Correlate activities and considerations to avert double tax in EPC
October, 11th 2008
Appropriate structuring of EPC (engineering, procurement and construction) contracts is essential to minimise both direct and indirect tax costs, says Mr Satish Aggarwal, Partner, Ernst & Young. He suggests that the establishment of one-to-one correlations between the individual activities and the considerations payable would help minimise the possibility of double taxation, something highly undesirable especially in the context of infrastructural projects such as construction of dams, power plants, urban housing facilities and other areas of national importance.
For starters, the concept of EPC is quite common in the infrastructure, real estate and industrial construction sectors. EPC contracts include all activities ranging from initial conceptualisation and design, providing or procuring the required goods and services from various sources, to construction, installation and commissioning of the project, explains Mr Aggarwal, in the course of a recent email interaction with Business Line.
These contracts are also often referred to as lump-sum turnkey contracts as they envisage the project owner merely having to turn a key to commence operations upon completion of the contract. EPC contracts thus have multiple facets requiring the contractor to perform a wide array of diverse yet integrated activities.
Excerpts from the interview.
What is the international practice with regard to EPC taxation?
Internationally, the determination of taxes leviable on EPC contracts is relatively simple. For example, in the EU countries such as the UK, France and Germany, VAT (Value Added Tax) is levied at a single rate on both supply of goods and provision of services. This makes it largely irrelevant to segregate the contract into components pertaining to goods and services.
Currently, India is one of the few jurisdictions in the world where EPC contracts are subjected to separate taxes on goods and services.
However, with the possible introduction of GST (Goods and Services Tax) in the country by 2011 in the place of taxes such as VAT, CST, Service Tax and Excise Duty we can expect the complicated tax structure currently in place for EPC contracts to be simplified.
How does our tax regime approach EPC contracts?
In India, taxation of EPC contracts is determined on the basis of the activities involved in each contract. Broadly, an EPC contract is divided into two parts, viz. offshore activities and onshore activities.
Direct taxes are levied on profit derived by a company from executing the contract, while indirect taxes are levied on specific transactions such as Customs Duty on imports, Excise Duty on manufacture of goods, Service Tax on the provision of services, and Central Sales Tax (CST)/ VAT on the sale of goods.
What is your view on the segregation approach?
While from a direct tax perspective, segregation of activities between what are done offshore and onshore is important, from an indirect tax perspective, segregation of the activities to be performed under a single contract is imperative in order to ensure that the appropriate taxes are paid on the various individual components of the contract.
In the absence of such segregation, the possibility of double taxation on various components, or litigation with the tax authorities, cannot be ruled out.
On the direct tax front, is there clarity for the EPC players?
From a direct tax perspective, interpreting the law based on certain judicial precedents, no tax liability arises where, for example, the sale of equipment takes place outside India and the title is transferred outside India.
In other words, if the entire activity related to supply of equipment is carried out from outside India and no part of this work is done from within India, there should not be a direct tax liability in India on such supply.
This issue, however, is not free from doubt, being fact-specific; and numerous companies are engaged in litigation at various levels with the Revenue authorities in this regard.
What would you, therefore, advise as precautions to be taken?
To mitigate the taxability of sale of equipment from outside India, it is important to ensure that the contract clearly brings out the distinction between the onshore and offshore activities and the considerations payable in respect of each.
It is also important to ensure protection from the possibility of being treated as an Association of Persons where the contract is being executed by a consortium consisting of two or more parties.
For this purpose, the contract should clearly and separably specify the scope of work, related remuneration, and roles and responsibilities in respect of each party apart from other things.
Consortia are common in EPC
True. A majority of the EPC contracts in the infrastructure sector these days are awarded on the basis of international competitive bidding (ICB), where a large number of international and Indian entities participate in the bidding process.
Depending on various factors such as complexity, size and requirement for highly specialised execution, ICB procedures may be of two types, i.e. where individual segments of the contract are awarded to specialist contractors, or the entire contract is awarded to a single bidder.
It has also become fairly common for contracts to be awarded to a consortium of companies, where each consortium member specialises in one of the individual segments of the contract.
As for the indirect taxes, what are the issues?
With regard to indirect taxes, where the individual elements of an EPC contract are clearly identifiable, determination of chargeability to various taxes is relatively easy. In the case of such separable or divisible contracts, the individual components of each contract may be examined for ascertaining the appropriate levy and the taxable amount attributable to each transaction.
Can such splitting-up pose difficulties, at times?
The integrated nature of activities involved in the execution of composite or indivisible EPC contracts poses a few problems, when the contract is sought to be segregated into individual segments for the purpose of levying taxes.
In most cases, the contracts are an amalgamation of individual activities which cannot be delinked from one another.
Further, the flow of payments is usually staggered over the duration of the contract, and may not always relate to the individual activities. There may be a situation where the payments are milestone-based, i.e. based on completion of specific stages in the course of the entire contract, or even timeline-based. This further complicates matters of taxation, as it would be a formidable task to accurately determine the amount attributable to specific transactions such as supply of goods, provision of services etc.
Do our tax laws have provisions that help avert double taxation of EPC contractors?
At present, there is no umbrella legislation in force which would levy a single tax on the composite consideration paid for the multitude of activities that constitute an EPC contract. However, certain tax legislations do provide certain options to EPC contractors to determine the specific taxable amounts, in order to ensure that only the appropriate amounts are taxed and there is no overlapping or double taxation.
Take, for instance, VAT. This is leviable only on the value of goods supplied in the course of execution of an EPC contract. Accordingly, the state VAT legislations provide for a deduction of the amount attributable to labour and services provided, from the total contract value.
In cases where such amounts are not clearly quantifiable, the deduction may be taken as a prescribed percentage of the total contract value, or alternatively, tax may be paid at a lower rate on the entire contract value under a composition scheme.
Correspondingly, Service Tax laws provide for a deduction of the value of goods supplied from the total contract value, with Service Tax being levied only on the value of services provided by the contractor. Alternatively, Service Tax may be paid at a lower rate on the entire contract value, under a composition scheme.
Do EPC contractors still end up paying excess taxes?
Yes. In the case of indivisible EPC contracts, which have services as an unusually greater component as compared to supply of goods, or vice versa, excess taxes would invariably have to be paid in respect of one or more levies.
This is because the options currently available under various legislations do not ensure complete accuracy in segregation of the composite consideration, though the legislative intent is clearly to facilitate accurate calculation of the taxable amount under each levy.
Empirical research has shown that tax payable under composition schemes and under the general provisions would be the same, only if the amounts attributable to goods and services are in a particular proportion to each other.
Accordingly, as far as commercially feasible, contracts should be structured in a manner that the activities and payments relating to supply of goods and provision of services, respectively, are separately identifiable.