, Section 66E (as

effective from July 1, 2012) of the Finance Act includes “service portion in the execution of

works contract” in the list of “declared services”; therefore the service part is to be segregated

from the whole Works Contract and same has to be subject to service tax.

Primarily service tax is payable on the value of service as calculated under new “Rule

2A” of “Service Tax (Determination of value) Second Amendment Rules, 2006”13. This rule

is in order to align with new system of taxation of services based on negative list the old Rule

2A of said ‘Valuation Rules’ and ‘Works Contract Composition Scheme, 2007’ have been

replaced with this new Rule.

For such valuation:

1. Regular Scheme:

Rule 2A (i) Value of service portion in the execution of a works contract shall be

equivalent to the gross amount charged for the works contract less the value of property in

goods transferred in execution of works contract.

2. Standard Deduction Scheme:

Rule 2A (ii) Where the value is not determined under the clause (a), person liable to

pay service tax shall determine tax payable in the following manner14:

(A) In cases of works contract entered into for execution of original works, service

tax shall be payable on forty percent of the total amount charged for the works

contract;

(B) In case of works contract, not covered under sub clause (A), including works

13 Notification No. 24/2012-ST, dated June 6, 2012, Department of Revenue, Ministry of Finance, Government

of India. 14 Notification No. 11/2014-ST, dated July 11, 2014, Department of Revenue, Ministry of Finance, Government

of India.

In Rule 2A of the Service Tax (Determination of Value) Rules 2006, Category “B” and “C” of works contract

are merged into single category, with percentage of service portion as 70%.


[75]

contract entered into for:

(i) Maintenance or repair or reconditioning or restoration or servicing of

any goods; or,

(ii) Maintenance or repair or completion and finishing services such as

glazing or plastering or floor and wall tiling or installation of electrical fitings of

immovable property;

Service tax shall be payable on “seventy percent” of the total amount charged for the

“Works Contract”.

Therefore, what is essential at the outset is to demarcate between Sale portion and

Service portion. Apart from this, it is to be concluded that such contract is a works contract.

Thus, Consequently the Service portion is subject to Service tax liability.

WORKS CONTRACT AND VALUE ADDED TAX

Deemed Sale

Prior to the 46th Amendment to the Constitution of India, the indivisible works

contracts were not subject to the levy State Sales tax. Finally, the 46th Amendment to the

Constitution of India was made to add a sub-article (29-A) as under:

“(b) A tax on the transfer of property in goods (whether a goods or in some other form)

involved in the execution of a works contract”.15

After the said 46th Amendment to the Constitution, the States were empowered to

levy Sales Tax on such sales, called as “Deemed sales” involved in the execution of works

contract.

Under the State Sales Tax Acts, no contractor or contractee were entitled to claim any

set off of Sales Tax paid to their vendors in purchase of inputs. There was a double taxation,

having a cascading effect, in the hands of Contractors in the Sales Tax Regime.

POST VAT SCENARIO – LEVY OF VAT ON INDIVISIBLE WORKS CONTRACTS (DEEMED

SALES)

All the states have integrated in their respective State VAT Acts, the provisions of

“Works Contracts” for levying VAT on the deemed sales involved in the execution of works

15 The Constitution of India 1950, art 366 (29-A) (d).


TAX REGIME?

2015

[76]

contracts. The advantage to the contractors is that under the VAT system, the contractors like

manufacturers can take benefit of VAT set off/Credit of the VAT already paid in purchasing

the inputs from local vendors, which could not be availed in the Pre-VAT Regime.

There is a homogeneity under the works contract provisions in the Post VAT Regime.

In all the state VAT provisions, there are three options available for the Contractors to levy

VAT on deemed sales (Works Contracts) and VAT is levied on the “Material Value” of the

Contract. The said three options (Uniform in all the VAT States) are as under,

Actual Labour Deduction

Standard Labour Deduction

Composition Tax (Alternative Option)

1. Actual Labour Deduction Option:

Under this option, the VAT is payable on the “Material Value” of the Contract. The

deductions are available for arriving at the Material Value from the total contract price. Such

deductions are specified in the corresponding provisions of the state VAT Acts or the

Contractors can arrive at the Material value/price of the Contract by adopting cost + value

Addition method. The Contractor determines the Material Price after adding Material Cost

and Margin to such cost.

In this option, the Contractor can get full VAT set off/credit of the VAT paid to the

local vendors in purchasing of inputs, provided he maintains corresponding ‘Tax Invoices’

for the VAT paid to his local vendors. Similarly, the Contractee /Customer also can avail the

full exemption except on the input purchases covered under the Negative list under the State

VAT Act on which no VAT set off/Credit is available. Mostly the Civil Works, Construction

jobs, erection of immovable property (Structures) are covered in the Negative lists.

2. Standard Labour Deduction:

Under this option, the VAT is levied on the “Material Value” of the Contract. The

Material value is calculated after subtracting the “Labour Portion” from the total contract

value/Price.


[77]

However, in this option a table is provided in the State VAT Act/Rules which shows

“Standard Labour portion” attributed to different types of works contracts. The Contractor

deducts such “Standard Labour portion” as provided in such tables from the total Contract

price to arrive at the “Material value”. The Contractor would charge 12.5% VAT, on such

material value. Each State has provided under their respective VAT Acts, the said “Standard

Labour” table, under this option. (Like in Maharashtra for Civil Works it is 30%, for Plant &

Machinery 15%, for Annual Maintenance Contracts 40%).16

The benefit in this option as compared to the first option is that it is litigation free.

The Sales Tax Departments would permit the said ‘labour portion deductions’ as the same are

provided in the VAT Rules itself. Also no identification record has to be maintained by the

contractor for the materials used in the contracts.

The Contractor gets full credit/set off on the VAT paid on the inputs and the

Contractee also gets full set off of the VAT paid provided the said purchases are not in the

Negative list of VAT set off/credit.

3. Composition Tax (Alternative option)

This is an alternative option, simpler option for those Contractors who cannot

maintain the proper Accounts, Record of the material and other portion in their contracts. The

contractee/customer prefers this option as small amount of Composition Tax 2%/4% is

payable to the Contractor instead of 12.5% VAT payable in other options. However, VAT

credit/set off is not be available to them in this option.

Under the “Composition” option, the Contractor has to pay Composition Tax (VAT)

on the total Contract value/price, No deduction of labour is available in this option. Similarly,

No VAT set off/Credit is available on the purchases of inputs to the Contractors and the same

is not available to the Contractees also. The Rates of Composition Tax differ from state to

state. Generally it is 2% (for civil contracts) @ 4% for other Contracts. No VAT set off/credit

is available to both the Contractor and the Contractee in the Composition tax option.

PROBLEMS FACING CURRENT WORKS CONTRACT REGIME

Since its’ inception after the 46th amendment to the constitution, the deemed sale

provision, incorporated in Art. 366, has created a lot of confusion amongst works contractors,

16 The Maharashtra VAT Rules 2005, rule 58.


TAX REGIME?

2015

[78]

as the same transaction is interpreted differently in two different statutes i.e. the state VAT

Acts and the Finance Act, 1994 for service tax. In the food industry the constitution under

Art. 366 (29A) gives clear definition to state that services are incidental to the deemed sale,

so as to not split the same transaction into two different parts, sadly same is not true for

works contracts.

A major problem facing works contract is the standard deduction scheme. Under this

scheme the works contract is split into parts through legal fiction. The effect of such a split is

that the effective taxation is on more than 100% of contract value. For example under the

Maharashtra VAT Act, in an original civil works contract the standard labour deduction is of

30% of the total value of the contract (taxing 70% of the total contract under VAT), whereas

under service tax the labour portion is 40% of the original civil works contract, thereby

effectively taxing the total contract on 110% of the contract value. As these are pre-decided

values fixed in the legislation, the assesse cannot challenge such rates. The assesse cannot

maintain all documents in big construction projects so effectively only option with the

assesse is the composite scheme in which deductions aren’t available.

The basic cannons of a good tax regime is that it should be easy to comprehend. The

law not being clear on works contract, has made it difficult for contractors to comply with the

regime. The most glaring problem with the current regime is the non-availability of cross

linking of input credit or set off mechanism between various taxes like VAT, service tax and

Central sales tax. The two most problematic incidences in execution of works contract are

when goods have to travel from one state to another and when both goods and services are

involved in the works contract. When Input goods are purchased from outside a state in

which the works contract is being executed it is subject to levy of Central Sales Tax and such

tax paid on inputs is not available as credit or set off in later stages hence having a cascading

effect as tax is paid not only on the value addition done to a commodity but also on the

original input and the tax paid on such input. The non-availability of credit is also a problem

in transactions where both sale and services are involved, in these transactions also as there

are different taxes levied i.e. VAT and service tax and there is no cross linking mechanism

for such credit or set off available under the current tax regime. The coming of GST will

hopefully will solve this problem as indirect taxes will be merged together and providing set

off or credit will be easier.


[79]

IMPACT OF ‘GOODS AND SERVICES TAX’ ON WORKS CONTRACT

The intent to merge the major indirect taxes into a generic “Goods and Services tax”

was expressed by the government as early as 2006. The ‘Goods and Service tax’ is a

comprehensive tax regime to levy tax on manufacture, sale and consumption of goods and

services at national level. The Constitution of India provides for separate levy of taxes by

States and Union. This is for the first time in the constitutional history of India that both State

and Union shall have concurrent powers to levy taxes.17 There will be a concept of Integrated

GST for the purposes of inter-state trade and State GST for states. Apart from this, GST will

also have a comprehensive database for information sharing which will be instrumental in

avoiding cascading effects of the taxation and mitigate inflationary tendencies.

Works Contract are set to be affected by the introduction of an uniform GST as it will

provide for cross-linking of the credit mechanism between taxes on goods and services and

thus avoiding the problem of cascading effect and double taxation present under the current

indirect tax regime. Although the “CENVAT Credit Rules” have provided for tax credits but

their scope is limited to excise duty, the tax on sale of goods being beyond their coverage and

in the absence of a mechanism for availability of credit across different taxes, the citizens not

only end up paying tax on tax but also have to bear its inflationary ramifications. Upon the

implementation of GST the problem of cross-linking of tax credit will be eliminated and the

taxation of works contract will become easier as there will be no need to separate goods

portion from service portion to avail tax credit or set-off.

The problem with the current indirect tax regime is that there is no interaction

between manufacturing stage of commodities and selling stage in as much as the availability

of the credit of the duty in inputs are concerned. The excise duty paid on manufacture is

available as credit to the next stage manufacturer, but not to the seller of the goods.18 This is a

provision set to affect not only works contract but every transaction where goods pass

through intermediaries, as presently tax credit of duty already paid on inputs cannot be

availed.

The dispute today regarding indivisible works-contract are that the different

composition schemes provided under various state VAT’s and service tax make the combined

tax on more than hundred percent of the contract value. With GST, there will be a provision

17 The Constitution (122nd Amendment) Bill 2014, cl 246-A. 18 CENVAT Credit Rules 2004, rule 3.


TAX REGIME?

2015

[80]

for seamless transfer of input tax credit across all transactions which avoid tax cascading,

eliminate double taxation and improve resource allocation. Further, a single rate across all

goods and services will eliminate classification of disputes and make the assessment more

predictable. The harmonization of tax assessment, levy and collection procedures across

states as proposed under GST will reduce compliance cost, limit evasion, enhance

transparency and improve collection efficiency.

Today any commodity, in general, is produced on basis of physical inputs as well as

services, and there should be integration of VAT on goods with tax on services and there

should be a removal of the cascading effect of service tax. In GST, both the cascading effect

of CENVAT and service tax are removed with set-off, and a continuous chain of set-off from

the original producer’s point to the service provider’s point up-to retailer level is established

which reduces burden of all cascading effects. This is the essence of GST and that is why it is

not just VAT plus service tax but an improvement over the previous system.

The implantation of GST may also do away with the concept of “deemed sale”19,

putting at rest the unending litigation on that front with a proposed amendment to Article 366.

19 The Constitution of India 1950, art 366 (29-A).

Documents

VOL II GOODS AND SERVICE TAX ONE STOP SOLUTION TO … · 6/3/2018 · Services Tax’ can act as a panacea for the long standing issue. INTRODUCTION The authority to levy tax is