Wednesday, February 17, 2010

Service Tax and Works Contracts


A recent decision of the Punjab and Haryana High Court Commissioner of Central Excise v. Vahoo Colour Lab clarifies the scope of service tax in the context of works contracts. Issues around works contracts have been controversial in relation to income tax as well as sales tax. The controversy in income tax law (in relation to TDS under Section 194C) has been discussed here; and the issue of sales and service tax on software has been discussed here. Insofar as sales tax is concerned, the controversy has been over legislative competence. Certain contracts – works contracts being one such example – have elements of transfer of property as well as service. Are they to be taxed, then, as a sale of goods or as a rendering of services? The difficulty arises because the States have the competence to tax sales of goods; while the Union has the competence to tax services.

The issue was discussed by the Supreme Court elaborately in the context of building contracts, in State of Madras v. Gannon Dunkerley, AIR 1958 SC 560. The Court held that the concept of ‘sale’ must be given its legal understanding for the purposes of ascertaining legislative competence; and involved three elements – (a) the objective existence of goods; (b) the intention of the parties to transfer title in those goods; (c) actual transfer of title in furtherance of that intention, supported by consideration. It was held that a tax on an alleged sale of goods in building contracts would be outside the legislative competence of states. In an elaborate judgment, Justice Venkatrama Aiyar said, “We are… of opinion that on the true interpretation of the expression "sale of goods" there must be an agreement between the parties for the sale of the very goods in which eventually property passes. In a building contract, the agreement between the parties is that the contractor should construct a building according to the specifications contained in the agreement, and in consideration therefore receive payment as provided therein… there is in such an agreement neither a contract to sell the materials used in the construction, nor does property pass therein as movables. It is therefore impossible to maintain that there is implicit in a building contract a sale of materials as understood in law…” Applying this logic, a typical works contract would not involve a sale of goods.

Subsequent to the decision, Article 366(29A) was inserted into the Constitution of India, which laid down several categories of ‘deemed’ sales. It was provided that a “tax on the sale or purchase of goods” would include inter alia a “tax on the transfer of property in goods (whether as goods or in some other form) involved in the execution of a works contract.” To this extent, then, the decision in Gannon Dunkerley was overridden. It must be stressed, however, that the principle of Gannon Dunkerley would continue to apply outside of the specific categories mentioned in Article 366(29A). As Justice Ruma Pal stated in BSNL v. Union of India, “Gannon Dunkerley survived the 46th Constitutional Amendment in two respects. First with regard to the definition of 'sale' for the purposes of the Constitution in general and for the purposes of Entry 54 of List II in particular except to the extent that the clauses in Article 366(29A) operate. By introducing separate categories of 'deemed sales', the meaning of the word 'goods' was not altered. Thus the definitions of the composite elements of a sale such as intention of the parties, goods, delivery etc. would continue to be defined according to known legal connotations” The only change is where the amendment specifically includes the concept of deemed sales. Works contracts are one such element; and states do have the competence to levy sales tax on works contracts. The extent of taxability was again discussed by the Supreme Court in Imagic Creative, (2008) 2 SCC 614.

Imagic dealt with whether the charges collected towards the services for evolution of a certain design, on which service tax had been paid under the relevant provisions of the Finance Act, 1994 were also liable to tax under the Karnataka Value Added Tax Act, 2003. The Court held, “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.” Thus, the Court held that sales tax would not be payable on the entire value of the contract – the service element must be calculated; and sales tax would be payable on the remainder.

Before the Punjab and Haryana High Court, the question was similar – except that here, the Court had to determine the extent to which service tax would be payable (as opposed to the extent of sales tax as in Imagic). The case involved the question of “whether the assessee is liable to pay the service tax on the value of goods/material consumed, during the course of processing of photography or not…” The Court began by noting that the photography contract was to be treated as a works contract [this is settled law now, but earlier there was a controversy – see Rainbow Colour Labs, 118 STC 9 (SC) and Associated Cement v. Commissioner of Customs, 2001 JT (2) SC 141]. Next, it interpreted BSNL as having laid down the principle that “if the nature of transaction involved is composite contract, of service and sale and if the components of sale element are discernible, then both the components cannot be re-mixed for the purpose of relevant tax.” Consequently, a result analogous to Imagic was reached; and the Court held that service tax and sales tax operate in two different spheres; and service tax would be payable only on the service component and not the whole amount of the consideration.

The decision illustrates that as a matter of law, the confusion in this area is on its way to being cleared. Nonetheless, there might still be several difficulties in ascertaining what part of the consideration is to be attributed to the service element and what part is to be attributed to the sale element. Hopefully, these difficulties will be cleared by the comprehensive Goods and Services Tax.

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