By Sunil B. Gabhawalla, Chartered Accountant
Article
1. Composite Contracts — Introduction :
A composite contract is one which has constituent elements
but the customer is interested in the final outcome of the contract. In such a
contract, the constituent elements are so integrally connected and
interdependent with each other that it is not feasible to look at the elements
in isolation. Such composite contracts may also include minor elements which are
incidental and ancillary to the main objective of the contract. Such elements of
a composite contract are to be treated as means of attaining the ultimate object
of the contract. For example, in a turnkey contract for design engineering,
procurement, construction, installation and commissioning of a power plant, the
individual element of engineering cannot be viewed in isolation of the
procurement, construction, installation and commissioning. In a lighter vein,
one can say that the icing on the cake cannot be viewed separately from the cake
itself !
1.1 Works Contracts — Species of Composite Contracts :
Composite contracts involving both the supply of materials
and rendering of services (in reasonably dominant proportions) are known as
works contracts. A turnkey contract of the nature referred to above is a good
example of a works contract. In a works contract, there is a transfer of
materials from the contractor to the employer/contractee, however, the said
transfer is not by means of sale.
In a works contract, the contractor agrees to perform some
work on the client’s property (may be moveable or immoveable). The performance
of work also involves the use of some materials of the contractor. As the
contractor uses these materials to perform the work, the materials get attached
to the property of the client in such a fashion that such contractor’s materials
can no longer be removed without substantial damage either to the contractor’s
materials or the contractee’s property. Since the property which is the subject
matter of the work belongs to the client, the ownership of the materials so
attached on the property passes on to the client albeit in an indirect fashion.
1.2 Accretion :
Consider the case of a building contractor who constructs a
building on the land of the client using his owned bricks, sand, cement, etc.
Till the stage he applies the cement on the land and lays a brick on it, the
cement and brick belongs to the contractor. But once the cement paste and the
brick are applied on the land, these ingredients fasten themselves to the land.
It is then not possible or viable to remove the cement or brick from the land
(without fundamental damage). Since the land belongs to the contractee, the
ownership in the cement and brick gets transferred to the contractee by
inference and not by way of sale. This process of the contractor’s materials
getting embedded in the client’s immoveable property is referred to as the
transfer of ownership in goods through the process of accretion.
1.3 Accession :
Consider another example of a garage undertaking to paint the
car of its client. Similar to the earlier example, till the stage the garage
applies the paint on the car, the paint belong to the garage. But once the paint
is applied on the car, the liquid paint gets attached on the metal of the car.
It is then not possible to remove the paint without fundamental damage. Since
the car belongs to the client, the ownership in the paint also gets transferred
to the client by inference. This process of the contractor’s materials getting
embedded in the client’s moveable property is referred to as the transfer of
ownership in goods through the process of accession.
1.4 Blending :
One more situation of works contract could be a case where
multiple moveable products owned by the contractor are ‘blended’ together to
create a new moveable product which is non-marketable in nature. Consider the
case of a printer who uses paper and ink to print cheque books for its client
bank.
In this case, the transaction cannot constitute a sale
because cheque books are not marketable and there-fore are not goods. However,
the properties in the paper and the ink have passed on to the bank the moment
the printer blended these two moveable products. Thus, there is a transfer of
the ownership in goods through the process of blending.
2. Nature of Indirect Taxes and applicability to Composite Contracts :
At this juncture, it may be relevant to broadly classify the
indirect taxes based on the nature of the taxes. At one end of the spectrum are
duties on goods like customs duties and excise duties which are levied on
specified activities i.e., the activity of import/export of goods or the
manufacture of goods. Since the levy of duty is on an activity and not on a
transaction, it is apparent that the duty is attracted irrespective of whether
the product constitutes an end in itself or a means to an end.
At the other end of the spectrum are taxes like sales tax
(VAT) and service tax which are levied on specified transactions i.e.,
the transaction of sale of goods or the provision of services. Since the levy of
the tax is on a transaction, one has to look at a transaction. A transaction is
the cake itself (i.e., the end) and not the icing on the cake (i.e.,
the means to an end). This therefore suggests that for taxing the transaction,
one looks at the tax implications on the cake and not on the icing !
3. Composite Contracts — Judicial Thinking :
Before proceeding any further, it may be relevant to look at
the judicial thought process on this aspect.
In a landmark case1
pertaining to sales tax, the Supreme Court held that a building contract is one
entire and indivisible contract; there is no sale of goods as a separate
contract. A series of judgments of the High Courts and the Supreme Court
followed this case taking the same view.
In another situation, the contract provided for progressive release of payments dependent on the stage of execution of a particular component. The Supreme Courf observed that in an indivisible, composite contract, it is not possible to vivisect the same. The Court accepted the commercial practice in spreading the contractual payments over the entire period of the execution of the contract and held that progressive release of payments would not have any bearing on the nature of the contract.
In a case pertaining to income tax, an Indian company entered into separate contracts with the foreign company for purchase of equipment and for supervision of erection, start-up, putting into commission, etc. of the equipment. The A.P. High Court held that the terms of the separate agreements clearly showed that it was one and the same transaction. One could not be read in isolation of the other. The considerations for services in connection with the supervision of erection, start-up, putting into commission, etc. were part of the payment of the sale price of the equipment. Thus, in spite of two separate contracts, the High Court considered these as part of single sale transaction.
In a landmark judgment? pertaining to service tax, the Department tried to levy service tax on the drawing, designing and commissioning activities, for which separate amounts were indicated in the price break-up in the turnkey contract. Negating such attempt, the Tribunal held that the contract between Daelim and IOCL was a works contract on turnkey basis. It cannot be vivisected for subjecting a part of the contract price to service tax.
From each of the above decisions, it is amply clear that the judiciary has consistently looked at composite contracts as a whole and has not permitted a vivisection of such composite contracts.
4. Constitutional Amendment & Implications under VAT:
On the basis of recommendation of the Law Commission, the Parliament passed 46th Constitutional Amendment, introducing a legal fiction by defining ‘tax on the sale or purchase of goods’ in Article 366(29A) to include certain types of deemed sales. Thus, the following non-sale transactions were brought within the service tax net:
(a) Non-voluntary transfer of goods for consideration
(b) Transfer of property in goods involved in the execution of works contract
(c) Delivery of goods on hire-purchase or instalment payments
(d) Transfer of right to use goods
(e) Supply of goods by unincorporated association or body to members for consideration
(f) Supply of food or beverage by way of or as part of service.
With respect to works contracts, one of the deemed sales, in view of the above amendment, sales tax/VAT could be levied on the value of the supply portion of the contract. Thus, there is a sale of the goods supplied in the execution of works contract for the limited purpose of sales tax/VAT. In this sense, through legal fiction, an indivisible composite contract becomes divisible. However, the Supreme Court” has held that the 46th Constitutional amendment is valid only for those entries in the three lists in the Seventh Schedule where the expression ‘tax on the sale or purchase of goods’ appears. Effectively, the amendment is applicable only with respect to sales tax/VAT law and not for any other law. This amendment has not brought any change in the normal legal meaning of ‘sale’. Therefore, for purposes outside sale tax/VAT, the concept of indivisible composite contract continues to be valid. Further, the Supreme Court”, held that even after the 46th Constitutional amendment it is not permissible to split composite transactions except in the case of works contracts and supply of food and beverages as part of the service in restaurants and hotels for sales tax/VAT. In other words, the principles enunciated in Gannon Dunkerley & Co. case, survives for purposes other than tax on these two deemed sales introduced by the Constitutional amendment.
5. Implications under Service Tax -before 1-6-2007:
The above discussion brings to light a question regarding the applicability of service tax provisions to composite contracts. Over a period of time, there has been a gradual expansion in the scope of taxable services. Some relevant service categories are listed in the table below :
Right from the time the category for taxing consulting engineering services was brought into the Statute, there were constant attempts to levy service tax on the ‘consulting’ element of the composite contracts. While the 46th Constitutional Amendment permits the States to levy tax on transfer of goods involved in the execution of a works contract, no specific authorisation is available to the Centre for artificially vivisecting such contracts for the purpose of levy of service tax and hence the Courts have consistently held that composite contracts cannot be made liable for service tax? under the category of consulting engineering services.
Since 2003, the Legislature has gradually expanded the scope of taxable services to cover various activities involving performance of work. From an industry perspective, such performance of work could be either on a stand-alone basis or as an element of a composite contract. While there were no doubts on the coverage of activity done on a stand-alone basis (‘labour job’), there was uncertainty on the coverage of the activity done as a component of a composite ‘works contract’.
The Department interpretation at that stage was to argue on the principle of aspect theory and suggest that the levy of service tax was, in principle, in order. To address the issue of valuation and cascading impact of taxes, the Department provided the following alternatives:
1. Discharge of service tax on the full value of the contract with corresponding credit of duties/taxes paid on inputs and input services
2. Discharge of service tax on the value of the service component (by identification and reduction of the value of the goods sold) with corresponding credit of taxes paid on input services
3. Discharge of service tax on a presumptive value of the service component (i.e., 33% of the gross value of the contract) with no credit of taxes paid on inputs/input services.
Notwithstanding the above mentioned options, can it be argued that there really is no authority to levy a service tax at all in the absence of a specific constitutional amendment? After all, even for levy of sales tax, a Constitutional amendment was required and it has already been held that the Constitutional amendment has only restricted applicability vis-a-vis sales tax laws.
The answers to the above questions could be debatable and would depend on whether one treats a works contract as a whole as constituting an activity and therefore a service (View 1) or one looks at works contract as independent of both goods and services (View 2).
In case View 1 is adopted, the levy of service tax can be said to be effective from the date the respective category for execution was introduced, say construction service. All the three alternate options for discharging the tax liability would ensure that there is no cascading effect. In case View 2 is adopted, the levy of service tax would actually require a Constitutional amendment.
Before the dust could settle down on the said controversy, the judiciary was flooded with a plethora of cases wherein the Department’s attempt to tax the services embedded in a composite contract was challenged. In fact, the Bangalore Tribunal went ahead and held that a composite contract cannot be vivisected to levy a tax on the erection, commissioning and installation component of the said composite contract”.
6. Implications under Service Tax – from 1-6-2007:
In order to overcome the above controversy and specifically provide for a mechanism to tax the service component of a works contract, a new category of service was introduced with effect from 1-6-2007 to tax specified works contracts.
However, as highlighted earlier, in case a view is taken that the service component is embedded within a composite contract, the composite contract cannot be vivisected merely by insertion of a taxable category of service. Hence the levy of service tax under the category of ‘Works Contracts Services’ can be constitutionally challenged.
If one holds the conservative view that the entire composite contract is a service, there was really no need for the introduction of the category of ‘Works Contracts Services’, since the basic categories were wide enough to cover the impugned transactions. In either of the situations, the introduction of the category of ‘Works Contracts Services’ becomes redundant. The law cannot be interpreted to bring about redundancy in any of the provisions.
Therefore it can be strongly argued that the levy of service tax is not constitutionally valid even after the introduction of works contract services as a category, since the Legislature does not have the authority to vivisect a composite contract.
7. Non-Vivisection – Practical Ramifications:
While there is a strong legal justification to challenge the applicability of service tax on works contracts, a business needs to evaluate the position taken from a practical perspective. Being an indirect tax, any aggressive position taken can result in an opportunity cost (since the tax would have been recovered from the client in the case of a conservative position). Further, the availability of CENVAT Credit to both the service provider and service recipient (in many cases), effectively results in no additional cost on account of adoption of a conservative position. Thus, one may reconcile the position to accept the levy of service tax under the category of ‘Works Contract Services’ with effect from 1-6-2007.
With the introduction of a new category to tax only speCified works contracts, it can be argued that the Legislature accepts the principle that the works contracts could not be taxed under the basic category itself and therefore the new category was created. Therefore, no service tax was payable in the past periods in cases where works contract tax was payable. This view has already found favour with the judiciary 10. Thus, one can safeguard the liability for the past periods.
8. Conclusion:
The article tries to explain in a nutshell the theory of non-vivisection of composite contracts and its ramifications vis-a-vis levy of service tax on works contracts. It does not deal with the issues concerned with valuation and claim of credit, since they are secondary to the basic issue of levy of service tax itself.
The article also does not deal with the tax implications of other types of composite contracts wherein, say, multiple services are bundled. Over a period of time, the law will evolve. It appears that a long-term solution could be to have an integrated Goods and Service Tax with a comprehensive coverage of all supplies of goods and services. Till the time such a GST regime is evolved, these issues will continue to present uncertainty for the industry.
It is a challenge to both the profession and the business to confront and comply with uncertainty.
