Implications of Service Tax & Value Added Tax on Works Contract

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PROLOGUE

In India, tax on sale of goods is levied by the States assales tax / VAT whereas tax on rendering of services islevied by the Central Government in the form of servicetax. Sometimes, there may arise a situation where aparticular work accomplished on behalf of contracteeinvolves both transfer of the moveable property as wellas rendering of service, such as construction ofbuildings, laying down of pipelines, erection of plantand machinery, etc.There would be no intricacy in determining the VAT andservice tax liability, if, in such kind of contracts, the materialand service portion are easily divisible. Quandary arises whenthe work cannot be vivisected into material and laboursegments. Thus, indirect taxation of works contracts has beena complex area both under the truculent world of State VATand Finance Act.

WHAT IS WORKS CONTRACT?Works contract involves both, supply of goods and rendering

Nitesh Agarwal*, ACSPartner, RANJ & AssociatesCompany Secretaries Hyderabad.

[email protected]

Vinay Kumar Joshi*, ACSHyderabad.

The practice of `works contract' is widely prevalent for executing construction/erection works. Indirect taxation of workscontracts has been a very complex area giving rise toconsiderable litigation. Sales tax /VAT and service tax aspectsrelating to works contract have been closely analysed here.

Implications of Service Tax & Value Added Tax on Works Contract

* The information presented and opinions expressed herein are those of theauthors and do not necessarily represent the views of RANJ & Associates,Company Secretaries.

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of services. In a normal sale there is a transfer of property indefinite or ascertained goods and such goods remain samebefore and after their delivery. However, in works contracts,goods, before delivery and after the execution of workscontracts are disparate and may differ in form as well. Forexample, at the site of construction of a building, before theconstruction commences, the goods like cement, steel, sandetc. are lying but after the construction a building (immovablegoods) comes to an existence. This is the distinction betweena "normal sale" and a "deemed sale". The basic principlesestablishing a works contract are:u Goods must be involved in the execution of the worksu Property in goods must pass during the execution of worksnot before or after the execution of worksu Some work has to be done on the property of thecontractee by the contractoru There must be dominant intention to effect the transfer ofproperty in goods in execution of works contract, passingof the property in goods must not be only incidental to thecontract.TAX ON WORKS CONTRACT : HISTORICAL BACKGROUND Madras was the first State which attempted to bring within itstax grid transactions of works contract by amending theterms- 'goods', 'sale' and 'turnover' in the Madras GeneralSales Tax Act, 1939. The expression 'sale' was amended soas to bring within its ambit transfer of property in goodsinvolved in the execution of works contract. The term 'goods'was also amended so as to include materials used inconstruction, fitting out, improvements etc.The question as to whether the cost of the goods suppliedby a building contractor in the course of construction ofbuilding could be subjected to payment of sales tax was finallyresolved by the Supreme Court in State of Madras v. GannonDunkerley and Co. (Madras) Ltd.1958 AIR 560, 1959 SCR379 where it was held that in a building contract which wasone, entire and indivisible, there was no sale of goods andhence, levy of sales would not arise.Aftermath of the above judgements was a bundle ofproblems and also complaints from various States that therewas a large scale leakage of sales tax revenue by theadoption of devices such as hire purchase system. Thislacuna was referred to the Law Commission of India and itwas decided to levy sales tax on transactions of the naturementioned above. Consequently, in the year 1982 Parliamentpassed the 46th Amendment amending the Constitution inorder to bring many of the transactions, in which property ingoods passed but were not considered as sales for thepurpose of levy of sales tax, within the scope of the powers ofthe states to levy sales tax.

APPLICABLE LAWS

Following is the extract of relevant provisions of tax lawsapplicable to works contracts:Value Added Tax under relevant state VAT Act The power of the States to levy VAT on sales andpurchases of goods is to be found only in Entry 54 of ListII of Schedule VII of the Constitution of India. VAT iscalculated and paid on the material portion of the workscontract.For the purpose of our discussion we take the followingdefinitions under the Andhra Pradesh Value Added TaxAct, 2005: As per Section 2 (34) (b) of the said Act 'Tax'means a tax on the sale or purchase of goods payableunder the Act and includes a tax on the transfer ofproperty in goods whether as goods or in some other forminvolved in the execution of a works contract." Therefore,section 2(34)(b) is the charging section whereby theAPVAT Act was made applicable to works contracts.As per section 2 (45) of Andhra Pradesh Value Added TaxAct, 2005 'Works Contract' includes any agreement forcarrying out for cash or for deferred payment or for anyother valuable consideration, the building construction, manufacture, processing, fabrication, erection,installation, laying, fitting out, improvement, modification,repair or commissioning of any movable or immovableproperty.Service Tax under Finance Act, 1994 Service Tax is primarily a tax on services rendered by oneperson to another. Service tax is computed on the servicepart of the works contract.

Section 65(105) (zzzza)``Taxable services means services provided or to be providedto any person, by any other person in relation to theexecution of a works contract, excluding works contract inrespect of roads, airports, railways, transport terminals,bridges, tunnels and dams." ( A -79 )


In the year 1982 Parliament passedthe 46th Amendment amending theConstitution in order to bring manyof the transactions, in whichproperty in goods passed but werenot considered as sales for thepurpose of levy of sales tax, withinthe scope of the powers of thestates to levy sales tax.


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Explanation: For the purposes of this sub-clause, "workscontract" means a contract wherein,- (i) transfer of property in goods involved in the execution of such contract is leviable to tax as sale of goods, and(ii) such contract is for the purposes of carrying out-(a) erection, commissioning or installation of plant, machinery, equipment or structures, whether pre-fabricated or otherwise, installation of electrical and electronic devices, plumbing, drain laying or other installations for transport of fluids, heating, ventilation or airconditioning including related pipe work, duct work and sheet metal work, thermal insulation, sound insulation, fire proofing or waterproofing, lift and escalator, fire escape staircases or elevators; or(b) construction of a new building or a civil structure or a part thereof, or of a pipeline or conduit, primarily for the purposes of commerce or industry; or(c) construction of a new residential complex or a part thereof; or(d) completion and finishing services, repair, alteration, renovation or restoration of, or similar services, in relation to (b) and (c); or(e) turnkey projects including engineering, procurement and construction or commissioning (EPC) projects;This is the charging section whereby the works contractswere brought within the service tax net.

DETERMINATION OF VALUE INEXECUTION OF WORKS CONTRACTIt is straightforward to determine the taxable value undernormal sale but computation of value under works contractinvolves hardship. To negate this, a clarification was providedin Service Tax (Determination of Value) Rules 2006, whichreads as follows:Rule 2A of Service Tax (Determination of Value) Rules 2006-Subject to the provisions of section 67, the value of taxableservice in relation to services involved in the execution of aworks contract (hereinafter referred to as works contractservice), referred to in sub-clause (zzzza) of clause (105) ofsection 65 of the Act, shall be determined by the serviceprovider in the following manner:- (i) Value of works contract service determined shall beequivalent to the gross amount charged for the workscontract less the value of transfer of property in goodsinvolved in the execution of the said works contract.Explanation: For the purposes of this rule-(i) Gross amount charged for the works contract shall not include Value Added Tax (VAT) or sales tax, as

the case may be, paid, if any, on transfer of property in goods involved in the execution of the said works contract;(ii) Value of works contract service shall include,-(iii) labour charges for execution of the works;(iv) amount paid to a sub-contractor for labour and services;(v) charges for planning, designing and architect's fees;(vi) charges for obtaining on hire or otherwise, machinery and tools used for the execution of the works contract;(vii) cost of consumables such as water, electricity, fuel, used in the execution of the works contract;(viii) cost of establishment of the contractor relatable to supply of labour and services;(ix) other similar expenses relatable to supply of labour and services; and(x) profit earned by the service provider relatable to supply of labour and services;(ii) Where Value Added Tax or sales tax, as the case may be,has been paid on the actual value of transfer of propertyin goods involved in the execution of the works contract,then such value adopted for the purposes of payment ofValue Added Tax or sales tax, as the case may be, shallbe taken as the value of transfer of property in goodsinvolved in the execution of the said works contract fordetermining the value of works contract service underclause (i).



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Rule 17(1)(e) Andhra Pradesh VAT Rules, 2005Following amounts are allowed as deductions from the totalconsideration received or receivable for arriving at the value ofthe goods used in execution of works contract, at the time ofincorporation-(i) Labour charges for execution of the works;(ii) Charges for planning, designing and architect's fees;(iii) Charges for obtaining on hire or otherwise machinery andtools used for the execution of the works contract;(iv) Cost of consumables such as water, electricity, fuel, etc.,used in the execution of the works contract, the propertyin which is not transferred in the course of execution of aworks contract;(v) Cost of establishment of the contractor to the extent it isrelatable to supply of labour and services;(vi) Other similar expenses relatable to supply of labour andservices;(vii) Profit earned by the contractor to the extent it is relatableto supply of labour and services;(viii) amounts paid to a sub contractor as consideration for theexecution of works contract whether wholly or partly;Provided that, the contractor VAT dealer shall arrive at thevalue of goods at the time of incorporation, tax rate wise, fromout of the taxable turnover arrived at as above, on proratabasis taking the ratio of value of goods liable to tax at differentrates against the total value of purchases relating to suchcontract.Provided further that, subject to the filing of returns andpayment of tax as per clause (d), the VAT dealer shall pay thebalance amount of tax arrived at by following this clause at thetime of finalization of accounts relating to the particular work.Such additional taxable turnover and taxes payable shall bedeclared in the return for the month in which accounts arefinalized.Therefore, these rules were brought forward in order to aid theassesee in determining the exact cost of material involved andservice rendered in a works contract, so as to compute anddischarge their liability in relation to VAT & Service Tax Liabilityunder works contract.VALUATION OPTIONS AVAILABLEFOR WORKS CONTRACTThere are various options available to an assessee tocalculate his tax liability in respect to the works contractundersigned by him. The options are explained as follows:

Itemized Deduction This is the normal method of calculating the tax liability,whereby the assessee has to maintain detailed record ofall the purchases and expenses which are eligible asdeductions under the works contract. On the basis of thedocuments related to material absorbed in a WC anassesee may pay the VAT and on the balancing figure theservice tax liability can be discharged.Standard DeductionAs the name suggests, under this method of computationof tax liability of a works contract, a specified or standardpercentage of total contract value is allowed as adeduction. Such percentage is fixed by the governmentdepending upon the service component involved incontracts on a general basis. A standard deduction maybe opted by the Assesee in case the works contract isindivisible in nature and maintenance of detailed recordsof allowable deductions is intricate. Taxpayers have tochoose between using standard deduction or itemizeddeduction, they cannot use both in a same tax year.COMPOSITION SCHEMEThe composition scheme is a scheme whereby theassessee is given an option to pay the tax at a lower ratein the cases where computing the actual price of theservice rendered or goods sold is an uphill task. It is analternative to method of computing tax liability. The

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Scheme of composition is a mechanism provided tocollect the tax. The objective of such a mechanism is tominimize the inconvenience caused to the assessees andalso to the department in computing the figures. It isprevalent under the VAT laws of almost all the states at thesame time the scheme is also offered under the servicetax laws. In order to relieve some businesses of the needto keep detailed records, the law makes provision for asimpler method of accounting for Service Tax and VAT.Such a method is called a composition scheme and isavailable for assessees under the following:Service TaxRule 3 of Works Contract (Composition Schemefor Payment of Service Tax) Rules, 2007

``Notwithstanding anything contained in section 67 ofthe Act and rule 2A of the Service (Determination ofValue) Rules, 2006, the person liable to pay servicetax in relation to works contract service shall have theoption to discharge his service tax liability on theworks contract service provided or to be provided,instead of paying service tax at the rate specified insection 66 of the Act, by paying an amount equivalentto 4 (Four) per cent of the gross amount charged forthe works contract."Rule 17 (3) of Andhra Pradesh VAT Rules, 2005

Treatment of works contracts (other than forState Government or Local Authority) undercomposition(a) Any VAT dealer who executes a contract and opts to pay tax as specified in clause (c) of sub-section (7) of Section 4 must register himself as a VAT dealer;(b) The VAT dealer mentioned in clause (a) above shall pay tax at the rate of four percent (4%) of the total consideration received or receivable whichever is earlier.Rule 17 (4) of Andhra Pradesh VAT Rules, 2005

The Treatment of Apartment Builders andDevelopers under composition-(a) Where a dealer executes a contract for construction and selling of residential apartments, houses, buildings or commercial complexes and opts to pay tax by way of composition under clause (d) of sub section (7) of Section 4, he must register himself as a VAT dealer;(b) The VAT dealer shall have to pay tax by way of composition at the rate of four percent (4%) on twenty five percent (25%) of the total consideration received or receivable towards cost of land as well as construction or the market value fixed for the purposes of stamp duty, whichever is higher and the balance seventy five percent (75%) of the total consideration received or receivable shall be allowed as deduction for the

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The Scheme of composition is amechanism provided to collect thetax. The objective of such amechanism is to minimize theinconvenience caused to theassessees and also to thedepartment in computing thefigures. It is prevalent under theVAT laws of almost all the states atthe same time the scheme is alsooffered under the service tax laws.



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Comparative Analysis of TaxLiability under each of the threeSchemes

Analysis - I

Particulars Normal Standard Deduction CompositionScheme Scheme SchemeVAT CALCULATION

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purpose of computation of taxable turnover;whereas 1% is required to be paid on total consideration received or receivable in case of TOT dealers after the deduction mentioned in Rule 17 (5) (b) of APVAT Rules, 2005.ADVANTAGES AND DISADVANTAGESOF COMPOSITION SCHEMEAdvantages

u It simplifies the calculation of tax liability of a dealeru It saves a lot of labour and effort in keeping recordsu It's not been mandated by the law, hence optional to adoptu Generally a very small amount of tax is payable under this schemeu There will be a simple return form to cover longer return periodDisadvantagesu Under this scheme the dealer is not able to claim input tax credit on purchases made by himu Dealer will not be able to issue tax invoices to its customers. Special provisions for claim of set off and tax invoice would applyu Purchaser shall not get any tax credit for the purchases made by him from the dealer operating under composition scheme

COMPARATIVE ANALYSISIt might be a predicament for an assessee to opt the best ofthe above schemes which keeps its tax liability bare minimum.To chalk out the finest alternative, let us take the followingexample and calculate the tax liability under the variousschemes provided by the statute:

w Total consideration agreed between the contractor and the contractee for the works contract in relation to installation of electrical devices is Rs. 35 lacs.w Total purchases amounts to Rs. 5,20,000/- (Inclusive of 4% VAT) w Total purchases amounts to Rs. 17,17,500/- (Inclusive of 14.50% VAT)w Total input services received from consultancy firm amounts to Rs. 2,75,750/- (Inclusive of 10.30% service tax)w Labour charges for execution of the works Rs. 5,00,000/- w Market value fixed for the contract amounts to Rs. 39,00,000/-

In the above hypothetical case, an assessee may opt for thestandard deduction scheme since it portrays the lowest taxliability. However, the composition scheme may not bebeneficial in all the cases. The fraction of service involved inthe works contract will affect the cost benefit ratio. Hence,following table may be helpful in calculating the cost benefitratio in the various possible cases of works contract:

Total Value ofworks contractValue of materialportion transferredunder the contractNet amountchargeable toVATVAT %Total Output VAT

Less: Total InputVAT

Net VAT Payable

Rs. 35,00,000/-N.A.

Rs. 8,75,000/-[25% of totalconsideration]4%

Rs. 35,000/-

N.A

Rs. 35,000/-

Rs. 35,00,000/-Rs. 24,00,000/-[6 lacs @ 4% and18 lacs @ 14.5%]Rs. 24,00,000/-4% and 14.50%respectively

Rs. 2,85,000/-[6,00,000 X 4%= 24,000/-18,00,000 X14.50%= 2,61,000/-]Rs. 2,37,500/-[5,00,000 X 4%= 20,000/-15,00,000 X14.50%= 2,17,500/-]Rs. 47,500/-

Rs. 35,00,000/-Rs. 24,50,000/-[Let say, 70% of thecontract value]Rs. 24,50,000/-4% and 14.50%respectively

Rs. 2,89,100/-[6,30,000 X 4%= 25,200/-18,20,000 X14.50%= 2,63,900/-]Rs. 2,37,500/-[5,00,000 X 4%= 20,000/-15,00,000 X14.50%= 2,17,500/-]Rs. 51,600/-

SERVICE TAX CALCULATIONValue of serviceportion under thecontract Net amountchargeable toService TaxService Tax %Total OutputService TaxLess:Total InputService Tax Net ServiceTax PayableTotal TaxPayable (VAT + ST)

-Rs. 34,65,000/-[35,00,000-35,000]

4%Rs. 1,38,600/-

Rs. 25,750/-[2,50,000 X 10.30%]Rs. 1,12,850/-Rs. 1,47,850/-

[35,000 + 1,12,850]

Rs. 11,00,000/-

Rs. 11,00,000/-10.30%

Rs. 1,13,300/-Rs. 25,750/-[2,50,000 X 10.30%]

Rs. 87,550/-Rs. 1,35,050/-[47,500+87,550]

Rs.10,50,000/- [30% of the contract]

Rs.10,50,000/-10.30%

Rs. 1,08,150/-Rs. 25,750/-[2,50,000 X 10.30%]

Rs. 82,400/-Rs. 1,34,000

[51,600+82,400]



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From the above table we can roughly say that if the elementof service is more than 20% in Works Contract, it will becost beneficial to opt for Composition Scheme. However, atthe same time we have to consider the other influencingfactors too.NOTABLE JUDICIALPRONOUNCEMENTS

Whether a construction contract also involvingengineering / commissioning be vivisected andproportionately charged to Service taxDaelim Industrial Co. v. CCE 2003 (89) ECC 140, 2003 (155)ELT 457 Tri Del: Indian Oil Corporation Ltd. awarded acontract on a lump sum basis to Daelim Industrial Co. Ltd.(DICL) for construction of a diesel hydro-desulphurisationplant so as to reduce the sulphur content in diesel. A show-cause notice was issued by the Additional Commissioner,Central Excise, Vadodara holding that DICL was liable to payservice tax on residual process design and detailedengineering, "commissioning of plant" applicable to"consulting engineers" which was also seconded by theCommissioner (Appeals). Moving to the Apex Court, DICLcontented that their contract was a works contract anddesign, drawing in question (which was less than 7 of thetotal cost of the deal) was incidental to the execution of theworks contract and it is not amenable to vivisect the contractto be split into individual components for levy of service tax.The Supreme Court, on a close examination of the termsof the contract and on what has been stated above,concluded that the said contract was a works contract onturnkey basis and not a consultancy contract. Settingaside the impugned orders, the SC directed theDepartment to return the amounts so far paid by theappellants, without any delay.

Whether serving of meals to the 'resident' visitors ofa Hotel considered to be sale of the food to them?

State of Punjab and Anr. v. Associated Hotels of India Ltd1967 20 STC 1 P H: Associated Hotels of India Ltd (AHIL)owns a chain of hotels, one of the main lines of its businessactivity is to provide residential accommodation and their tarifffor the persons staying in their hotels is an inclusive one forlodging as well as three principal meals, viz. breakfast, lunchand dinner. the petitioners had been filing the returns of theturnover under the Act and the Assessing Authority under theAct had been treating the service of meals to residents in thehotels as sale of foodstuffs but in their overall charges madefrom the guests had allowed 75 per cent, rebate on a notionalbasis on account of rent of the premises, amenities providedetc. Objecting to the levy of the tax on the so-called sale offood the company made an application to the Excise andTaxation Officer, Simla and the plea was turned down. In a writpetition, the Single Judge of High Court opined that theessential ingredients of a sale as defined in Section 2(h) of theAct are that there should be an agreement between theparties for transferring the title in the goods, that it must besupported by money consideration and that in consequenceof the transaction property must pass in the goods to thevendee.The court noted the following facts of the instant case:(i) that there is no splitting up of the charge made from a resident in a hotel, (ii) that a guest in a hotel is not only entitled but is specifically debarred from claiming any reduction in his bill if he does not take food in the hotel, (iii) the guests to whom the meals are served cannot under the agreement take away the food for later consumption or giving it away to someone else and(iv) he has no right to reject the food.On these facts the court's view was that no sale of foodtakes place appears to be unexceptionable and fullysupported by authorities.EPILOGUE

Taxation of works contract has always posed problems for both,the taxpayers and the administration. Factors such aspercentage of service involved, terms of payment, amount ofCENVAT available, nature and scope of the contract, etc., needto be strategically considered and various options be weighed toenable the assessee keeping a tab on his tax liability. Thisprocedure must be exercised prior to evaluation of tax liabilities inrespect of the said works contract and the option so implementedshall be applicable for the entire works contract and shall not bewithdrawn until the accomplishment of the said works contract.Therefore, if structured carefully, the options available to computetax liability could be a boon for the works contractor.

Analysis - II

Materialfraction(in Rs)(a)102030405060708090

Servicefraction(in Rs)(b)908070605040302010

Service Taxliability underNormalmethod(in Rs)(c)9.278.247.216.185.154.123.092.061.03

Service Taxliability undercompositionmethod(in Rs)(d)4.004.004.004.004.004.004.004.004.00

Cost-benefit(in Rs)(c-d)(e)5.274.243.212.181.150.120.81(1.94)(2.97)


Implications of Service Tax & Value Added Tax on Works Contract

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