MARCH 27, 2012

Budget is hugely Negative for Realty Sector

S Sivakumar, CA

THE Budget 2012-13 would, once again, seem to pick up the Realty Sector for some harsh treatment. That, no sector has benefited from this Budget is small consolation for the Realty Sector, though. At least, the Budget is not negatively impacting the other Sector, to the extent that, it does, to the Realty Sector.

This is an attempt to discuss some major Budget proposals that would negatively affect the Realty Sector, in a big way…

TDS on purchase of immovable properties – an unworkable proposal

In terms of Section 194LAA of the Income tax Act, as proposed in the Finance Bill, to take effect from October 1, 2012, any person responsible for paying any sum to a resident transferor by way of consideration for transfer of any immovable property (other than agricultural land), shall have to deduct at source, an amount of 1% of such consideration, as income tax thereon. It has been further provided that, no deduction is required to be made where such consideration is less than Rs 50 lakhs in cases where such property is located in ‘specified urban agglomeration areas' or is less than Rs 20 lakhs in cases where such property is located in any area other than specified areas. Specified Areas' include metro cities and other areas. It has also been provided that, where such consideration is less than the value adopted for registration by the appropriate authority (eg. Sub-Registrar) for levying stamp duty, the value adopted for stamp duty would be deemed to be the consideration, for purposes of this provision.

This is a very confusing and impracticable proposal, which would put the Realty Sector in deep trouble. The proposal talks of levying TDS on the consideration towards transfer of immovable property. Whether TDS is to be effected also on the construction value of the apartment/house remains totally unclear. In most parts of the country, Developers enter into two agreements, viz. one for the sale of the undivided portion/interest of the land and the other, for the construction of the apartment. Typically, it is the land which is registered as the immovable property and hence, the reference to immovable property in the Budget can be taken only to refer to land. If this view is taken, the entire purpose of bringing in this proposal would get defeated, frustrating the whole purpose of this proposal, as the value of land is very unlikely to be more than Rs 50 lakhs even in metro cities.

Moreover, the relationship between the Developer and the apartment buyer is one of service provider-service receiver and in cases where the land is not owned by the Developer, the transferor is the Land Owner and not the Developer. Even in cases where the Developer is also the owner of the land, he would become the transferor only at the time of registration of the apartment, by which time, a significant portion of the amounts towards construction and sale of undivided portion of the land would already have been paid by the apartment buyer, i.e. the transferee.

Yet another issue which can create a lot of practical problem is the proposal to treat the valuation fixed by the Sub-Registrar for payment of stamp duty, as the deemed consideration, where the actual consideration is lesser. This seems highly impractical, as the apartment buyer could be effecting payments on the basis that the consideration is less than the specified amounts, only to find out, at the time of registration, that the valuation fixed by the Sub-Registrar is more than the specified amount. How does he go back to deduct tax, on the amounts already paid by him is anybody's guess.

This proposal can only work in cases where the Developer enters into a single agreement of sale of the apartment and even here, a lot of practical problems could arise.

This could prove to be another big operational issue for Developers, especially, given the fact that individuals who are buyers of immovable properties would have to be effect the TDS, despite that, it is provided that they are not required to obtain TAN, etc. Of course, it is not clear if the apartment buyer, viz. the proposed transferee is required to effect the TDS every time he effect payment of an instalment to the Developer, as the Guidance No.2 talks of ‘transfer of title' meaning ‘change in ownership' in Para 2.5-1.

The proposal, as it stands now, will all cover sale of immovable properties between individuals also.

This is a highly ill-advised move on the part of the Government. The problem is, the rate would not remain at 1%, as we have seen in other cases. The Realty Associations would be well advised to lobby with the Government for the dropping of this proposal.

Reverse Charge mechanism vis-à-vis works contract services would drive out non-corporate players

This is another obnoxious proposal contained in the Budget. For reasons best known to it, the Government is now bringing certain services including works contract services into the reverse charge mechanism. In terms of Notification No. 15/2012-ST dated 17-3-2012 which will take effect from a date to be notified on the passing of the Finance Bill, the service recipient is required to discharge, 50% of the service tax leviable on works contract services rendered by individuals, partnership firms and LLPs.

It is a well-known fact that, a significant portion of the Realty Sector is comprised of non-corporate players, especially, in the construction sector. Due to this development, the non-corporate contractors would get discriminated against the corporate contractors, who are not covered under the reverse charge mechanism. This move could sound the death knell for the non-corporate contractors, as most Developers and Builders would find it very painful, to go under the reverse charge mechanism and pay 50% of the service tax leviable on the contractors. This would be especially so, in the case of Developers and Builders, who are promoting commercial complexes. Due to the change in the definition of ‘input service' brought about by the Finance Act, 2011, Developers and Builders building commercial complexes which are proposed to be let out, are denied cenvat credit in respect of input works contract and commercial/industrial construction services. Given this, they would be far worse off, as compared to Residential Realty Developers, as in the case of the former, the service tax under the reverse charge mechanism would have to be made out of their pockets with no cenvat credit being available, adding to the overall cost of commercial projects. In my view, though the said Notification talks of cenvat credit being available to the service recipient paying service tax under the reverse charge mechanism, such credit would not be available to the commercial realty Developers who let out their properties, in the light of the changed definition of ‘input service' brought about by the Finance Act, 2011.

This is a move in the wrong direction, which would add to the Sector's woes. More importantly, this would drive out the non-corporate contractors, out of business, which seems highly unjustified.

Is service tax payable on joint development agreements?

The Government had brought out a highly contestable circular No 151/2/2012 dated February 10, 2012, stating, interalia, that, joint developments are subject to service tax levy. Attempts have been made to reinforce this view, in this Budget. Let's take a look at the definition of service, as proposed, as is relevant here:

"service" means any activity carried out by a person for another for consideration, and included a declared service, but shall not include an activity which constitutes merely a transfer of title in goods or immovable property, by way of sale, gift or in any other manner…

It is clear from the definition given above, that a mere transfer of title in immovable property in any manner would not constitute a service. Can a view be taken that, exchange of flats by the Developer, for land provided by the Land Owner is a mere transfer of title in immovable property.

The Department would not think so. In terms of the Guidance Note issued, in Para 2.5.2, the following comment is made, with regard to the meaning of the word ‘only':

Quote

The word ‘only' signifies the transactions which involve only transfer of title in goods or immovable property is not included as service. A transaction which in addition to a transfer of title in goods or immovable property involves an element of another activity carried out or to be carried out by the person transferring the title would not be excluded from the definition of service.

Unquote

In the case of joint development agreements, the Land Owner is largely not involved in any activity and it is left to the Developer to construct and transfer the flats to the Land Owner, in terms of the joint development agreement and hence, can a view be taken, that, joint development agreements are covered by the exception clause given in the definition of ‘services'.

Further, in the illustration given under Para 2.2.4 in Guidance Note No.2, it has been specifically mentioned that, non-monetary consideration would cover supply of goods and services in return for provision for service. The fact that, the flats constructed by the Developer in exchange for the land given by the Land Owner as non-monetary consideration would seem to contradict the Government's own statement given in the same Para that, only goods and services are covered. Immovable property, by no stretch of imagination, can be considered as goods.

If one has to draw a parallel with the VAT law, ‘sale' covers only transactions for cash or for deferred payment of other valuable consideration [vide Section 2(29) of the Karnataka VAT Act, 2003]. It is clear that joint developments, being essentially barter transactions, are not subject to the levy of sales tax/VAT. With the word ‘consideration' not being defined in the proposed new service tax law and with the Guidance Notes having no legal sanctity, a lot of litigation is going to arise on the leviability of service tax on joint development agreements, even post Budget 2012-13. This Budget, instead of clarifying issues, has only added to the confusion, vis-à-vis the levy of service tax on joint development agreements.

Construction services vs Works Contract services – the confusion continues unabated

As we know, we are moving to the implementation of levy of service tax based on a negative list of services. One would then, have expected to Government to specify a negative list and levy service tax on all other ‘activities', as per the new definition. Instead of doing this, the Government has brought about a list of ‘declared services' in the inclusive part, perhaps, to cover certain services from out of the current list which have seen a lot of litigation.

In terms of the Budget proposals, under the ‘declared list' specified under Section 66E(b), there is one item which reads as "construction of a complex, building, civil structure or a part thereof, including a complex or building intended for sale to a buyer, wholly or partly, except where the entire consideration is received after issuance of certificate of completion by the competent authority". It would seem, per se, that the entire construction industry has been included under this head. However, the declared list further lists, under Section 66E(h), ‘service portion in the execution of a works contract'. In terms of the Finance Bill, "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, improvement, repair, renovation, alteration of any building or structure on land or for carrying out any other similar activity or a part thereof in relation to any building or structure on land.

A harmonious construction of these two heads under the declared list could lead to the conclusion that, while Developers/Builders who carry out the construction activity themselves would get treated as ‘works contractors', while the pure Developers who do not undertake the construction activity would still be liable in terms of the declared list. The essential difference would however be, that, in the case of the pure Developers, service tax could get levied on the entire value of the transaction, as the benefit of charging service tax only on the ‘service' portion is available only for works contracts. This is especially so, as the construction services are not included under the list of proposed service for which abatement has been announced, post Budget.

The Government is bringing a new Rule 2A of the Service tax Valuation Rules, as per which, the following methodology would be used for arriving at the ‘service portion' of the works contract, which as we saw above, is now forming part of the ‘declared services'. Though, service tax would be leviable only on the services portion of the works contract, in cases, where the works contractor opts to claim deduction towards labor and like charges, under the VAT law based on an ‘option', the new service tax law prescribed much higher percentages towards the services portion of the works contracts. To cite the specific case of the provisions contained in the Karnataka VAT Rules, 2005, the works contractor is allowed to opt for a deduction of 30% of the gross receipts (excluding the cost of land) towards labour and like charges, under Rule 3(2)(m) where he does not maintain separate books of accounts. Under the new dispensation, such works contractor would be required to pay service tax on 40% of the gross receipts. The proposals contain the following table:

It is clear that the above scheme would result in the same part of the transaction getting taxed both under VAT and under service tax. Under the VAT law, the deduction towards labour and like charges, when separate books are not maintained, does not exceed 30%. In the light of the fact, under the new dispensation, the minimum value specified would be 40% for the services component (this is 60% in the case of other works contract), between 10% and 30% of the total value of the transaction value would get taxed both under VAT as well as, under service tax, thereby significantly adding to the overall service tax element.

The Government would now seem to further reinforced its plan to continue with the scheme of levying service tax on the land value also, in terms of the amendments proposed for taxation of works contracts. It is however, not clear, if the works contractor would be entitled to opt for any of the three schemes given above, on a contract to contract basis.

It has also been provided that free supplies of materials would be included for purpose of arriving at the gross amount charged, for levy of service tax, under the new dispensation.

Service tax leviable if there is more than one residential unit

Under the existing law, service tax is leviable only on construction of residential complexes and a residential complex is defined to mean, interalia, more than 12 residential units. In terms of the negative list notified by the Government, exemption is being granted to services provided to construction of original works pertaining to single residential unit otherwise than as part of a residential complex. Hence, except for single units or single building having a single residential unit, service tax would be leviable on all other transactions. The definition of residential complex has also gone a change, with a restricted meaning now.

Thus, practically, all of the residential construction transactions would now come under the service tax law. This is another bignegative news for the Realty Sector as even smaller projects would come into the service tax net.

Trading in immovable property might also get covered

Under the proposed new dispensation, exemption is allowed only in respect of trading in goods. Going by the main definition of ‘service', it would seem that, trading in apartments/immovable property would also be considered as a ‘service', so long as the activity does not constitute a mere transfer of title. Thus, second and subsequent sales of apartments/flats could come under the service tax net, if it can be established that the transaction is not one of mere transfer of title of immovable property.

Construction for self/personal use also taxable now

In terms of the Budget proposals, exemption from levy of service tax is available only for Government or Local Authority, MPs, MLAs, Constitutional Authorities, etc. This would mean that, the concept of exemption being available for construction for ‘personal use' would not be available. Consequently, construction of residential units by a company for its employees would also be taxable. It would no longer be possible to take a view for claiming exemption on the basis that the complex is being used for personal use.

Developers of commercial/industrial complexes liable to pay service tax on electricity distributed/transmitted

In yet another obnoxious development, the Budget specifies, under the negative list of services, transmission or distribution of electricity by an electricity transmission or distribution utility. This could mean that, Developers /Landlords who are required to provide back-up power and distribute/transmit power obtained from the Electricity Boards, etc., could be liable under service tax, as the exemption from levy of service tax is available only for public utility undertakings. The TRU Circular makes it clear that Developers would be liable for service tax for the electricity transmitted/distributed except operating under a distribution license given under the Electricity Act, 2003.

Developers would be liable for full service tax on composite transactions/other works contracts

Under the new service tax dispensation, the only works contracts that are recognized for providing exemption towards the ‘goods' element are those in respect of construction, erection, commissioning, installation, etc. It has also been indicated that, exemption in respect of the goods portion is also available in respect of catering services. Except for these, the Government has stated that, the entire value of the consideration would be subjected to the service tax levy, not-withstanding the fact that, under the VAT law, many of these transactions are recognized as works contracts. In other words, most composite transactions which are recognized as works contracts under the VAT law, would not be recognized as works contracts under the service tax law.

The Government has also stated that Notification No. 12/2003 would get withdrawn. This would mean that, many transactions undertaken by Developers/Builders, in respect of which, exemption is currently available in respect of the ‘goods portion' under the current law, would get taxed on the full value including the value of the ‘goods', resulting in a significantly increased dosage of service tax, on composite transactions.

Before parting …

The overall impact of service tax for the Realty Sector is bound to go up significantly, both in terms of the increase in the rate as well as, due the extensive coverage of the Realty Sector under the service tax net.

Developers/Builders would do well to revisit their agreements and bring all possible activities under the works contract transaction as any transaction which cannot be treated as a ‘works contract' involving transfer of property in goods taxable under the VAT law, would get charged at the rate of 12.36%. Specific examples would include preferential location charges, floor rise charges, etc.

Developers/Builders would need to fine tune their strategies vis-à-vis VAT, in the light of the new service tax provisions, especially, in terms of claiming deduction for labour and like charges under the VAT law. In some cases, it would be better for Developers to claim deduction towards labor and like charges, on the basis of actuals rather than, on the basis of the fixed percentages specified, under the VAT law, given the impact on service tax.

Developers/Builders who enter into single agreements for sale of flats, etc. would have no choice but to pay service tax on 25% of the total consideration including the value of land, when the break up between the land value and the construction cost is not clearly shown / demarcated. This could work out to high figures, in the case of projects with a high component of land cost. Developers, in some cases, might be better off, following the two agreements system, viz. one each for the sale of undivided portion of land and for construction of the flat, as the service tax element on 40% of the total value excluding the value of land might be lower than 25% of the total transaction value including the value of land.

As compared to the huge negatives, the Budget does seem to have some very minor positive features like the interest subsidy for the smaller housing loans, exemption in respect of construction for Government projects,

I don't know if I have justified the repetitive usage of the word ‘hugely' in the topic.

(The Author is Director, S3 Solutions Pvt Ltd, Bangalore)