JANUARY 17, 2008

By S Sivakumar

THE Supreme Court's last week judgment in IMAGIC CREATIVE PVT LTD Vs COMMISSIONER OF COMMERCIAL TAXES, reported in 2008-TIOL-04-SC-VAT, has thrown up several interesting questions of the leviability of VAT on composite and indivisible contracts.

The question that arose before the Apex Court was, whether, sales tax could be levied, in terms of the provisions of the Karnataka Sales Tax Act 1957, on the entire value of a contract involving advertising services including the value of services, in respect of which, service tax is being paid. Here was the case of a service provider, who was using materials / goods in the course of providing the service as part of an indivisible contract and had been paying service tax. The Karnataka Commercial Taxes Department took the view that it was a composite contract of sale, wherein the taxable value of the goods sold being printed booklets got enhanced by the utilization of the soft skills involved in the process and that, sales tax was payable on the entire value of the contract. The Karnataka High Court, in a judgment (2006-TIOL-431-HC-KAR-IT), upheld the levy of sales tax on the entire value of the contract, including the service element. On appeal, the Apex Court has held that in an indivisible contract (involving sale of materials and rendering of services), there was no justification for levy of sales tax on the entire transaction value.

Some of the highly relevant wordings used by the Apex Court are reproduced below:

'A distinction must be borne in mind between an indivisible contract and a composite contract. If in a contract, an element to provide service is contained, the purport and object for which the Constitution had to be amended and clause 29A had to be inserted in Article 366, must be kept in mind' (Para 25).

The Apex Court further states in Para 28 of its order, as follows:

'28. Payments of service tax as also the VAT are mutually exclusive. Therefore, they should be held to be applicable having regard to the respective parameters of service tax and the sales tax as envisaged in a composite contract as contradistinguished from an indivisible contract. It may consist of different elements providing for attracting different nature of levy. It is, therefore, difficult to hold that in a case of this nature, sales tax would be payable on the value of the entire contract; irrespective of the element of service provided'.

Now, there are several interesting questions that could emerge, post this judgment.

Can sales tax/VAT be levied on indivisible contracts on which service tax has been paid.

I don't think we have a clear view on this question, given the facts and circumstances governing the case decided by the Apex Court. Let's bear in mind that the question before the Apex Court was, whether, sales tax could be levied on the entire value of an indivisible contract on which, service tax was being levied. The Apex Court, of course, overruled the High Court and gave a firm 'No'. It was not an issue before the Apex Court as to whether sales tax could be levied on the goods part of the transaction. We need to keep in mind, the decision rendered by the Apex Court in the BSNL Case, wherein the Apex Court had held in Para 85 of the judgment that 'in a composite contract of service and sale, it is possible for the State to tax sale element provided there is a discernible sale and only to extent relatable to such sale', which continues to hold good, despite this judgment.

This position is understandable, in the light of the VAT laws of the country, wherein, in the case of levy of VAT on works contracts, a deduction towards labour and like charges are allowed, while computing the taxable turnover. There is a corresponding logic that we have under the service tax law, wherein, the value of the goods and materials sold by the service provider to the recipient of the service, are exempted from the levy of service tax, in terms of Notification No. 12/2003-ST dated 20th June 2003, which is still valid.

In my opinion, there would not have been a problem, if the State of Karnataka had sought to tax the sale element involved in the contract, which it seems, the assessee was willing to pay. Instead, the State tried to levy sales tax even on the service element, which is what landed it in trouble, with the Apex Court.

Indivisible Contracts v. Composite Contracts

The judgment, in my opinon, seeks to create a distinction between 'indivisible contracts' and 'composite contracts'. The Apex Court states in Para 25 of its judgment, as follows:

'It has expressly been laid down therein that the effect of amendment by introduction of clause 29A in Article 366 is that by legal fiction, certain indivisible contracts are deemed to be divisible into contract of sale of goods and contract of service. In Gannon Dunkerley case (supra), it had been held:

'Keeping in view the legal fiction introduced by the Forty-sixth Amendment whereby the works contract which was entire and indivisible has been altered into a contract which is divisible into one for sale of goods and other for supply of labour and services, the value of the goods involved in the execution of a works contract on which tax is leviable must exclude the charges which appertain to the contract for supply of labour and services.'

What would amount to an indivisible contract and what would amount to a composite contract, would obviously, depend on the facts of the case. Read in conjunction with the decisions of the Apex Court rendered in the BSNL Case (2006-TIOL-15-SC-CT-LB), one gets the view that while indivisible contracts, other than those covered by the 46th Amendment resulting in the introduction of Article 366(29-A) i.e. works contracts, catering contracts and hire purchase contracts cannot be subjected to sales tax / VAT, States do have the right to levy sales tax/VAT on composite contracts on the sale element.

Of course, the Commercial Taxes Departments of the States would tend to view all contracts as composite contracts and try and levy VAT on the goods portion of these contracts and in my opinion, it would become extremely difficult to distinguish between an indivisible contract and a composite contract, in practical situations.

Though the judgment has been rendered in the context of the sales tax law, the conceptual distinction between an indivisible contract and a composite contract would hold as well, in the context of service tax.

Are Software Development Contracts Composite Contracts from the VAT point of view

This is very tricky question which will continue to haunt the software industry, post the judgments rendered by the Apex Court in the TCS case (2004-TIOL-87-SC-CT-LB) and the latest case. In the course of delivering the judgment in the TCS case, the Supreme Court had opined as under:

'Thus, even unbranded software, when it is marketed/sold, may be goods. We, however, are not dealing with this aspect and express no opinion thereon because in case of unbranded software other questions like situs of contract of sale and/or whether the contract is a service contract may arise.'

The fact remains that in a significantly high chunk of software development contracts, there is a transfer of unbranded software, which are to be considered as 'goods'. Till now, there has been no attempt by the States to tax the element of consideration pertaining to sale of these unbranded software. While the States cannot tax the entire value of the software development contract, which are essentially service contracts, there seems to be no bar for the States to try and tax the goods element of the contracts. In my opinion, going by the definition of the term 'works contract'', software development contracts involving delivery or transfer of unbranded software which are 'goods', could well get covered under the VAT net.

Any Service Tax Implications arising out of tbis case?

It is interesting to note that one can see a distinction, in terms of the mind of the Apex Court, as revealed in the judgments that it rendered in the Daelim case and in the BSNL case. In the Daelim case (2004-TIOL-66-SC-ST ), the Supreme Court had upheld that an indivisible works contract on a turnkey basis cannot be vivisected for purposes of levy of service tax. On the other hand case, in the BSNL case (2006-TIOL-15-SC-CT-LB ), the Court had upheld the levy of both VAT and Service tax, on the sale and the service elements, respectively, of what is essentially a composite contract, so long as there was a discernable sale and consequently, a service. This view is getting re-established, although in an indirect manner, in the latest judgment, though rendered, as aforesaid, in the context of the sales tax law.

(The author is Bangalore-based Director of S3 Solutions)