There is a lot of mystery regarding taxation of Construction activities in India. The mystery starts from the fact that a Construction contract involves both labour and material and hence, both Service tax and Value Added tax is levied on one transaction. The process becomes more complex depending upon a number of factors such as the Scope of work, the nature of the contract, whether the contract includes any further sub-contracting, whether individual prices have been specified for each part of the scope of work and whether the contract involves off-shore and on-shore activities etc.
Let us first consider the Indirect taxes applicable on a Construction contract. As already stated above, a Construction contract involves both labour and materials. Hence, a Construction contract is liable to both Service tax and Value Added tax.
Service tax is levied on the labour component of the Construction Contract and the present rate of Service tax is 10.3%. It is important to note that a basic principle of Service tax is that there should be a provision of a service. Hence, if an activity does not involve the provision of a service, it would not be liable to Service tax. The Construction services were liable to Service tax under the taxing entry of “Commercial or Industrial Construction service” / “Construction of Complex service” (“Construction services”).
With respect to Turnkey / Composite contracts, the issue of whether Service tax can be levied in respect of a Works Contract came up for the first time before the Customs, Excise & Service Tax Appellate Tribunal (“CESTAT”) in the case of Daelim Industrial Company vs. Commissioner of Central Excise [2003 (155) ELT 457], wherein, it was held that a Works Contract on a turnkey basis cannot be split up and part of it made liable to Service tax. This decision was followed by various other decisions taking a similar view. This led to the introduction of the taxing entry of “Works Contract Services”.
Value Added Tax (“VAT”) / Sales tax is levied on the “transfer of property in goods involved in the execution of a Works Contract”. The levy of VAT / Sales tax is on the deemed Sale of goods. In the context of Sales tax (now VAT), the question whether the State had the power to levy Sales tax in case of a Works Contract was for the first time dealt by the Supreme Court in the landmark decision in State of Madras vs. Gannon Dunkerly & Company [1959 SCR 379]. The Court analysed the meaning of sale and held that an essential ingredient of sale is that there must be transfer of property in the goods as goods by one to another. This means that the State could not split a Works Contract levy tax on the supply of goods involved in the execution of a Works Contact. This necessitated a constitutional amendment and by the 46th Amendment Act, 1982 the definition of “tax on the sale or purchase of goods” in Clause (29A) of Article 366 was amended to introduce the concept of “deemed sale” where, by legal fiction, in case of Composite Contract (e.g. Works Contract), the State would have the power to levy Sales tax on the basis that there has been a transfer of title in the goods.
The Construction Industry is faced with some key issues:
• Whether it is permissible to split up an indivisible Construction contract for levy of Service tax;
• The Dominant intention theory and its impact on taxation of Construction contracts;
• Taxability of a contract i.e. whether a ‘sale’ contract would become liable to Service tax or VAT;
• Classification issues i.e. whether services are liable under the taxing entry of Construction services or Works Contract services;
• Valuation and Availability of Credit under VAT and Service tax considering classification and various options available;
• Issues related to composition schemes under VAT and Service tax;
• Applicability of Service tax and availability of credit when the property is constructed and rented out at a later stage; etc.
Each of the aforesaid issues assumes significant importance from an overall cost perspective. The cost of direct taxes in India could range from 12% to 24%. Hence, it is imperative to properly structure the contracts at the bidding stage itself. Any oversight at the initial stages may result either in additional tax costs or may lead to future litigations. If the bidder is not diligent, he also faces the risk of not going through the bid at all, thereby, also resulting in a loss of his profits.