MAY 09, 2015

By M G Kodandaram

THE Levy and collection of taxes (Vat/CST/ Excise duty/Service tax) on 'Works Contract' has remained a daunting task to the States as well as the Central Authorities for the past 60 years. Successive Governments have failed to provide suitable legislation for effective collection of taxes on works contracts. Added to this, the efforts of the Enforcement Agencies, both state and central, for immediate remedial action, as available under law during the relevant period has been disastrous as they have utterly failed to protect and safeguard the interests of the Public exchequer. Large companies and industrial houses engaged in the business of such 'Works Contract' in general, and in the manufacture and commissioning of lifts and elevators, machineries, key projects etc. have been taking advantage of the above circumstances and lapses to strategically mislead the Authorities to evade payment of proper duty/taxes. Now, we are in the historical moment of embracing a new regime of taxation of goods and services, by introduction of GST. It is, I feel, the right time for all of us to come out with proper legislation for 'Works Contracts' followed by effective enforcement so that we can put an end to this undying saga. Let us briefly look into the various decisions of the Apex and other legal forums so that we can learn and educate ourselves, and come out with proper and effective legislation for handling of 'Works Contract' in GST regime, so that we can control the damage it has caused to the public revenue all these years.

The Works Contract since fundamentally involves transactions in goods as well as services is under dispute under various states sales tax/vat legislation. Respective states have power to make legislations (Article 246) in respect of seventh schedule, list II—State List, entry 54, i.e., 'Taxes on the sale or purchase of goods'. As the 'works contract' results in sale of immovable property, whether the state authorities have the powers to legislate and levy tax under the stated entry was the primary matter disputed during 1950s. The Supreme Court in its order in the case of State of Madras vs. Gannon Dunkerley & Co. (Madras) Ltd., - 2002-TIOL-493-SC-CT-LB, held that 'the expression "sale" in entry 54 of list II is the same as that used in the Sale of Goods Act 1930; that Section 4(1) of the Sale of Goods Act, 1930 defines sale as a "contract whereby the seller transfers or agrees to transfer the property in goods to the buyer for a price"; that accordingly a transaction, in order to be 'sale' for the levy of Sales Tax, should result in transfer of ownership in goods from seller to purchaser; that in a building contract, there is no sale of goods, and it is not within the competence of the Provincial Legislature to impose a tax on the supply of the materials used in such a contract treating it as a sale". This opened up the scope for avoidance of sales tax, which resulted in huge loss of huge revenues to the state exchequer during the period around 1950 to 1983.

The Central Government on recommendations of the Law commission set up for this purpose, introduced clause 29A in Article 366 on 2 nd February 1983, by way of 46 th Amendment to the Constitution and nullified the observation of the Supreme court case cited above.

Relevant portion of the amendment is reproduced below for quick reference -

"Article 366 (29A) - tax on the sale or purchase of goods includes... (b) a tax on the transfer of property in goods (whether as goods or in some other form) invoked in the execution of a works contract;"

After the Amendment, it had become possible for the States to levy Sales Tax / Vat on the transfer of property in goods (whether as goods or in some other form) involved in execution of a works contract irrespective of the fact that the contract might have been a composite one and the intention of the parties were not to sell the goods. Accordingly the States amended the Sales Tax laws and included the property transferred in the execution of a Works Contract within the tax net of the Sales tax / VAT. Added to this the constitutional validity of the 46 th Amendment was upheld in the case of M/s Builder Association of India vs. Union of India - 2002-TIOL-602-SC-CT which eased the situation a bit.

But in the meanwhile, large industries engaged in works contract had a way out to defeat the intentions and purpose of the above constitutional amendment and state legislations. They started moving parts and materials used for setting up of lifts etc., (goods and consumables) as interstate sales. They argued that the states have no power to impose tax on these 'works contract' as the transactions are covered under CST Act to which the 'deemed sales' amendment made to the Constitution is not applicable. The disputes that arose during this period ended in huge loss of revenue to the state exchequer as the honourable Apex court in the case of Gannon Dunkerley. & Co. vs. State of Rajasthan - 2002-TIOL-103-SC-CT-CB,held that the state in exercise of its legislative power under Entry 54 of the State List read with Article 366(29A) (b), is not competent to impose a tax on such a transfer (deemed sale) which constitutes a sale in the course of inter-State trade or commerce or a sale outside the State or a sale in the course of import or export. Later on, to overcome this legislative hurdle, the Central Government amended the definition of "sale" under CST Act by the Finance Act, 2002. Introduction of the new definition of "sale under Section 2(g) to include "transfer of property in goods" (whether as goods or in some other form) involved in the execution of a Works Contract" (w.e.f 11 th May 2002) solved this issue to a large extent.

Each state defined Works Contract to suit their needs. Further the valuation of works contract for payment of VAT/CST also added ambiguity in legislation and enforcement. Each of the state Vat laws /CST had different yardsticks to determine the assessable value for payment of Sales Tax/Vat/CST, which the industries exploited to their advantage. Popular methods adopted included -

(i) Actual Labour Deduction Option

(ii) Standard Labour Deduction

(iii) Composition Tax

In most of the State Vat Acts, the provisions of Tax deducted at source (TDS) are also incorporated. Various states levied tax on entry of goods into the state from outside the state and which is referred as Entry Tax. The tax is to be paid to the recipient state in addition of CST payable to the originating state. The constitutional validity of Entry Tax is under litigation at several forums. There are further twists and turns to this story which I will revisit after discussing certain aspects of Central Excise and Service Tax levy in brief.

The excisability of goods, movable or otherwise, has been under dispute from the beginning and the industries used all the legal lacunae to evade payment of proper duty on goods involved in 'Works contract'. Based on various judicial pronouncements / clarifications, setting at rest the various disputes that arose from 1960s, CBEC issued an order under section 37B of Central Excise Act 1944, to bring uniformity in the levy of Excise Duty on such 'Works Contracts'. The cases based on which the section 37B Order No.58/1/2002–CX dated 15th January, 2002 has been issued are-

(i) Quality Steel Tubes Pvt. Ltd. vs. CCE - 2002-TIOL-25-SC-CX

(ii) Mittal Engineering Works Pvt. Ltd. vs. CCE Meerut - 2002-TIOL-201-SC-CX

(iii) Sirpur Paper Mills Limited Vs CCE, Hyderabad - 2002-TIOL-200-SC-CX

(iv) Silica Metallurgical Ltd. vs. CCE Cochin [(1999 (106) ELT 439 (Tribunal)] as confirmed by the SC vide their order dated 22.2.99 [1999 (108) ELT 58A (SC)]

(v) Duncan Industries Ltd. Vs. CCE Mumbai [2000 (88) ECR 19 (SC)

(vi) Triveni Engineering & Industries Ltd. vs. CCE - 2002-TIOL-14-SC-CX-LB

(vii) CCE Jaipur Vs. Man Structurals Ltd. - 2002-TIOL-182-SC-CX-CB

The relevant portions of the s.37B order applicable to 'Works Contracts' are-

"(i) for goods manufactured at site to be dutiable they should have a new identity, character and use, distinct from the inputs / components that have gone into its production. Further, such resultant goods should be specified in the Central Excise Tariff as excisable goods besides being marketable i.e. they can be taken to the market and sold (even if they are not actually sold). The goods should not be immovable."

"(iii) Where change of identity takes place in the course of construction or erection of a structure which is an immovable property, then there would be no manufacture of "goods" involved and no levy of excise duty."

"(v) If items assembled or erected at site and attached by foundation to earth cannot be dismantled without substantial damage to its components and thus cannot be reassembled, then the items would not be considered as moveable and will, therefore, not be excisable goods."

"(vii) When the final product is considered as immovable and hence not excisable goods, the same product in CKD or unassembled form will also not be dutiable as a whole by applying Rule 2(a) of the Rules of Interpretation of the Central Excise Tariff. However, components, inputs and parts which are specified excisable products will remain dutiable as such identifiable goods at the time of their clearance from the factory or warehouse."

Based on various judicial pronouncements, the CBEC clarified the excisability of certain specific instances which included-

"Turn key projects like Steel Plants, Cement plants, Power plants etc. involving supply of large number of components, machinery, equipments, pipes and tubes etc. for their assembly / installation / erection / integration / inter-connectivity on foundation/civil structure etc. at site, will not be considered as excisable goods for imposition of central excise duty. The components, however, would be dutiable in the normal course."

"Refrigeration/Air conditioning plants - These are basically systems comprising of compressors, ducting, pipings, insulators and sometimes cooling towers etc. They are in the nature of systems and are not machines as a whole. They come into existence only by assembly and connection of various components and parts. Though each component is dutiable, the refrigeration/air conditioning system as a whole cannot be considered to be excisable goods. Air conditioning units, however, would continue to remain dutiable as per the Central Excise Tariff."

"Lifts and escalators - (a) though lifts and escalators are specifically mentioned in subheading 8428.10, those which are installed in buildings and permanently fitted into the civil structure, cannot be considered to be excisable goods. Such lifts and escalators have also been held to be non-excisable by the Govt. of India in the case of Otis Elevators India Co Ltd reported in 1981 ELT 720 (GOI). Further, this aspect was also a subject matter of C&AG's Audit Para No.7.1 (b)/98-99 [DAP NO 186] which has since been settled by the C&AG accepting the Board's view that such lifts and escalators are not excisable goods. Also refer CCE vs. Kone Elevators India Ltd reported in 2001 (45) RLT 676 (CEGAT- Chen)"

From the above it is clear that upto the year 2002 there was no uniform approach by the Excise department in respect of levy of Excise Duty, which resulted in prolonged litigations and in huge loss of revenue to the exchequer. The situation later to the above order is no different as the industries taking advantage of the clarification, started undervaluing the goods, by adopting CAS-4 methodology applicable to goods not sold but captivity consumed in "Works Contract". The department lacked manpower, time and the skill to check the veracity of these certificates churned out. In course of time the officers stopped asking for such certificates as the volumes were too huge to manage. The situation today is no way different and, therefore, it needs to be corrected on priority in the GST regime.

The levy of service tax on works contract was introduced on 1.6.2007 and it was thought to be an excellent method to plug the duty evasion, as an attractive rate of 2% service tax on the composite value (gross value charged in a works contract) was imposed. As the very basis of levy of Service tax was questioned (Maharashtra Chamber of Housing Industry v. UOI (2012) - 2012-TIOL-78-HC-MUM-ST refers) the same was diversified to make the gross value charged in a works contract minus the cost of goods as the value subjected to Service Tax. Under the regime of service tax, upto the point of introduction of negative list of taxation in July 2012, there were two schemes in place for the purposes of valuation of works contract services:

(a) Works Contract Composition Scheme, 2007 – where the service tax was payable @ 4.80% on gross amount charged.

(b) Rule 2A of Service Tax (Determination of Value) Rules, 2006 – where the service tax was payable at normal rate on the service portion of works contract.

"Service" under section 65B (44) of Finance Act 1994, defined for the first time w.e.f. 01-07-2012 included the Declared Services within its domain. Declared Services are defined under Section 65B (22) of the Finance Act, 1994 as 'any activity carried out by a person for another person for consideration and declared as such under Section 66E of the Finance Act, 1994'. Under 66E (h) 'service portion in the execution of a works contract' were notified as declared services. This helped the department to overcome the decision of various courts. To further facilitate proper levy, "Works Contract" has been defined in Section 65B (54) as under-

"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 new definition has enlarged the scope of the Works Contract by including activities relating to movable property, in addition to immovable property, within its ambit. The new definition covers services such as composite AMC, Authorised Service Station etc.

Further, the valuation such transactions are regulated by Rule 2A of Service Tax (Determination of value) Rules, 2006. Two options of valuation are available to the taxpayer under Rule 2A, as amended by Notification No. 24/2012-ST dated 06 th June 2012.

(i) Regular Scheme - Rule 2A(i) of the said rules provides that 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 the execution of the said works contract;

OR

(ii) Standard Deduction Scheme - Rule 2A(ii) provides that where value has not been determined under Rule 2A(i) as above,the person liable to pay tax on the service portion involved in the execution of the works contract shall determine the service tax payable in respect of works pertaining to (i) original works at 40% of the "total amount" charged; (ii) maintenance, repair, reconditioning or restoration or servicing of any goods at 70% of the "total amount" charged and (iii) in case of other contracts not included above at 60% of the "total amount" charged (now 70% from 01.10.2014).

In addition to the above, in certain instances, service receiver is made to pay 50% or 100% of the obligation and the remaining 50% or nil, by the service provider, (partial reverse charge & full reverse charge mechanism) bringing more uncertainty and confusion to the issue which was already under innumerable disputes. Further smaller service providers utilising the exemption (value not exceeding Rupees 10 lakh) are forced to pay Service Tax, which he is obliged to pay under the partial or full reverse charge mechanism. This has defeated the purpose set out in the notification.

Added to this, the levy of sales tax as well as service tax on a single transaction involving 'works contract' brought in a new set of litigations and the connected delay which was exploited by innumerable industries engaged in such business. One of the major disputes in works contract was regarding splitting of the contract into supply of services and goods wherein the Apex court in the case of BSNL vs. UOI - 2006-TIOL-15-SC-CT-LB held that in the execution of works contract splitting of the service and supply of goods has been constitutionally permitted in Article 366(29A)(b); that splitting of contracts into service and goods is not permissible in other cases because it is not works contract falling under Article 366(29A)(b). Hence as per the dominant intention theory, providing 'Sim-card and mobile service' is a service contract and not a sale contract, the transfer of the property in goods takes place as an incidence of contract of service and accordingly no sale tax is applicable.

To overcome the problem arising out of the above decision, in the year 2012 changes were brought in Finance Act 1994, by introduction of the concept of Declared Services. By this move, all disputed services were brought into service tax network, without giving room for any ambiguity and litigation.

The recent decision of the Hon Supreme Court, in the case of lift manufacturers opens up the Pandora box once again on the legality of levy of service tax and sales tax on such 'works contracts'. The larger (5-Judge) bench of the Supreme Court, on a writ petition in Kone Elevator India Pvt Ltd v State of Tamil Nadu and ors - 2014-TIOL-57-SC-CT-CB, by a majority decision, held that the contract for manufacture, supply and installation of lifts in a building is a "works contract" and not a "contract for sale". The above larger bench has overruled the earlier decision of a 3-member bench of the Supreme Court in State of AP v Kone Elevator India Pvt Ltd - 2005-TIOL-30-SC-CT-LB, wherein it had been held that the main object of the contract was to sell the lifts, and that the works done for installation was incidental to the sale of lifts. For drawing this conclusion, the Supreme Court relied upon the decision of another larger bench of the Supreme Court in Larsen & Toubro Limited and another v State of Karnataka and another - 2013-TIOL-46-SC-CT-LB, wherein the legal test of a works contract as defined under clause (29A) (b) of Article 366 of the Constitution had been analysed, and the SC had held that a single and indivisible contract for supply and labour is allowed to be split. The Supreme Court in the instant case (Kone Elevator India Pvt Ltd v State of Tamil Nadu - 2014-TIOL-57-SC-CT-CB held that 'the "dominant nature test" or "overwhelming component test" were not applicable to the transaction in hand. After the lifts were assembled and installed with skill and labour at site, it became a permanent fixture of the building, and hence it was not a case of sale of chattel or a chattel being attached to another chattel'.

This is a landmark decision, not only for the contracts for sale and installation of lifts, but also for all similar 'works contracts'. Many contracts in different industries have been treated as sales contracts because the labour and service elements were considered to be secondary in value compared to the supply of goods. Now the authorities should take immediate actions to open up all such cases and collect service tax on the service portion of such contracts. Certain units engaged in works contract related products, taking advantage of the legal upheaval and confusion, are discharging the Service tax on the value based on pro-rata basis without any legal backing, which should be ended immediately.

The ploy played by the industries engaged in works contracts proved dear as the enforcing authorities, unsure of legislative intentions, allowed the prolonged litigation route to exist, resulting in huge loss of revenue to the central/state exchequer. Even now there is no uniform and proper enforcement of Excise, Service tax or Vat laws in respect of 'works contract' as the cases are pending for long periods in various legal forums. It is the right time for the teams working towards a holistic GST regime to look into this issue with a view to set the matters right at the beginning. If proper legislation and enforcement is not put in place in the beginning itself, the loss to the exchequer will remain perennial. It is also the right time for the executives of states/ central authorities to form special teams to pursue all the pending cases to their logical end so that the revenue loss is minimized.

The author wants to offer the following suggestions which may be considered while finalizing the legislation.

(i) A definition of 'works contract' needs to be inserted in the subject 122 Constitutional Amendment bill under consideration so that there is uniformity across the country.

(ii) Uniform concept in valuation be prescribed in the proposed Central Act and made applicable to state legislations also.

It is in the fond hope that GST may mark an end to the lasting debate surrounding the taxability of Works Contract that I have attempted this article. I will be pleased if the authorities examine this issue in detail and come out with solution in the form of effective legal framework so as to avoid further loss of revenue to the exchequer in the new regime.

(The author is Superintendent of Central Excise, NACEN, Bengaluru and the views expressed are strictly personal.)