SERVICE TAX IMPLICATIONS OF REDEVELOPMENT OF CO-OPERATIVE SOCIETY ON OR AFTER 01-07-2012

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Synopsis

In this article the author analyses the relevant definitions and typical terms and concepts used in documentation of redevelopment of housing and commercial societies.

He explains the Service Tax implications on existing Society/members and on Developers on construction of Rehab flats/units and also analyses the valuation of rehab construction services and valuation of development rights in light of Circular issued by the Service Tax authorities.

He also dissects the provisions of point of time rules applicable and CENVAT eligibility in respect of input services and capital goods used in redevelopment projects.

1. Preamble:

1.1. Acute shortage of land, rising population, ever increasing demand for housing and its sky rocketing prices has brought about an innovative concept of redevelopment of old properties in Mumbai. Re-development is a unique feature typical to the real estate sector in Mumbai. One rarely finds redevelopment projects in other cities due to availability of ample land and possibility of expansion of city in all directions.

Re-development has become a necessity in Mumbai, as countless buildings have outlived their estimated useful life and such buildings are beyond repair. Most property owners or societies are financially incapable of undertaking extensive repair or restoration. In a redevelopment project, the developer exploits the development potential and existing members get reconstructed flats/units with modern amenities, additional area, corpus and other allowances. Redevelopment is, therefore, a win-win solution for society, members and the developer.

1.2. Redevelopment is a complex economic transaction having far reaching implications under the Income-tax, VAT, Stamp duty, Service tax and other such laws. This article covers only the Service tax implications for the society, its members and the developer in respect of redevelopment of society property on or after 1st July 2012.

1.3. The reference to the following phrases/abbreviations in the article would mean:

• The Act – The Finance Act, 1994
• Valuation Rules – Service tax (Determination
of value ) Rules,2006
• POTR – Point of Taxation Rules, 2011
• CCR – CENVAT Credit Rules, 2004

2. Typical documentation and terms of redevelopment of housing and commercial societies:

2.1. A Developer normally executes following agreements:

• “Development Agreement” with the society.
• “Permanent Alternative Accommodation Agreement” with existing members for allotting flats/units in redeveloped building (“Rehab flats/units”).
• “Agreement to sale” with purchasers of  new flats (“Saleable flats”).

2.2. The society appoints a developer for reconstruction of specified area for its members. In consideration, the society transfers the balance development potential (FSI and rights to load TDR) to the developer for constructing saleable flats/units.

2.3. The usual terms of a redevelopment project are as under:

• Developer pays cash consideration for development potential (popularly known as FSI) to society.

• Developer allots flats/units in a redeveloped building to members.

• Developer may allot flat/unit to some members in his other project.

• Developer may purchase flats from existing members for consideration.

• Developer pays the following to the members

Lump-sum consideration to compensate consequential increase in maintenance and property tax on redeveloped building (popularly known as “Corpus allowance”)

Rent allowance to cover rent for temporary accommodation.

Shifting allowance to cover shifting cost such as transportation etc.

Reimbursement of brokerage for temporary accommodation.

Hardship allowance

• Developer may provide temporary alternative accommodation to members:

In his other project; or
In flats/units taken by him on rent.

2.4. Developer may sell additional area to existing members at concessional or market rate.

2.5. Developer sells saleable flats/units to Purchasers who will be admitted as members by society at later date.

3. Crux of redevelopment transaction:

Redevelopment transaction is a barter trans action between society/members and developer, the particulars whereof are tabulated below:

Question arises whether above-referred transactions are liable to service tax? If yes, when are such transactions taxable and what is the value of such services?

4. Relevant definitions, terms and concepts:

4.1. The relevant extract of definition of “Service” u/s. 65B(44) of the Act:

“‘Service’ means any activity carried out by a person for another for consideration, and includes a declared service, but shall not include

(a) An activity which constitutes merely,-

(i) a transfer to title in goods or immovable property, by way of sale , gift or in any manner; or

(ii) ………
……”

4.2. The relevant extract of section 66E of the Act:

Following shall constitute declared services, namely:-

(a) ……..
(b) 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 is received after issuances of completion certificate by the competent authority
(c) ……
(d) ……
(e) agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act
(f) …….
(g) …….
(h) service portion in the execution of a works contract

4.3. “Works contract” is as defined u/s. 65B(54) to mean a contract wherein:

• transfer of property is in goods involved in the execution of such contract; and
• such contract is leviable to tax as sale of goods; and
• such contract is for the purpose of carrying out construction of any movable or immovable property.

4.4. The service tax implications for builder, developer, labour contractor and works contractor differ from each other. It is essential to understand these terms and the meaning of the word “immovable property”. The service tax legislation does not define these terms. One may have to go by the definitions in the General Clauses Act or common parlance meaning of such terms.

4.5. The term “Immovable Property” as defined under Clause (26) of General Clauses Act, 1897 includes land, benefits to arise out of land and things attached to the earth or permanently fastened to anything attached to the earth.

4.6. “Builder” should mean a person constructing the building on land owned by him with intention to sell the flats/units.

4.7. “Developer” should mean a person who acquires development rights in the land and constructs the building thereon for sale.

4.8. Contractor constructs building on the land owned by another person. The contractor can further be classified as “labour contractor” or “works contractor”. The labour contractor undertakes a pure “service” contract and uses material provided by the principal. The “works contractor” undertakes composite contract and uses his own material in execution of the contract.

4.9. The issue is whether the developer is a “builder” or a “works contractor” vis-à-vis construction of rehab flats/units for a society and its members. The effective tax rate, date of service tax applicability, valuation and relevant Rules and notifications etc., are different for builders/ developers and for works contractors. In a society redevelopment project, the developer usually does not get title to or rights in land pertaining to rehab portion. The developer gets the development rights or right to construct saleable portion on society’s land.

The contractor or works contractor constructs
the building on the land belonging to its principal.
The construction material (belonging
to and used by the contractor) passes from
contractor to the client by the principle of accretion.
As far as construction for rehab flats/
units in redevelopment project is concerned,
the developer does not have the rights in the
land. He constructs on the land belonging to
the society. One can, therefore, safely conclude
that the developer is a “works contractor” for
construction of rehab flats/units in a redevelopment
project.

The society grants development rights (balance
after utilisation for rehab construction) to the
developer for constructing saleable portion. The
developer gets valuable rights in land pertaining
to saleable portion. The developer acts as a
“builder” selling the flats/units to the purchasers
along with underlying rights in the land.

In most of the redevelopment projects, the
developer acts in a dual capacity i.e., “Works
contractor” for rehab portion and “builder”
for saleable portion. However, it will be advisable
to examine the redevelopment agreement
minutely, to determine the exact scope and
role of the developer for assessing Service tax
implications.

5.1. A Society/members transfer development rights
to developer for reconstructed flats/units and
other consideration in cash.

In the absence of a definition of the term
“Immovable property” in the Service tax legislation,
one may adopt the definition of “Immovable
property” given under Clause 26 of
General Clauses Act, 1897. Development rights
are squarely covered under the above referred definition of immovable property. Transfer of
such immovable property is outside the ambit
of Service tax.

5.2. Members usually get Corpus allowance, rent allowance,
shifting allowance, hardship allowance
etc. Two possible views as to the taxability of
such allowances are as under:

• All the above referred allowances are
consideration for a single deliverable i.e.,
transfer/relinquishment of rights in the
property by the members to the developer.
It is a transaction of immovable property
not liable to Service tax.

• Such allowances are a consideration for
different deliverables by the members. It
is not a consideration for transfer or relinquishment
of members’ rights in immovable
property. Such allowances are received by
the members for having agreed to vacate,
shift and tolerate the hardship associated
with shifting during the reconstruction
of the society’s building. Even lump-sum
compensations received by members (for
compensating them for consequential increase
in maintenance and property tax on
redeveloped buildings-popularly known as
“Corpus allowance”) may be regarded as
consideration for agreeing to tolerate the
financial burden in the future. There are all
chances of the Service tax authority treating
these to be declared service u/s. 66E(e) of
the Act. In such a case, members receiving
such allowances would be liable to Service
tax, if the total value of all services (including
these allowances) provided by them is
above one time threshold exemption limit
of Rs. 10 lakh.

5.3. Sometimes, the developer may provide temporary
alternative accommodation to members in
his other project or in flats/units taken by him
on rent. As the transaction between developer
and members is not in cash, the issue would
arise as to the taxability of these transactions in
the hands of members. It is a barter transaction
and consideration received in kind is liable to
Service tax, if the transaction is that of service is
taxable. The taxability of such service is already
discussed in the preceding paragraph.

6. Service tax implications for developer on construction
of residential flats allotted to existing
members in redevelopment project on or
before 30-06-2012:

Prior to 1st July, 2012, the construction of a
residential complex was taxable either under
“Construction of complex” category u/s. 65 (105)
(zzzh) or under “works contract service” u/s.
65(105)(zzzza) of the Act. The term “Residential
Complex” was defined u/s. 65(91a) of the Act.
The construction of a complex for personal use
was specifically excluded from the definition of
“Residential Complex”. Hence, any construction
of a Residential complex for personal use was
not taxable under any of the above referred
categories.

The Central Board of Excise and Customs (CBEC),
vide their circular 151/2/2012- ST dated 10th February,
2012, clarified that re-construction undertaken
by a building society by directly engaging
a builder/developer will not be chargeable to
Service tax as it is meant for the personal use
of the society/its members. The relevant extract
of the aforesaid circular is reproduced for ready
reference.

“Re – construction undertaken by a building society
by directly engaging a builder/developer will
not be chargeable to service tax as it is meant
for the personal use of the society/its members.”

The developers, therefore, were not liable to
Service tax till 30-06-2012 in respect of residential
flats allotted to existing members of the society
in redevelopment project.

7. Service tax implications on construction of
Rehab flats/units allotted to existing members
of the society in redevelopment project on or
after 01-07-2012:

7.1. The service tax legislation has been revamped
w.e.f 01-07-2012. Section 65 (105) listing out
taxable services and section 65(91a) defining
residential complex is no longer on statue book.
Circular no. 151/2/2012-ST dated 10th February,
2012, being inconsistent with the new Service
tax legislation, is no longer valid and subsisting
after introduction of negative list based levy.
In view of a substantial change in the law, it is necessary to revisit the issue whether developers
are liable to Service tax in respect of rehab
flats/units allotted to members of the society.

7.2. India has adopted the ‘Negative List based
service taxation’ w.e.f. 01-07-2012 wherein any
activity is liable to service tax, if such activity
is:

• Covered under definition of “Service” as
defined u/s. 65B(44) of the Act; and

• Not falling in “Negative List of Services” as
listed u/s. 66D of the Act; and

• Provided within the taxable territory; and

• Not covered under Notification no. 25/2012
dated 20-06-2012 or any other exemption
notification.

7.3. As discussed in para 4.9, the developer is a
“works contractor” for construction of rehab
flats/units in redevelopment project. The service
portion in a works contract is a declared service
u/s. 66E(h) of the Act and is a “service” as
defined u/s. 65B(44) of the Act. Such service is
neither in the negative list of services (as listed
in section 66D of the Act) nor is it exempt under
any of the exemption notification. In view of
this, any such service provided within taxable
territory (whole of India except Jammu and
Kashmir) is liable to Service tax w.e.f. 01-07-2012.

The Maharashtra Chamber of Housing Industry
(MCHI) has sought clarification from the Service
Tax Commissioner, Mumbai-I on the issue whether
Builders/Developers are liable to Service tax in
respect of rehab flats/units allotted to society
members in redevelopment project. The Commissioner,
vide his letter F.No.V/ST-I/Tech-II/463/11
dated 31-08-2012, clarified that Service tax is leviable
on construction of such rehab flats/units.
8.

Valuation of rehab construction service :

8.1. In a redevelopment project, the developer receives
consideration in the form of development
rights for constructing Rehab flats/units. Any
activity carried out by one person for another
person for consideration (whether in cash or in
kind) is a service. Section 67 of the Act requires
a service provider to include the monetary value
of consideration in kind in the value of taxable
services provided by him.

8.2. Section 67 of the Act deals with determination
of value of taxable services:

8.3. Developer receives consideration in the form
of development rights for constructing rehab
flats/units in a redevelopment project.

Section 67(1)(ii) is applicable when value of
consideration received in kind is ascertainable.
Section 67(1)(iii) applies when the value of
consideration is not ascertainable in ordinary
course.

An erroneous notion which prevails is that the
value of development rights is not ascertainable
and hence, the construction service in respect
of Rehab flats/units are to be valued u/s. 67(1)
(iii) read with Rule 3 of Valuation Rules. The Service tax authorities, relying on Circular
No.151/2/2012-ST dated 10-02-2012, value the rehab
flats/units at the rates at which similar flats are
sold by the developer. This is not a correct proposition,
as the Service tax is leviable on the value
of consideration (i.e. development right) received
by the developer and not on the value of flats
which is a consideration received by members/
society for granting development rights to the
developer. The construction of the rehab portion by the developer is a “Works Contract” service.
Such service cannot be valued at the market
value of rehab flat/units arrived at, by applying
the rate of saleable flats as sale rate of saleable
flats includes the land value. In a Redevelopment
Project, the land attributable to rehab flats/units
belongs to the society/members and it is never
transferred by the developer to the members or
the society. Hence, the land value should not
be included while ascertaining the value of the
construction service for rehab flats.

Development rights are liable to stamp duty and
market value of such rights (for the purpose
of stamp duty) is prescribed in the Government
reckoner of majority of the States. The value of
consideration (i.e Development Rights) is, therefore,
ascertainable and hence valuation is to be
done u/s. 67(1)(ii) of the Act. A very strong view
is prevalent that the value of development rights
(consideration received in kind by builder for
construction of rehab flats/units to members)
should be taken at stamp duty valuation.

8.4. The monetary value of development rights is
gross consideration for works contract executed
by the developer for the society. It is a gross
consideration for works contract which comprises
of material and service value. One has
to segregate the service portion from the total
value of the works contract. Section 67(1) of
the Act read with Rule 2A of Valuation Rules
prescribes following two valuation methods for
valuing the service component in the works
contract:

• Specific Valuation Method [Rule 2A (i) of
Valuation Rules]

• Presumptive Valuation Method [Rule 2A (ii)
of Valuation Rules]

Under the Specific Valuation Method, the value
of service portion is worked out by reducing
value of goods (material) used from gross
contract value excluding VAT. The service value
should not be less than specified overheads
relating to the project.

It is practically impossible
to work out the value of service portion
under this method for redevelopment project.
Under Presumptive Valuation Method, the value
of service portion in the works contract for
new construction (original works) is deemed
to be 40% of gross consideration/contract value
excluding VAT. Thus in the redevelopment
project, the effective service tax rate under
presumptive method would be 4.944% of the
value of development rights.

The developer is eligible for Cenvat Credit of
input services and capital goods irrespective
of the valuation method followed by him.

9. Point of Taxation for construction of rehab
portion:

9.1. The question arises when Service tax on rehab
portion is payable by the developer? Point of
Taxation Rules, 2011 determines the point of
taxation (‘POT’) i.e., the point of time when
service shall be deemed to have been provided.

The provisions, rules, notifications and circulars
subsisting on POT should be applied for determining:

• Taxability of transaction

• Applicable tax rate

• Valuation

• Cenvat eligibility

• Due date for tax payment

9.2. Works contract service is a continuous supply of
service. In case of continuous supply of service
where the provision of the whole or part of
the service is determined periodically on the
completion of an event in terms of a contract,
which requires the receiver of service to make
any payment to the service provider, the date
of completion of each such event as specified
in the contract shall be deemed to be the date
of completion of provision of service;

Explanation to Rule 3 of POTR provides that
whenever any advance is received by the service
provider towards the provision of taxable
service, the POT shall be the date of receipt of
such advance.

9.3. The point of taxation arises when service provider
is legally entitled to receive consideration
(development right in land) from service recipient
(society). The point of time when developer
receives irrevocable rights in the land is a point of taxation for rehab construction. The taxable
event occurs at such point and service tax liability
triggers on such date for developer.

One has to examine the development agreement
carefully to determine the point of taxation
and it could be any of the following probable
dates:

• Date of execution of development agreement.

• Date of developer getting vacant possession
free from all encumbrances.

• Date on which developer gets necessary
permissions (IOD, Commencement Certificate
etc) from local authority or government
to commence the construction.

• Date on which developer completes the
construction of area earmarked for original
occupants/members.

• Date on which full consideration for land
rights is paid to the society.

• Any other relevant date, specified in development
agreement, on which the substantial
rights in land are unconditionally and
irrecoverably bestowed on the developer.

The POT is a date on which developer have
received Sale Consideration (in form of development
rights) in advance for flat to be allotted to
the society/members. The liability to discharge
Service Tax arises on such date even if construction
is not started on such date.
The Redevelopment project for residential
complex in respect of which POT has already
arisen before 30-06-2012 is not liable to service
tax even if:

• Construction is started on or after 01-07-
2012.

• Construction is started before 30-06-2012
but completed on or after 01-07-2012.

• Possession of Rehab units given on or after
01-07-2012.

The developer acts as a builder in respect of
saleable portion of project. Sale of under construction
flats/units are liable to service tax @
3.09% or 3.708%.

The developer is liable to Service tax on rehab
and saleable portion. Both are taxable activities
and hence, the developer is entitled to claim
Cenvat in respect of input services and capital
goods used in redevelopment projects subject
to provision of Cenvat Credit Rules, 2004.

It is the duty of the Government to provide
affordable shelter to citizens. Instead of encouraging
redevelopment activities through tax
concessions, Government levies service tax on
redevelopment projects. The levy is harsh and
unjust but it is often said that tax and equity are
strangers. Developers will have to factor tax
incidence in their project cost. In order to avoid
future dispute or litigation, it will be advisable
to incorporate a clear clause in agreement as
to who will bear the service tax incidence on
rehab flats/units.