Service tax on Construction and Real
Estate Sectors, including Works Contracts

A. Introduction

This paper briefly outlines major aspects relating to the above subject and is not intended to be exhaustive. Readers may refer to the official text of the statute(s) and the notifications issued by the Government of India apart from circulars for full information. The discussion is terse, condensed topic-wise and no attempt is made to dwell on matters which require exhaustive discussion and debate.

B. Nature of service tax

1. Service tax is levied under the Finance Act, 1994.

2. There is no separate enactment for service tax, but the levy is a part of Chapter VAA of the Finance Act, 1994. A separate service tax law is expected to be enacted by the year 2010. Expert and highpowered committees have emphasized the need for such a law due to the phenomenal growth of the tertiary segment which is currently over 60% of the GDP.

3. Initially the levy was at the rate of 5% on three services, but has been extended over a period of time to cover hundred services and is at the rate of 12.36%. The tax is currently levied at 12% plus an education cess at 3% on tax.

4. Service tax is sanctioned after 2003 by a Constitutional amendment to the Seventh Schedule — Entry 92C, and introduction of a new Article 268A.

5. Service tax is on service provided/rendered/performed or delivered and is not on sale or manufacture of goods.

6. Service tax levy is administered by the Central Excise and Customs department. In large cities separate Commissionerates have been constituted for the purpose.

7. Service tax is generally payable by the service provider, but the law also permits collection from the service receiver in certain cases, as for example certain domestic services like transport agency/ sponsorship and services received from foreign service providers who have not establishment in India.

8. Service tax Rules, 1994 and Cenvat Credit Rules, 2004 form an integral part of the law pertaining to this levy. There are separate rules governing import and export of services and for valuation of taxable services.

9. The Constitutional validity of service tax has been challenged but all courts including the apex court have upheld the same.

10. Service tax is an indirect tax as per the Central Boards of Revenue Act, 1963.

C. Service tax on construction and real estate sector

1. Earlier, interior decorators and real estate agency services were taxed from 16-10-1998. Some of the services enumerated in the real estate agency category overlap with specific services brought under tax from 10-9-2004. But specific services brought under tax net later on would be taxable prospectively and not otherwise. There is no question of taxing any service retrospectively, and even if a provision says that it is for the removal of doubts, courts are empowered to look into the object of the statutory amendment and go behind the intent, to ascertain if it is retrospective. See Virtual Soft Systems vs. CIT, 2007 (289) ITR 83 (SC).

2. Construction services include industrial and commercial construction services, and also construction of residential complexes. These are taxable from 10-9-2004 and 16-6-2005 and include a host of services. Finishing services relating to buildings also fall under this activity. Works contract services are brought under tax from 1-6-2007 and a separate scheme providing for composition rate has been introduced for this category.

3. Site formation services are separately taxed from 16-6-2005 which includes earth moving, excavation, clearance and demolition activity.

4. Engineering consultancy services are under tax net from 7-7-1997 and services of architects are taxable from 16-10-1998.

5. Certain types of construction activity pertaining to infrastructure projects, e.g. roads, culverts, bridges, railways, airports, tunnels, etc., are excluded from the purview of service tax.

6. Erection, installation and commissioning services are taxable. Formerly only installation and commissioning was taxable, but from 10-9-2004, erection activity of plant, machinery and equipment is also brought under the tax net.

7. Real estate agents and brokers were brought under tax in 1998 itself.

D. Works Contract Tax (WCT) levied by states, Service tax and Cenvat

1. Both the categories of levy are in force, but there have been controversies which are still raging, and the Hon’ble Supreme Court had occasion to decide an important case BSNL vs. UOI, 2006 (2) STR 161 (SC), where the Court held that the decision in State of Madras vs. Ganon Dunkerly & Co, [1958] 9 STC 353 (SC) would still hold good in cases where the 46th amendment to the Constitution has not expressly enlarged the definition of sale in Article 366. WCT is under the state dispensation, under sales tax on goods, whereas service tax and Central Excise (Cenvat) are levied by the Union.

2. For the purpose of reckoning the value of taxable services, the value of goods sold or transferred while rendering services can be excluded from the gross amount charged.

3. Only the gross amount charged for rendering services would be liable for tax under service tax law and nothing more, i.e. the value of goods sold, or deemed to be sold / consumed in the course of service should not be taxed.

4. As stated earlier, works contract tax (WCT) is a state subject and service-tax a Union / Central subject. One has no jurisdiction to levy a tax on an activity, which the other can subject to the levy, vide BSNL decision supra. Nevertheless, service involved in the execution of works contract has been brought to tax from 1-6-2007. It may be appreciated that while transfer of property in goods involved in the execution of a works contract is taxed as a sale and the Constitution after the 46th Amendment has expressly provided for the states to tax such a transaction, there is no parallel provision in the Constitution for taxing service involved in the execution of a works contract. However, it is implied that entry 92C of the Union List and Article 268A would have to be so construed to enable the Union to tax services involved in works contract execution, provided no tax is levied on sale of goods. While doing so, the decisions of the apex court including the one in BSNL need to be taken due cognizance and the mechanism for valuing services to be brought to tax cannot indirectly do what the Constitution expressly prohibits, i.e. the Union taxing sale of goods under the Union List.

5. The segment relating to “sale” of goods which is reckoned for works contract purpose under state law, can be employed as the yardstick to measure the value of goods sold for reckoning the service element, where there is a composite contract.

6. The Service Tax Valuation Rules, 2006 have been framed under the Act, but these rules cannot override the charging section 66 or the valuation section 67 of the Act (Finance Act, 1994).

7. Cenvat credit representing duty of excise and CVD paid on the inputs and capital goods used for rendering a service is available for set off against service tax liability, apart from service tax paid on input services used to render a given service. However the benefit of certain notifications is not available in such cases.

8. A person who renders multiple services can have a single registration certificate endorsing all the services therein.

9. A multi-unit company with centralized accounting system/ billing system can have a composite registration certificate.

10. A person can have a single contract for rendering works contract, construction, development and other services, and the consideration for each service may be bifurcated and enumerated in the contract. It is also possible for a person to have different contracts for different services, sale of goods, work unconnected with service tax and pay service tax on the pure service element discernible from the contract.

11. The substance of the contract and intent of parties would prevail over the form of the contract.

12. Nomenclature given to a transaction is not determinative of the nature of a transaction. In other words, one would have to give due regard to the intent of parties, the conduct of parties and the nature of activity encompassed in a given contract carried out.

DD. Works contracts and service tax

DD.1. It may be noted that from 1-6-2007, the service tax law has been amended to provide for taxing works contract services involving the following types of contracts:

(a) Erection, commissioning or installation of plant, machinery, equipment or structures, electrical/electronic devices;
(b) Construction of new building/ structure/ pipeline, new residential complex, completion and finishing services;
(c) Turnkey projects including EPC projects, i.e. engineering, procurement and construction or commissioning projects

DD.2. The above category of service has been made a taxable service in terms of section 65(105)(zzzza) of the Act (Finance Act, 1994). However, works contracts relating to roads, airports, railways, transport terminals, bridges, tunnels and dams are out of the tax net, by virtue of the exception carved out. The following are the important features of the definition of works contract as per the service tax law, and a contract to be brought to tax under this head, should satisfy the ingredients set out below:

• There should be transfer of property in goods involved in execution of such contract, and the same liable to tax as sale of goods, and

• The contract in question should be for carrying out the works set out in the earlier paragraphs in (a), (b) or (c).

DD.3. The intent of bringing the above amendment in the Union Budge of 2007 can be seen from a circular issued on 28-2-2007 by the Tax Research Unit of the Government of India, MF(DR) No. 334/1/2007- TRU. Para-6.4 of the circular states that VAT or sales tax is leviable on transfer of property in goods involved in executing a works contract. The proposed taxable service is to levy service tax on services involved in executing such contracts. Infrastructure projects are left out from taxation. The taxable value of the service is that part relatable to services provided in execution of works contract, to be determined on the actual basis on the strength of records maintained by the assessee. The assessee has an option of working under a composition scheme notified by the Government, provided he does not avail Cenvat credit on specific items.

DD.4. What is self evident on reading the circular of the Government cited supra is that the levy of service tax on works contracts is a new one, and cannot be made applicable retrospectively. There were decisions of the Tribunal and Apex Court, which had laid down the law that indivisible contracts cannot be split or vivisected for levy of service tax, as for example the decisions in Daelim Industrial Co. Ltd. vs. CCE, 2006 (3) STR 124 (T) = 2003 (155) ELT 457 (T) affirmed by the Supreme Court in 2004 (170) ELT A181 (SC). The Tribunal decisions in Turbotech Precision Engineering (P) Ltd. vs. CCE, 2006 (3) STR 765 (T) and Larsen and Toubro vs. CCE, 2004 (174) ELT 322 (T) are also relevant in this context. It was to get over the effect of these rulings, that the statute expressly provides for taxing contracts involving sale of goods, where sales tax levy is attracted, so as to impose service tax on the service segment of the contract. Prima facie one cannot object to the taxation of services involved in works contract execution.

DD.5. If there is a contract, which does not involve transfer of property in goods but has a pure and simple labour element, albeit some meagre material being used to render the service, that would not be a works contract and would remain a labour contract. The levy of sales tax on such contracts being absent, there cannot be service tax under the category of works contract. It is another thing that the contract in such cases may fall under some other classification of services applying the rules of classification enumerated in section 65A of the Act.

DD.6. Valuation of works contract service would have to be in accordance with rule 2A of the Valuation Rules, 2006. These rules, called the valuation rules for short, are subject to section 67 and cannot override the parent enactment. This is also evident from the definition of value in rule 2(c) of the said rules. In simple language the value of the works contract for levy of service tax shall be the gross amount charged for the contract excluding the value of property in goods transferred while executing the said contract. The value shall also exclude the VAT or sales tax paid on transfer of propery in goods supra. The value shall include the following:

• Labour charges for execution of the works;

• Amount paid to sub-contractor for labour and services;

• Charges for planning, designing and architect’s fees;

• Charges for obtaining on hire or otherwise, machinery and tools;

• Cost of consumables such as water, electricity, fuel, used in the execution of the works contract;

• Cost of establishment of the contractor relatable to supply of labour and services;

• Profit earned by the service provider relatable to supply of the labour and services.

DD.7. The rule also provides that the value of goods (transfer of property in goods for payment of sales tax or VAT) adopted to pay sales tax or VAT, shall be adopted as the value of transfer of property in goods for executing the works contract, provided that sales tax or VAT has been paid on the actual value of such transfer of property.

DD.8. It would be pertinent to note that the Supreme Court in the case of Gannon Dunkerley & Co. and Others vs. State of Rajasthan, 1993 (88) STC 204, while dealing with the legislative powers of states to tax works contracts had held that the states had no competence to tax deemed sales and had laid down postulates for arriving at the value of goods involved in the execution of works contract. The Court had held that the same should be valued by excluding the expenses incurred on labour and other services.

The Court held that the cost of incorporation of the goods in the works contract was to be excluded for measure of levy of sales tax on works contract. The Court held that incorporation of goods in the works was distinct from the contract for transfer of property in goods. At pages 233-235 of the reported decision, their Lordships (Constitution Bench of Five Judges) took note of a convenient mode of ascertaining the value of labour and services involved apart from goods in the execution of works contract, and accordingly held that the value of goods involved in the execution of a works contract, will, therefore, have to be determined by taking into account the value of the entire works contract and deducting therefrom the charges towards certain elements relating to labour and services, which incidentally is precisely what has been done by reversing the method for ascertaining the value of services under service tax law. In the sense, what the sales tax law does to tax goods in works contract is to exclude service, and what the service tax law does to tax services is to exclude goods and include those services as set out in the decision of the apex court in 88 STC 204 at p. 235. The Court held that the amounts referable to services would have to be determined in the light of the facts of a particular case on the basis of material provided by the contractor.

DD.9. The Composition Scheme for service tax on works contract

The above scheme has been notified so as to come into effect from 1-6-2007. This scheme has a non obstante clause in rule 3. The Rules are the Works Contract (Composition Scheme for Payment of Service Tax) Rules, 2007. The words notwithstanding anything in section 67 of the Act in rule 3 are objectionable and have the effect of overriding the statutory valuation mechanism for evaluation of value of taxable services under the Act. Rules cannot override the statute. Further these rules provide for the payment instead of paying the service tax at the rate specified in section 66 of the Act an amount equivalent to two per cent of the gross amount charged for the works contract. The gross amount charged should exclude the sales tax or VAT paid on the goods. The italicized segment of the rule raises issues of grave importance. There have been controversies in Central Excise law, particularly in the context of Cenvat rules, whether an amount payable at a certain rate is the same as the duty leviable under section 3 of the CE Act, 1944.

A further condition is that the person opting for the composition can do so, provided he does not avail Cenvat on the inputs used in relation to the works contract. Such option can be exercised in respect of each contract, and shall be done before paying tax on the particular contract, and cannot be withdrawn till the completion of the said contract.

E. Important cases decided by apex court relating to the subject

1. State of Madras vs. Gannon Dunkerley & Co Ltd, [1958] 9 STC 353 (SC) wherein the Hon’ble Supreme Court held that the classical concept of “sale” would apply to the entry in Entry 48 of List II of 7th Schedule. A contract under which a contractor agreed to set up a building would not be a contract for sale and the said contract was ‘entire and indivisible’ and there was no separate agreement for sale of goods justifying the levy of sales tax by the State legislatures. Further it was observed that the expression “sale of goods” in Entry 48 is a nomen juris its essential ingredients being an agreement to sell movables for a price and property passing therein pursuant to that agreement. In a building contract which is one, entire and indivisible, there is no sale of goods and it is not within the competence of the State legislature to impose a tax on the supply of the materials used in such a contract treating it as a sale.
   
   Note: It may be appreciated that the above decision of the Supreme Court among other things, ultimately led to 46th Amendment amending the definition of the expression “tax on the sale or purchase of goods” in Article 366(29A) of the Constitution. This amendment was in accordance with the Finance Commission’s recommendations.

2. In Builders Association of India vs. State of Karnataka [1989] 73 STC 370 (SC), the Hon’ble Supreme Court held that the enlargement of the definition of “sale” in Article 366(29A) of the Constitution to include “tax on transfer of property in goods involved in the execution of works contract” is to enable the State Governments to tax transfer of property in the goods involved in the execution of a works contract. It does not enable the States to tax the entire works contract itself.

3. Gannon Dunkerley & Co vs. State of Rajasthan [1993] 88 STC 204 (SC) and Builders Association of India vs. State of Karnataka [1993] 88 STC 248 (SC), (the second Builders Assn. case) the Hon’ble Supreme Court held that even after the amendment to Article 366(29A) of the Constitution by 46th Amendment, the power of the State Governments to impose tax on sale of deemed sales as in Articles 366(29A)(a) to (f) is subject to other Articles in the Constitution such as Article 286, etc and restrictions under CST Act, 1956 would still be applicable. As regards ‘measure’ for the levy of works contract tax as contemplated by Article 366(29A)(b), the same is restricted to the value of goods involved in the execution of a works contract. The measure for the levy of the tax has to be the value of the goods at the time of incorporation of the goods in the works and not the cost of acquisition of the goods by the contractor. The value of the goods involved in the execution of a works contract will have to be determined by taking into account the value of the entire works contract and deducting therefrom the charges towards labour and services.

4. K. Raheja Development Corporation vs. State of Karnataka 2006 (3) STR 337 (SC)— This decision of the Honorable Apex Court rendered in the context of ‘works contract’ in Karnataka Sales Tax Act, 1957 is extremely important and in para 18 of the decision, the Court held thus:
   
   “..It must be clarified that if the agreement is entered into after the flat or unit is already constructed, then there would be no works contract. But so long as the agreement is entered into before the construction is complete it would be a works contract.”
   
   Note: The above observation of the Hon’ble Court is of considerable significance in the context of Service Tax whereby in order to attract levy of service tax there must be relationship of “service provider” and “service receiver” which is quintessential. In a case where the “service provider” has constructed a commercial / industrial or residential complex without there being any customer/client and in a case where after the construction is completed, a person enters into contract for sale of apartment/flat/immovable property, then there can be no question of service tax being attracted applying the above ratio. In the above situation, the transaction would be that of immovable property and not for rendering or providing of any taxable service.

5. Bharat Sanchar Nigam Ltd. vs. UOI 2006 (2) STR 161 (SC), wherein the Honorable Supreme Court held that out of six deemed sales in Article 366(29A) as amended by the 46th Amendment, only works contract and catering contract involved a kind of service and sale at the same time. These are the only two deemed sales situations which are constitutionally amenable to splitting of the service and supply of goods. Further, it was held that the ‘aspect theory’ can be applied to a contract of service and sale and it is possible for the State to tax the sale element provided there is a discernible sale and only to the extent relatable to such sale. However, ‘aspect theory’ cannot be applied to enable the value of the services to be included in the sale of goods or the price of goods in the value of service.
   
   Note: Though the above decision was rendered in the context of ‘tax on transfer of right to use goods’ vis-à-vis service tax in the case of providing telephone connection, wherein the Court held that ‘goods’ do not include electromagnetic waves or radio frequencies and there was no ‘transfer of right to use’ in providing telephone connection since there was no ‘goods’ in a deliverable condition, the decision is important insofar as it relates to valuation of goods and/or taxable service applying the ‘aspect theory’.

F. Important notifications and circulars

1. Notification No. 1/2006-ST dated 1-3-2006 [Sl. Nos. 7 & 10]: This is a notification granting exemption from the service tax payable, in relation to construction services in section 65(105)(zzq) and section 65(105)(zzzh) of the Act, on a value in excess of 33% of the gross amount charged. This notification is subject to the condition that the service provider opting to this notification is not entitled for Cenvat credit of duty paid on inputs or capital goods or the Cenvat Credit of service tax on input services used for providing the service.

2. Notification No. 12/2003-ST dated 20-6-2003: This is a general notification applicable to all taxable services under the Act. This notification grants exemption equal to the value of goods and materials sold by the service provider to the recipient of service. This notification is subject to the condition that there is documentary proof indicating the value of the goods and materials. There is also further condition that no Cenvat credit benefit should have been availed on goods and materials which were sold and in respect of which the exemption is claimed by the service provider.

3. MF (DR) Letter F.No. 332/35/2006-TRU dated 1-8-2006: The Ministry of Finance has clarified legal position in respect of certain issues relating to levy of service tax on “construction of complex” and “construction of commercial or industrial construction”. It is clarified that in a case where the builder, promoter or developer builds a residential complex, the contractor is liable to pay service tax on services provided to the builder/promoter/developer. However, if the builder/promoter/developer himself undertakes construction work on his own without engaging any contractor, then there would be no service tax leviable.

4. DGST Letter F.No. V/DGST/22/Audit/Misc./1/2004 dated 16-2-2006: The DGST has clarified that estate builders would be liable for payment of service tax apart from hired contractor, they being independent service providers. The decision of the Apex Court in K. Raheja Development Corporation was relied on. This clarification is at variance to the clarification dated -8-2006 supra of the Ministry of Finance.

5. A master circular has been issued by the GOI, pursuant to the Rustagi Committee Recommendations, rescinding many earlier circulars. The reader’s attention is called to the circulars in Nos.96/7/2007 and 07/8/2007 both dated 23.8.2007 issued by the Tax Research Unit of the MF (DR), Government of India. These are important circulars, which clarify several aspects of the Finance Act, 1994 and various taxable services including valuation and related matters.

Source : Published in 14th National Convention held on 7th, 8th & 9th December, 2007 at New Delhi.