CONTROVERSY : DIVISIBILITY OF WORKS CONTRACT

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Introduction
There has been long drawn controversy over the issue of taxability of works contract prior to the introduction of works contract service (WCS) in sub-clause (zzzza) in section 65(105) of the Finance Act, 1994 (the Act) with effect from 01/06/2007. The dispute dates back to the pronouncement of decision in Daelim Industrial Co. vs. CCE 2003 (155) ELT 457 (T). The controversy primarily relates to whether or not works contracts were taxable under the taxable services defined under the service tax law as commercial or industrial construction service (CICS)–with effect from 10/09/2004), construction of complex service (COCS) (w.e.f. 16/06/2005) or erection, commissioning or installation service (ECIS) (w.e.f. 01/07/2003). The decision in Daelim (supra) was doubted and referred to a Three Member Bench which was answered in CCE vs. BSBK Pvt. Ltd. 2010 (18) STR 555 (T) wherein it was ruled that turnkey contracts could be vivisected and service element therein could be subjected to service tax if the service was a taxable service under the Act. A contrary ruling by the Three Member Bench was however pronounced in Jyoti Ltd. vs. CCE 2008 (9) STR 373 and also in CCE vs. Indian Oil Tanking Ltd. 2010 (18) STR 577 (T). The Larger Bench in BSBK (supra) did not analyse or disagree with the operative ratio in the earlier decision of co-ordinate Benches. Therefore, BSBK (supra) could not have overruled or decided contrary to the decision by co-ordinate Benches. In this background, Larsen & Toubro while challenging an adjudication order confirming service tax demand somewhere in 2013 for execution of a turnkey contract prior to 01/06/2007, holding it as commercial or industrial service, also filed an application to refer the matter to Larger Bench in view of the above two conflicting decisions of Larger Benches. In the interim, Hon. Delhi High Court in G. D. Builders vs. Union of India 2013 (32) STR 673 (Del) ruled that after 46th Amendment to the Constitution, service portion of a composite contract could be vivisected for subjecting it to service tax by applying aspect doctrine for bifurcation of a composite contract. However, prior to this in CST vs. Turbotech Precision Engineering Pvt. Ltd. 2010 (18) STR 545 (Kar) and Strategic Engineering Pvt. Ltd. vs. CCE 2011 (24) STR 387 (Mad), it was decided that works contracts were not liable for service tax prior to 01/06/2007. Consequent upon CESTAT order referring the matter to Larger Bench, the revenue had appealed to Delhi High Court that since the issue stood resolved and decided in G. D. Builders & Others (supra) vide order dated 24/11/2013, for setting aside the order. The Delhi High Court disposed of the appeal in November, 2014 wherein consensus emerged that Five Member Bench can examine a preliminary issue whether the question raised was covered by the decision in G. D. Builders’ case (supra) and also that appropriate directions/orders could be passed after examining contrary view expressed by the Karnataka High Court and the Madras High Court in Turbotech Precision Engineering (supra) and Strategic Engineering (supra) respectively. Accordingly, the Larger Bench of five members headed by the Hon. President was constituted to look into the above limited angle. Although the reference was made for a limited purpose and applicability is confined to the period between 2004 and 2007, since the controversy over the issue is discussed at great length in approx. 220 pages interim order, the decision has assumed academic value. Various judicial precedents on the subject of works contract, taxability of sale of goods involved therein and adequacy of service tax provisions vis-à-vis works contracts vide a catena of judicial precedents have been analysed from various angles since the decision was reached in terms of majority. Discussed below are some of the key observations and views of both majority and minority members of the Hon. Larger Bench.

 Facts of The Case in Brief:
On behalf of  appellant Company, Larsen & toubro, it was pleaded that  g. d. Builders (supra) was per incuriam as it did not consider and explain several operative, relevant and binding precedents in the area and evolutionary history leading to enactment of distinct category of works contract from 01/06/2007 as several of its seminal reasons were passed sub silentio as the Appellants therein conceded that service component in a composite contract can be taxed but not as works contract per se and such other merits concerning taxability of works contract were not examined. Had the several facts of constitution limits and relevant legislative provisions, the enacting history of sub-clause (zzzza) and binding rationes been brought to the notice of the High Court, the conclusion drawn by the High Court could have been different and therefore G. D. Builders decision was based on concession by petitioners therein and did not have precedential vitality. Also, contrary decisions of Karnataka High Court in CIT vs. Turbotech Precision (supra) and Madras High Court in Strategic Engineering (supra) also need to be looked into. Revenue however contended that ruling in G. D. Builders is a binding precedent and not travelling beyond the scope of deliberations fixed by the Delhi High Court vide its order of 11th November, 2014 as contended by the Appellant. In view hereof, the facts and decision of G. D. Builders’ case (supra) as well as those of Turbotech Precision (supra) and Strategic Engineering (supra) were examined in addition to analysing the core issue of taxability of works contract prior to 01/06/2007 in terms of various judicial precedents and all the relevant provisions of service tax

Minority order: Brief Overview:
The minority order contains detailed analysis of scope of charging and valuation provision including the evolutionary history thereof and analysis and examination of a host of judicial precedents which interalia included Gannon Dunkerley & Co. and Others vs. State of Rajasthan & Others (1993) 88 STC 204 (the second Gannon Dunkerley), Larsen & Toubro vs. State of Orissa (2008) 12 VST 0031, Larsen & Toubro vs. State of Karnataka 2014 (34) STR 481 (SC) (a constitution Bench decision), K. Raheja Development Corporation vs. State of Karnataka 2006 (3) STR 337 (SC), Nagarjuna Construction P. Ltd. vs. UOI 2010 (19) STR 321 (AP). Mahim Patram (P) Ltd. vs. Union of India 2007 (7) STR 110 (SC), Bharat Sanchar Nigam Ltd. vs. UOI 2006 (2) STR 161 (SC), Kone Elevators India P. Ltd. 2014 (34) STR 641 (ST) etc. The glimpse of various inferences drawn is provided below:

In addition to examining the definitions CICS, COES and ECIS in section 65(105) and charging section 66, the scope of section 67 dealing with valuation of a service both prior to its amendment on 18/04/2006 and the amended provisions were examined and it was observed that section 67 read with the relevant clauses in section 65(105) and the charging provision leads to infer that “the gross amount charged by the service provider for providing CICS, COCS or ECIS shall be taxable value of such service.” Prior to the amendment of section 67, no exclusion was provided in section 67 on the lines of exclusion provided in Explanation 1 to section 67 that value of goods sold or deemed to have been sold in execution of works contract is excluded from the scope of taxable value referred to in section 67 as provided in clause (vii) to the said explanation for ECIS in respect of CICS or COCS.

•    Exemption  Notifications  Nos.12/2003-ST,  15/2004-ST and 1/2006-ST attest to the fact that the Central Government was clearly of the view that value of goods sold by a service provider to the recipient thereof is included in the taxable value u/s. 67. It cannot be believed that pure sale transaction simplicitor were sought to be excluded as these were anyway beyond the scope of the Union’s residuary power. Further, these exemption notifications indicate no methodology for valuation of goods sold during execution of works contract. The 2nd Gannon Dunkerley (supra) categorically ordained to exclude value of goods at the time of incorporation, the profit margin on goods, the cost of storage, transportation etc. No Board circular also was issued hinting such exclusion. Actually, Rule 2A inserted in Valuation Rules when works contract service was brought from 01/06/2007 expressly stipulates the value of taxable service to be determined with reference to WCS provided in (zzzza) of section 65(105). Thus, on its terms, Rule 2A has no application to CICS, COCS or ECIS even after 01/06/2007 whereas after 01/06/2007, CICS, COCS and ECIS continue to be taxable services and there is neither repeal nor omission of these services.

•     The definition of CICS, COCS and ECIS do not signal to cover works contract.

•     The Hon. Finance Minister in the Budget 2007-08 speech categorically stated that new levy is proposed to impose service tax on works contract.

•     Works contracts are distinct contractual arrangements and following a series of binding precedents and explicitly provided in Central and State legislations for bringing interalia works contracts within the scope of Union levy by expanding the scope of sale, defining works contracts in the Central Sales Tax Act and incorporating a specific power to make rules for computation/valuation of “deemed sale” in sales tax legislations and also introducing works contract category in the Finance Act, 1994 by expressly defining it together with complementary valuation Rules (Rule 2A) issued u/s. 94 of the Act to ensure proper valuation and confinement of levy strictly to service components also with effect from 01/06/2007. This integrated legislative and statutory landscape of the Act to the extent of works contract service in strict confirmation with constitutional limits on States and the Union taxation in this area as spelt out in second Gannon Dunkerley (supra) and all subsequent rulings including the latest Kone Elevator India Ltd. of 2014 (supra).

•     In view of the exclusivity and insularity ordained in terms of legislative powers pertaining to taxation, both the federal partners (the Union or the States) are forbidden to trench upon the exclusive domain allocated to each by the constitution. Therefore a vague/overboard definition coupled with ambiguous charging and indeterminate valuation provision could not suffice in terms of First Builders Associations of India (S.C.1989), Second Gannon Dunkerley (supra) and L&T Ltd. (Orissa 2008) (supra). When the charging and/or valuation provisions on a true and fair classification fall short of this specific requirement, collection of sales tax on works contract would fall aside as per the above precedents among various others.

•     In view thereof, Union’s intention to levy tax only on labour or service element must therefore be categorically expressed in charging provisions read with relevant taxable service and the valuation provisions. Such intention was explicated only by section 65(105)(zzzza) and not collectively through charging section, definition and valuation provisions so far as they related to CICS, COCS and ECIS.

•     It is an established interpretation principle that where two constructions are fairly possible, the construction sustaining the legislation should be adopted instead of one which renders it invalid.

•     In terms of revenue contentions, should it mean that insertion of WCS from 01/06/2007 and introduction of Rule 2A in the Valuation Rules were wholly unnecessary amendments in the existing legislative provisions?

•     Neither the provision of the Act,any rule made there under or exemption notification issued under section 93 indicate how and at what point of time during execution of works contract, the value of goods and material used in execution thereof are to be valued for applying reductions. Although Notification No.12/2003-ST provides deduction towards value of goods sold on furnishing proof of such sales does not provide for computation of profits booked by builders on the goods incorporated in the contract.

•    There  was  observation  in  Tamil  Nadu  Kalyana Mandapam Association’s case [2004 (167) ELT 3 (SC)] that it is well settled that the measure of taxation cannot affect the nature of taxation and therefore service tax levied as a percentage of the gross charge for catering cannot alter legislative competence of Parliament. This cannot be interpreted as propounding universal norm. This may be appropriate in the facts and circumstances of that case. The nexus and legislative competence tests are established by a long catena of binding authority including Constitution Benches including the second Gannon Dunkerley (supra) and K. Damodarasamy Naidu & Bros. AIR 1999 SC 3909, Tamil Nadu Kalyana Mandapam’s decision (supra) cannot be considered as having dissented or overruled entrenched principles consistently impounded and implicitly followed in a host of decisions including in to another legislation and tax such elements under the pretext of overreaching merely the measure of tax.

•     Since binding expositions of relevant principles qua binding precedents were not brought to the notice of the Hon. High Court, G. D. Builders (supra) decision is incuriam and sub silentio.

•     The analysis and the view concluded as: “28.  The decisions of the Karnataka and Madras High Courts, in Turbotech Precision Engineering Pvt. Ltd. and in Strategic Engineering Pvt. Ltd. have clearly concluded that a works contract is not leviable to Service Tax prior to 1-6-2007. Though, with respect there is not discernible a holistic analyses of the relevant statutory framework involved nor of the several precedents which support the conclusion recorded (in Turbotech and Strategic), as is found in the painstaking effort apparent in G.D. Builders, in our respectful view the conclusion that a works contract is defined, charged and is subject to the levy of Service Tax only w.e.f 1-6-2007 (on insertion of sub-clause (zzzza) in Section 65(105) of the Act), is consistent with the overwhelming catena of binding precedents considered and analyzed by us.”

•    Consequently, the decision in BSBK Ltd. (supra) to the extent it rules that a works contract is a taxable service prior to 01/06/2007 was respectfully an error and stood overruled.

Majority view: Per Shri J. P. R. Chandrasekharan,

Member (T): Brief overview:

Not agreeing with the above, Hon. Member (Technical) proceeded with recording apprehension at the outset over the instant reference in view of the revenue’s pending appeals before the Supreme Court after admission in 2008 and 2010 respectively in Jyoti Ltd. (supra) and Indian Oil Tanking Ltd.’s case (supra) in the same matter. Further, the Delhi High Court having taken a view on this very issue in G. D. Builders’ case (supra) as well as in YFC Projects P. Ltd.’s case (2014) 44 GST 334/43 Taxman.com 219 (Delhi) that works contracts could be vivisected and discernible taxable services could be taxed prior to 01/06/2007 it was noted that the Tribunal being subordinate to High Court and Supreme Court would be bound by these decisions and the matter did not recur post 01/06/2007 as the dispute essentially related to the period 2004 to 2007. Besides this reservation, it was also noted that the ratio of G. D. Builders was consistently followed by the Tribunal in many cases including by Hon. President in CCE vs. Gopal Enterprises 2014 (36) STR 674, Kalpik Interiors vs. CST 2014 (36) STR 1283 and in Hindustan Aeronautics Ltd. vs. CST 2013 (32) STR783 (Tri.-LB).

    In the said case of G. D. Builders (supra), after examining at great length various decisions which among others included Gannon Dunkerley vs. State of Rajasthan [2002-TIOL-103-SC-CT], K. Raheja [2005-TIOL-77-SC-CT], Larsen & Toubro vs. State of Karnataka 2010 (34) STR 481 (SC)], Nagarjuna Construction Co. Ltd. vs. UOI 2012-TIOL-107-SC-ST, State of Kerala vs. Builders Association of India [2002-TIOL-602-SC-CT, Tamilnadu Kalyana Mandapan Association 2004 (167) ELT 3 (SC) etc. whereby the following issues in brief among others were examined:

a. Service tax is levied on taxable services as defined in section 65(105) read with definition clauses and applicable only on the service element as the Central Government does not have power to impose tax on entries under List-II of Seventh Schedule to the constitution. It cannot levy tax on goods and material used in works contract as central sales tax is levied on material used in “works contract” with effect from 11/05/2002 vide amendment of Central Sales Tax Act.

b. Composite or works contracts are not included in 65(105)(zzq) viz. CICS and (zzzh) viz. COCS as they apply to only service contracts. Therefore, the exemption of 67% under notification cannot be considered a part of main statutory provision as in terms of section 93 of the Finance Act, 1994, the exemption granted cannot relate to works contracts as they are not covered by clauses (zzq) and (zzzh) of section 65(105). Such tax is imposed only from 01/06/2007 under 65(105) (zzzza). There is conflict between these clauses and what is covered by (zzzza) cannot be covered by (zzq) and (zzzh) of section 65(105). The two cannot co-exist. Subsequent legislation shows that the earlier only did not cover composite or works contracts.

c.    Section 66 is charging section and section 67 relates to valuation. Tax can be levied on the value of service and not beyond. There is provision for notional value to substract the value of material or goods.

d.Vagueness or uncertainty makes levy invalid and illegal.

e.    Exemption Notification has to be read while keeping its objective and purpose in forefront. It may provide a convenient formula for computing the value of service in a composite contract. The Notification however is optional and an alternative. It meets the tests laid down u/s. 93 and 94 and it has not been shown that the value prescribed therein is absurd or irrational.

f.    On the strength of factual and legal analysis undertaken, conclusion summarised in para 36 in a nutshell that post 46th Amendment to the Constitution, composite contracts can be bifurcated to compute value of goods sold/ supplied in construction contracts with labour and material and the service portion of the composite contracts can be subjected to service tax by applying aspect doctrine for vivisection of the contract.

  The above decision on an identical issue was followed before another Bench of the Delhi High Court in YFC Projects P. Ltd. vs. UOI (supra). In view of the foregoing, the above decisions are binding on the Tribunal.

    In furtherance of the above and analyzing one of the main points of difference that conflicting decisions of
Karnataka and Madras High Courts as against the Delhi High Court’s decision in G. D. Builders (supra) on the same/similar issue are available, it was observed that facts of these decisions were completely different. In CST vs. Turbotech Precision (supra), the activity of development, design, installation and commissioning and technology transfer was sought to be taxed as consulting engineering service by the department.

Similarly, in Strategic Engineering’s case (supra), the contract involved erection of pipes and also connecting the laid pipes and subjecting them to carry fluids. This activity was sought to be taxed as erection commissioning and installation service wherein the Hon. High Court held that the services provided under works contract were not liable prior to 01/06/2007. However, the question whether works contract could be vivisected and subjected to service tax was not the issue for consideration before the Hon. High Court. Therefore, the said decision has no relevance to the issue considered in G. D. Builders’ case (supra). In support of this contention, the Hon. Member interalia relied upon Alnoori Tobacco Products (2004 170 ELT 135 (S.C.)]. The relevant extract read as follows:

“11. Courts should not place reliance on decisions without discussing as to how the factual situation fits in with the fact situation of the decision on which reliance is placed. Observations of Courts are neither to be read as Euclid’s theorems nor as provisions of the statute and that too taken out of their context.”

  Accordingly, it was concluded that ratio of G. D. Builders stands uncontroverted and thus binding on all subordinate Courts including the Tribunal (irrespective of the strength of the Bench).

    Next examination pertained to the main issue of DIVISIBILITY of works contract prior to 01/06/2007 including analysing section 67 dealing with measure or valuation. The proposition of lack of adequate machinery provision was found without merits on the ground that four important elements of tax law viz. taxable event, the rate of tax, measure of tax and precision liable to tax were found existing in service tax law in section 65(105), sections 66, 67 and 68 of the Act and therefore the challenge was found not sustainable. As regards the primary issue relating to exclusion of value of goods, based on judicial pronouncements including in the case of K. P. Varghese vs. ITO 1981 AIR 1922 (SC), it was found that section 67 of the Act provided measure of the levy adequately and optional exemption notifications 12/2003-ST, 15/2004-

ST and 1/2006-ST as well as CENVAT Credit Rules, 2004 provided credit mechanism to capture value of services of goods. Therefore, at practical level of implementation, there is no difficulty to determine value of service rendered.

  At the end, the concept of works contracts was analysed in detail to distinguish it from the contracts for sale. It was observed that the Apex Court in Builders Association of India vs. UOI (supra) held that “by fiction, an indivisible contract has been made a divisible contract and the values of the goods involved in the execution of contract have been subjected to tax”. Further, it is restricted to the value of goods used and not the building as a whole. The law was further elaborated by the constitution Bench of Supreme Court in the second Gannon Dunkerley & Co. (supra). The Bench noted that contract of work is inherently a contract of service. The legal fiction created by Article 366(29A) of the Constitution to hold certain types of works contracts as deemed sale of goods in order that States could levy sales tax on the value of goods supplied as part of the works contract. Similarly, the 92nd amendment to the constitution provided for a specific entry for taxes on services in the Union list under entry 92C. Prior to this, entry 97 covered taxes on services. Thus, the power of Parliament to levy tax on services was never in dispute. Reliance was placed on Tamil Nadu Kalyana Mandap Association vs. UOI 2004 (167) ELT 73 (SC) which interalia held as follows:

“45. The concept of catering admittedly includes the concept of rendering service. The fact that tax on the sale of the goods involved in the said service can be levied does not mean that a Service Tax cannot be levied on the service aspect of catering….

46. It is well settled that the measure of taxation cannot affect the nature of taxation and, therefore, the fact that Service Tax is levied as a percentage of the gross charges for catering cannot alter or affect the legislative competence of Parliament in the matter…..

58. A tax on services rendered by mandap-keepers and outdoor caterers is in pith and substance, a tax on services and not a tax on sale of goods or on hire purchase activities.”

Similar reliance was placed on Association of Leasing and Financial Services Companies vs. UOI 2010 (20) STR 417 (SC) which interalia held:

“Merely because for valuation purposes inter alia “finance/interest charges” are taken into account and merely because Service Tax is imposed on financial services with reference to “hiring/interest” charges, the impugned tax does not cease to be Service Tax and nor does it become tax on hire-purchase/leasing transactions under Article 366(29A).”

Based on the above two decisions in respect of two transactions relating to catering services and hire purchase, it was found that since service tax could be levied on these services on the value attributable to the service component of composite transactions, the issue of divisibility of an indivisible contract for the levy of service tax was confirmed. It was observed that many services entail supply of goods and many examples were cited including those of photography services, cleaning services, banking services (entailing supply of cheque books, plastic cards for ATM transactions etc.) sound recording services (entailing supply of recording medium) etc. Further citing a recent decision of Apex Court in State of Karnataka vs. Pro Lab and Others 2015-TIOL-08-SC-LB which considered the issue of levy of sales tax on processing and supply of photographs, it was observed that if by virtue of clause 29A of Article 366 of the Constitution, the State legislature is empowered to segregate goods part of works contract to levy sales tax, the same logic would apply to the Central legislation for imposing service tax and Parliament is empowered to segregate service component of the works contract to levy service tax. Precisely, this was done by the Finance Act, 1994, when service tax was levied vide CICS, COCS and ECIS. It was further observed that statutory provision should be interpreted in the manner not to create discrimination among classes of service providers by taxing supplying services alone and another set providing both supply of goods and service not liable to tax. In effect, it was concluded with, “the issue referred to the Larger Bench is fully and squarely covered by the G. D. Builders case decided by the Hon. Delhi High Court”. Consequently, it has to be held that composite works contract can be vivisected and discernible service element could be subjected to service tax even prior to 01/06/2007.

Majority view: Per R. K. Singh, Member (T): Some key observations:

•     Concurring with the order of per Hon. Shri P. R. Chandrasekharan, it was observed that the judgments of the Karnataka and Madras High Courts did not infringe upon the ratio of the Delhi High Court in G. D. Builders as regards the subject matter covered by the latter and that the subject matter referred to the Five Member Bench was squarely covered by the decision of the Delhi High Court in G. D. Builders’ case (supra).

•     Section 67 adequately provided machinery provisions for measure of value of taxable service and which was not arbitrary by any standard whether post its amendment from 18/04/2006 or prior thereto. Since it refers to the value of service would imply that value of goods sold in a composite contract was not to be a part of the value for the purpose of this section.

•     Notification No.12/2003 needs to be viewed as a measure of abundant caution and care on part of the Government.

Majority view: Per Rakesh Kumar, Member (T): Some key observations:

•    “47.3 When indivisible works contracts are those contracts involving provision of service, in which there is transfer of property in goods from the service provider to the service receiver through accretion, and this transfer of property in goods is not sale, such contracts have to be treated as service contracts as in such contracts, there is absolutely no intention of transfer of property in and delivery of the possession of, a chattel as a chattel to the service receiver. A service contract will not cease to be a service contract just because the provision of service involves use of goods, the property in which gets transferred to the service recipient through accretion. Even the Law Commission’s Reports (Chapter IA para 7) refers to the works contract as “a contract for work (of service)”.

•     It is a well settled law that legal fiction has to be given effect to only for a limited purpose for which it was created and therefore Article 366(29A) can be employed only to enable State Governments to levy sales tax on certain contracts including specified contracts. Since works contracts are service contracts, the same would attract service tax even during period prior to 01/06/2007.

•    Just because State Governments have the power to levy sales tax on the transfer of property in goods involved in execution of works contract by invoking Article 366(29A), the power of Central Government to levy service tax on such works contract does not get restricted so as to confine the levy only to service portion of the works contract excluding the value of goods for providing the service. An inadmissible works contract is one single service contract whose value would include value of all goods and services which contribute to emergence of the service product.

•   Exemption Notification issued under section 93 of the Act to provide abatement of the taxable value of specified services (including ECIS, COCS and CICS) are sufficient to avoid tax on goods subjected to tax by the State Government and no machinery provision is necessary.

•     In commercial world, transactions of sale of goods and sale of services are intermixed and therefore some overlap is inevitable which has to be ignored in the interests of smooth functioning of laws governing the levy of tax on sale of goods and service tax.

•    Separate and specific constitutional provision together with the machinery for determining the measure is required only when State Government wants to tax goods portion in a service transaction or the Central Government wants to tax service portion of a sale transaction. However, for levying service tax on a service transaction including works contract, no machinery for exclusion of value of goods is required and for the lack of the said machinery, the levy cannot be held invalid.

Conclusion:

Since the revenue is already before Supreme Court against the order of Turbotech Precision Engineering (supra) and Strategic Engineering (supra), whether the above intellectual exercise would impact any litigation process is a question which is posed by many. Nevertheless, a threadbare analysis of technical and judicial aspects on the subject of works contract would be a worth read for a large number of professionals and other stakeholders.