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Service taxation of works contracts
April, 14th 2008
The issue of the appropriate taxation of the material and non material (labour/services) elements of a works contract has been a contentious matter for a long time.
The decision of the Supreme Court in Bharat Sanchar Nigam Ltd versus Union of India (2006 (2) STR-161), was a landmark one in that it held that value-added tax (VAT) and service tax were mutually exclusive and would operate in their respective domains.
It held that a transaction in its entirety could not be charged to both taxes and that consequently double taxation of a single transaction, comprising both services and transfer of property in goods, was impermissible. This principle is particularly relevant for understanding the treatment of works contract for the purpose of indirect taxes.
A recent decision of the Supreme Court in Imagic Creative Pvt Ltd versus Commissioner of Commercial Taxes (2008 (9) STR 337), has reaffirmed this principle in relation to a particular category of works contract. The Court had to address the question of whether the charges for conceptualisation and design of advertising material on which service tax had already been paid would be eligible to VAT under the relevant state VAT law.
The Kerala High Court had upheld the advance ruling in the matter that since the advertising material so conceptualised and created was undoubtedly sold, in that property in such materials stood transferred from the advertising agency to the customer who had commissioned the work, VAT would be chargeable on the whole contract, which was held to be an indivisible one.
The High Court took note of the judgements of the Supreme Court in the Associated Cement Company (ACC) case (2001 (128) ELT-21) as well as the Tata Consultancy Service case (2006 (3) SCC1) and held that the aforesaid activity did amount to an indivisible contract and was hence chargeable to VAT.
The Supreme Court, on appeal, set aside the order of the Kerala High Court and held that in both the ACC and the TCS cases, the taxation of a works contract involving both services as also the supply of goods was not in consideration and that the issue in those cases was in relation to determination of the value of goods alone, for the purpose of sales taxation.
Accordingly, the Supreme Court differentiated the above decisions and also took note of the decision in the BSNL case and held that in a composite contract such as the one in case (importantly, the Court distinguished a composite contract from an indivisible contract) and held that the respective parameters of services and sales taxation would apply on a mutually exclusive basis.
The Supreme Court therefore held that in the instant case it was incorrect to hold, as was done by the High Court, that sales tax/VAT would be payable on the value of the entire contract irrespective of the element of service provided thereunder, on the supposed ground of indivisibility.
The Supreme Court also held that the legal fiction that was created by the Constitutional amendment, in order to bring works contracts under VAT, was to be applied only to the extent it was applicable. Thus, while the full effect must be given to the legal fiction, it should not also be applied beyond the point which was contemplated by the legislature since this would lead to either anomaly or absurdity.
Efforts should be made in interpreting a statute to ensure that a reasonable outcome was achieved and where two statutes were relevant, the provisions of both were made equally applicable. These are significant and important observations by the Supreme Court and need to be kept in mind for future interpretations of works contracts.
In another recent decision in Johny Joseph versus State of Kerala [2008] 13 VST 64), the Kerala High Court has come to the conclusion that the activity of taking photographs and developing and printing of photograph film would, in totality, constitute a works contract and would hence be chargeable to VAT.
In this decision, the Kerala High Court was again concerned with the 46th Amendment to the Constitution which was made in order to empower the State to bifurcate a works contract and to levy sales tax on the value of the materials involved in the execution of such a contract, regardless of the magnitude of such value.
This case is interesting for the reason that it holds that after the decision of the Supreme Court in the BSNL case, as also in the ACC case, the erstwhile decision of the Supreme Court in Rainbow Colour Lab versus State of Madhya Pradesh [2006] 3 VST 95, was no longer good law and that the transfer of goods involved in the execution of a works contract, which was part of the deeming fiction created by the 46th Amendment, was chargeable to sales tax and that the intent of the contract was not relevant.
Purely through the deeming fiction, sales tax was applicable on the transfer of property in goods used in the works contract, regardless of its value. The High Court followed the decision of the Supreme Court in the BSNL case in coming to this conclusion. It is thus now settled that works contracts will now be chargeable to both service tax and VAT, insofar as they are composite contracts with both material and labour elements being present.
It is also equally clear that both these taxes can only be applied in their respective domains and cannot apply to the entirety of the contract. It is therefore incumbent on works contractors to ensure that they appropriately discharge their liabilities to the two taxes, as according to the options available under the respective statutes.
S Madhavan
(The author is Leader, Indirect Tax Practices, PwC. Views expressed are his own)
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