By TIOL News Service

NEW DELHI, SEPT 27, 2013: THE Supreme Court had in LARSEN & TOUBRO LIMITED &ANRVs STATE OF KARNATAKA & ANR - 2008-TIOL-186-SC-CT doubted the correctness of the judgement of the Court in Raheja Development Corporation Vs. State of Karnataka reported in 2005-TIOL-77-SC-CT and felt the decision needs re-consideration by a larger Bench.

The Court referred to Para 20 of the judgment in Raheja Development's case:

"Thus the appellants are undertaking to build as developers for the prospective purchaser. Such construction/development is to be on payment of a price in various instalments set out in the agreement. As the appellants are not the owners they claim a "lien" on the property. Of course, under clause 7 they have right to terminate the agreement and to dispose of the unit if a breach is committed by the purchaser. However, merely having such a clause does not mean that the agreement ceases to be a works contract within the meaning of the terms in the said Act. All that this means is that if there is a termination and that particular unit is not resold but retained by the appellants, there would be no works contract to that extent. But so long as there is no termination the construction is for and on behalf of the purchaser. Therefore, it remains a works contract within the meaning of the term as defined under the said Act. 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."

The Court observed,

The point which we have to examine is whether the ratio of the judgment of the Division Bench in the case of Raheja Development Corporation (supra) as enunciated in Para 20, is correct. If the Develop Agreement is not a works contract could the Department rely upon the second contract, which is the Tripartite Agreement and interpret it to be a works contract, as defined under the 1957 Act? We are of the view that if the ratio of Raheja Development case is to be accepted then there would be no difference between works contract and a contract for sale of chattel as a chattel. Lastly, could it be said that petitioner Company was the contractor for prospective flat purchaser. Under the definition of the term "works contract" as quoted above the contractor must have undertaken the work of construction for and on behalf of the contractor for cash, deferred or any other valuable consideration. According to the Department, Development Agreement is not works contract but the Tripartite Agreement is works contract which, prima facie, appears to be fallacious. There is no allegation that the Tripartite Agreement is sham or bogus .

And so referred the case to the Larger Bench.

The Larger Bench noted the broad facts in Raheja Development's case as:

1. Raheja Development carried on the business of real estate development and allied contracts;

2. Raheja Development entered into development agreements with the owners of land;

3. Raheja Development entered into agreements of sale with intended purchasers. The agreements provided that on completion of the construction, the residential apartments or the commercial complexes would be handed over to the purchasers who would get an undivided interest in the land also;

4. The owners of the land would then transfer the ownership directly to the society formed under the Karnataka Ownership Flat (Regulation of the Promotion of Construction, Sale, Management and Transfer) Act, 1972 (for short, 'KOFA').

The following definition of "works contract" was under consideration before this Court in Raheja Development': "works contract" includes any agreement for carrying out for cash, deferred payment or other valuable consideration, the building, construction, manufacture, processing, fabrication, erection, installation, fitting out, improvement, modification, repair or commissioning of any moveable or immovable property".

In light of the above facts and the definition of "works contract", the question before this Court was whether Raheja Development were liable to pay turnover tax on the value of goods involved in the execution of the works contract.

The Court in Raheja Development held as under:

(i) The definition of the term "works contract" in the Act is an inclusive definition.

(ii) It is a wide definition which includes "any agreement" for carrying out building or construction activity for cash, deferred payment or other valuable consideration.

(iii) The definition of works contract does not make a distinction based on who carries on the construction activity. Even an owner of the property may be said to be carrying on a works contract if he enters into an agreement to construct for cash, deferred payment or other valuable consideration.

(iv) The developers had undertaken to build for the prospective purchaser.

(v) Such construction/development was to be on payment of a price in various installments set out in the agreement.

(vi) The developers were not the owners. They claimed lien on the property. They had right to terminate the agreement and dispose of the unit if a breach was committed by the purchaser. A clause like this does not mean that the agreement ceases to be "works contract". So long as there is no termination, the construction is for and on behalf of the purchaser and it remains a "works contract".

(vii) If there is a termination and a particular unit is not resold but retained by the developer, there would be no works contract to that extent.

(viii) 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 works contract.

The Larger Bench analysed the Law and facts and started with the question,

Whether taxing sale of goods in an agreement for sale of flat, which is to be constructed by the developer/promoter, is permissible under the Constitution? And the Court observed:

When the agreement between the promoter/developer and the flat purchaser is to construct a flat and eventually sell the flat with the fraction of land, it is obvious that such transaction involves the activity of construction inasmuch as it is only when the flat is constructed then it can be conveyed. We, therefore, think that there is no reason why such activity of construction is not covered by the term "works contract". After all, the term "works contract" is nothing but a contract in which one of the parties is obliged to undertake or to execute works. Such activity of construction has all the characteristics or elements of works contract. The ultimate transaction between the parties may be sale of flat but it cannot be said that the characteristics of works contract are not involved in that transaction. When the transaction involves the activity of construction, the factors such as, the flat purchaser has no control over the type and standard of the material to be used in the construction of building or he does not get any right to monitor or supervise the construction activity or he has no say in the designing or lay-out of the building, in our view, are not of much significance and in any case these factors do not detract the contract being works contract insofar as construction part is concerned.

For sustaining the levy of tax on the goods deemed to have been sold in execution of a works contract, three conditions must be fulfilled:

(i) there must be a works contract,

(ii) the goods should have been involved in the execution of a works contract, and

(iii) the property in those goods must be transferred to a third party either as goods or in some other form.

In a building contract or any contract to do construction, the above three things are fully met. In a contract to build a flat there will necessarily be a sale of goods element. Works contracts also include building contracts and therefore without any fear of contradiction it can be stated that building contracts are species of the works contract.

Ordinarily in the case of a works contract the property in the goods used in the construction of the building passes to the owner of the land on which the building is constructed when the goods and materials used are incorporated in the building. But there may be contract to the contrary or a statute may provide otherwise. Therefore, it cannot be said to be an absolute proposition in law that the ownership of the goods must pass by way of accretion or exertion to the owner of the immovable property to which they are affixed or upon which the building is built.

Where a contract comprises of both a works contract and a transfer of immovable property, such contract does not denude it of its character as works contract. Article 366(29-A)(b) does contemplate a situation where the goods may not be transferred in the form of goods but may be transferred in some other form which may even be in the form of immovable property.

We have no doubt that the State legislatures lack legislative power to levy tax on the transfer of immovable property under Entry 54 of List 11 of the Seventh Schedule. However, the States do have competence to levy sales tax on the sale of goods in an agreement of sale of flat which also has a component of a deemed sale of goods. Aspects theory though does not allow the State legislature to entrench upon the Union List and tax services by including the cost of such service in the value of goods but that does not detract the State to tax the sale of goods element involved in the execution of works contract in a composite contract like contract for construction of building and sale of a flat therein.

The Larger Bench summarised the legal position, as follows:

(i) For sustaining the levy of tax on the goods deemed to have been sold in execution of a works contract, three conditions must be fulfilled: (one) there must be a works contract, (two) the goods should have been involved in the execution of a works contract and (three) the property in those goods must be transferred to a third party either as goods or in some other form.

(ii) For the purposes of Article 366(29-A)(b), in a building contract or any contract to do construction, if the developer has received or is entitled to receive valuable consideration, the above three things are fully met. It is so because in the performance of a contract for construction of building, the goods (chattels) like cement, concrete, steel, bricks etc. are intended to be incorporated in the structure and even though they lost their identity as goods but this factor does not prevent them from being goods.

(iii) Where a contract comprises of both a works contract and a transfer of immovable property, such contract does not denude it of its character as works contract. The term "works contract" in Article 366 (29- A)(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 alone. Nothing in Article 366(29-A)(b) limits the term "works contract".

(iv) Building contracts are species of the works contract.

(v) A contract may involve both a contract of work and labour and a contract for sale. In such composite contract, the distinction between contract for sale of goods and contract for work (or service) is virtually diminished.

(vi) The dominant nature test has no application and the traditional decisions which have held that the substance of the contract must be seen have lost their significance where transactions are of the nature contemplated in Article 366(29-A). Even if the dominant intention of the contract is not to transfer the property in goods and rather it is rendering of service or the ultimate transaction is transfer of immovable property, then also it is open to the States to levy sales tax on the materials used in such contract if such contract otherwise has elements of works contract. The enforceability test is also not determinative.

(vii) A transfer of property in goods under clause 29-A(b) of Article 366 is deemed to be a sale of the goods involved in the execution of a works contract by the person making the transfer and the purchase of those goods by the person to whom such transfer is made.

(viii) Even in a single and indivisible works contract, by virtue of the legal fiction introduced by Article 366(29-A)(b), there is a deemed sale of goods which are involved in the execution of the works contract. Such a deemed sale has all the incidents of the sale of goods involved in the execution of a works contract where the contract is divisible into one for the sale of goods and the other for supply of labour and services. In other words, the 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 the value of the material in the execution of works contract.

(ix) The expression "tax on the sale or purchase of goods" in Entry 54 in List 11 of Seventh Schedule when read with the definition clause 29-A of Article 366 includes a tax on the transfer of property in goods whether as goods or in the form other than goods involved in the execution of works contract.

(x) Article 366(29-A)(b) serves to bring transactions where essential ingredients of 'sale' defined in the Sale of Goods Act, 1930 are absent within the ambit of sale or purchase for the purposes of levy of sales tax. In other words, transfer of movable property in a works contract is deemed to be sale even though it may not be sale within the meaning of the Sale of Goods Act.

(x) Taxing the sale of goods element in a works contract under Article 366(29-A)(b) read with Entry 54 List 11 is permissible even after incorporation of goods provided tax is directed to the value of goods and does not purport to tax the transfer of immovable property. The value of the goods which can constitute the measure for the levy of the tax has to be the value of the goods at the time of incorporation of the goods in works even though property passes as between the developer and the flat purchaser after incorporation of goods.

Now the crucial question before the Larger Bench is whether the view taken in Raheja Development with reference to definition of "works contract" in KST Act is legally unjustified ?

The argument on behalf of the developers that the flat purchaser is entitled to transfer of flat and conveyance of fraction of land only when all installments have been fully paid and that shows that the agreement between the developer and the flat purchaser is the sale of flat and not to appoint the developer as the contractor of the flat purchaser for the purposes of carrying out the construction of the flat for and on behalf of the flat purchaser has no merit.

The submission did not find favour with the Supreme Court as it overlooks the typical nature of the development agreement which is followed by a tripartite agreement between the owner of the land, the developer and the flat purchaser. Effectively and de facto it is the developer who constructs the building for the flat purchaser. The developer does so for monetary consideration. The label of payment is not decisive but the factum of the payment is. The construction is done on payment of price as agreed upon between the developer and the flat purchaser. It is, thus, not correct to say that the work is undertaken by the developer for himself and for the owner and the construction is not carried for and on behalf of the purchaser.

In the development agreement between the owner of the land and the developer, direct monetary consideration may not be involved but such agreement cannot be seen in isolation to the terms contained therein and following development agreement, the agreement in the nature of the tripartite agreement between the owner of the land, the developer and the flat purchaser whereunder the developer has undertaken to construct for the flat purchaser for monetary consideration. Seen thus, there is nothing wrong if the transaction is treated as a composite contract comprising of both a works contract and a transfer of immovable property and levy sales tax on the value of the material involved in execution of the works contract.

In Article 366(29-A)(b), the term 'works contract' covers all genre of works contract and it is not limited to one specie of the contract. In Raheja Development , the definition of "works contract" in KST Act was under consideration. That definition of "works contract" is inclusive and refers to building contracts and diverse construction activities for monetary consideration viz; for cash, deferred payment or other valuable consideration as works contract. Having regard to the factual position, inter alia, Raheja Development' entered into development agreements with the owners of the land and it also entered into agreements for sale with the flat purchasers, the consideration being payment in installments and also the clauses of the agreement the Court held that developer had undertaken to build for the flat purchaser and so long as there was no termination of the contract, the construction is for and on behalf of the purchaser and it remains a "works contract".

The Larger Bench however clarified that activity of construction undertaken by the developer would be works contract only from the stage the developer enters into a contract with the flat purchaser. The value addition made to the goods transferred after the agreement is entered into with the flat purchaser can only be made chargeable to tax by the State Government.

The Larger Bench also noted that since Raheja Development in May, 2005 almost all States have modified their laws in line with Raheja Development and there is no justification for change in the position settled after the decision of this Court in Raheja Development.

The Larger Bench added that if at the time of construction and until the construction was completed, there was no contract for construction of the building with the flat purchaser, the goods used in the construction cannot be deemed to have been sold by the builder since at that time there is no purchaser. That the building is intended for sale ultimately after construction does not make any difference.

The Larger Bench emphatically held, “We are clearly of the view that Raheja Development lays down the correct legal position and we approve the same.”

(See 2013-TIOL-46-SC-CT-LB)