GUEST COLUMN

 

Taxation of Works Contracts – Fate under Model GST law?

 

By

Jigar Doshi - Partner, Sudit K. Parekh & Co.

Sunny Kachalia - Sr. Manager, Sudit K. Parekh & Co.

 

Works contract, which is essentially an activity involving provision of service along with transfer of property in goods has been permanently enmeshed in controversies both at the central and state level indirect taxes i.e. Service Tax and Value Added Tax (VAT) respectively. Such controversies exist on several fronts – whether the works contract is divisible or composite, tax deduction at source, treatment of subcontractors, determining proportion of goods and services and double taxation due to imposition of both state and central taxes.

 

The genesis of dispute can be traced to the constitution which grants the power to tax services to the Central Government whereas the power to tax transfer of property in goods vide the 46th amendment under article 366(29A)(b) of the Constitution of India is with the States. The 46th amendment was introduced pursuant to the Supreme Court ruling in the case of Gannon Dunkerly & Co 1958-VIL-01-SC, wherein it was held that State Government could not levy sales tax on Works Contract, lease contracts, etc. The complexity has only escalated with divergent court rulings over the years. This has resulted in severe hardships for genuine tax payers and nowhere does the cascading effect of multiple indirect taxes pinches as much as much as it does in works contract transactions in the light of restriction in input tax credits, increased compliances, ambiguities in provisions etc. The persisting tax uncertainty in the value chain involving works contracts has had a damaging impact on the economy and the dream of a stable and predictable indirect tax regime.

 

The Apex court in the case of Hindustan Shipyard Ltd. 2000-VIL-02-SC propounded the dominant intention theory wherein it was held that there could be three types of contract involving transfer of goods:

 

-         Supply of Materials and Labour

          (eg Construction of a building, roads, bridges, dams, etc)

          It is a works contract. It could be divisible contract or an indivisible contract.

 

-         Supply of labour wherein supply of materials is incidental to the contract (also referred to as Service contracts)

         (e.g. Painting, cleaning, overhauling, lubricating, greasing of an old machinery, tailor doing stitching work, etc.)

         It is not a Works Contract since predominant objective is to get services and not to buy/ sell any goods.

 

-         Supply of goods wherein some work is required to be done incidental to the sale

          (e.g. Supply and Installation of Air conditioners, etc.)

 

The above matter was analysed in detail by the Constitution Bench of the Supreme Court in the recent case of Kone Elevator India Pvt Ltd 2014-VIL-12-SC-CB, on the question whether installation is incidental to the supply of lift. The dominant nature theory for treating a contract as a works contract was rejected and it was held that that the activity of assembly and installation cannot be regarded to be incidental or ancillary to supply of goods since same is a contractual obligation requiring high level of skill and precision. It was held that the term “works contract” as used in Clause (29A) of Article 366 of the Constitution takes in its sweep all genres of works contract.

 

From not being taxed at all to the levy of tax on sale portion, and finally levy on service portion, works contract disputes have come a long way. Given the fundamental change promised by the impending GST regime, it would be interesting to witness the journey of works contracts. Under the Model GST law works contract is defined under Section 2 clause 107 as –

 

“works contract” means an agreement for carrying out for cash, deferred payment or other valuable consideration, building, construction, fabrication, erection, installation, fitting out, improvement, modification, repair, renovation or commissioning of any moveable or immovable property;”

 

Additionally, works contract is explicitly treated as supply of service under Schedule II – Point 5(f) of the Model GST Law.

 

Further, as per ‘Schedule II’ 5(b) of the Model GST Law, following shall also be treated as supply of service

 

“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 has been received after issuance of completion certificate, where required, by the competent authority or before its first occupation, whichever is earlier.”

 

Accordingly, it is hoped that the primary question of litigation i.e. to decide the character of contract whether it is a service, sale or composite contract should come to an end under the proposed GST regime.

 

The current complexities i.e. whether to adopt composition scheme, deduction method or actual bifurcation of contract into goods and service portion to select the least tax cost alternative should also come to an end unless some nasty surprise is thrown by way of any rules, notifications, etc. GST with the promise of being a comprehensive single tax rate regime, it should be hoped that the cumbersome calculations and permutations and combinations would be done away with. The model GST law provides for composition levy in case the turnover of a taxable person does not exceed Rs fifty lakhs in a financial year. Input tax credit shall not be available in such case. However, there is no clarity whether the composition levy would apply to works contract transactions as the modalities of the same shall be prescribed on the recommendation of the GST council and rules notified by the Central / State Governments.

 

Under the current Service tax legislation, a works contractor has an option to pay service tax at 15% on 40% / 70% of contract value (ie effective rate being 6% / 10.5% of contract value) or 15% on the actual value of service. Further, under VAT legislations, typically a contractor has multiple options / methods for determining goods portion of works contract. If the composition scheme is adopted by a contractor, the rate applicable could range from 1% to 8% of contract value (varies state to state). If the contractor opts for standard deduction, VAT is payable on 70-80% (in Maharashtra) of the contract value (ie effective rate being 9-11% of contract value). Model GST law being a comprehensive single tax rate regime, there is a possibility that the estimated GST rate (18% - 20%) can prove to be an increase in tax cost. However, the comparison of effective rate on works contract transactions as per current law vis-à-vis proposed GST law would depend on the nature of contract and method of valuation adopted under VAT and Service tax.

 

Further, under the current Service tax and state VAT legislations, there are several restrictions on availing input tax credit along with compliances such as TDS returns. However, the Model GST Law being a liberal credit regime, contractors should be able to avail input tax credit seamlessly throughout the value chain. However, it is important to note that section 16(9)(c) restricts input tax credit of goods and services acquired by the principal in the execution of works contract when such contract results in construction of immovable property (other than plant and machinery). The said provision may break the credit chain leading to increase in tax cost for the contractors.

 

Further Model GST law is silent in relation to various exemptions under current Service Tax regime for construction of specified properties such as construction of dams, airports, etc and on exemptions provided to a sub-contractors under VAT laws if the main contractor undertakes to discharge the liability.  It is expected that the clarity on the same would be provided at the time of finalisation of the law. Also, another matter which requires clarity is with regard to classification of activity as job work or works contract under GST law as the two have similar characteristics.

 

Further, implementation of GST would entail requirement of multiple registrations and would lead to increase in compliances for businesses. Accordingly, though implementation of GST seems advantageous, it would also pose challenges to businesses and set the ball rolling in terms of preparation on impact on business model and IT systems reconfiguration. In this context, it would be essential for contractors to restructure their operating models and get their pricing right in order to remain competitive in the market.

 

Thus, considering the overall impact of the draft GST law on works contracts, it appears to come with a package of both promises and concerns. Whereas the assesses were overburdened by the uncertainty and double taxation under VAT and Service Tax, unambiguously classifying works contracts as supply of service is undoubtedly a welcome move. It will be worthwhile to watch whether multiple rates under the GST regime could create any complexities for assesses. While the entire country is waiting with bated breath whether GST would be implemented in India on April 1, 2017 or not, it is time that businesses start reviewing their composite contracts from a fresh perspective. All eyes are on the monsoon session of Parliament in which it is expected finally that the constitutional amendment bill would see the light of day.  

 

Disclaimer: Views expressed are strictly personal. The content of this document are solely for informational purpose, it doesn’t constitute professional advice or recommendation.