Implications of VAT in
Real Estate Development Contracts

VAT envisages levy of tax on sale of goods. ‘Immovable property’, not being goods, is outside the purview of VAT legislation. However, even on the development of immovable property — whether by the owner himself or by a collaborator, the State gets its share of revenue because the owner or the collaborator has to purchase the material required for the construction of the building after payment of VAT. Many a times, the owner instead of constructing the building himself, engages a contractor for the construction of the building. The law in this regard was firmly established by the most authoritative and landmark decision of the Supreme Court till date in the case of State of Madras vs. Gannon Dunkerley & Co. (Madras) Ltd. (1958) 9 STC 353 (S.C.) that “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 Provincial Legislature under Entry 48 to impose a tax on the supply of the materials used in such a contract” because “the property in materials used does not pass to the other party to the contract as movable property” but, “the materials used therein would become the property of the other party to the contract only on the theory of accretion”. Of course, the Court further clarified that “the parties to the contract might enter into distinct and separate contracts, one for the transfer of materials for money consideration and the other for payment of remuneration for services and for work done. In such a case, there are really two agreements, though there is a single instrument embodying them, and the power of the State to separate the agreement to sell from the agreement to do work and services and to impose a tax thereon cannot be questioned”.

The result of this decision, coupled with other decisions on the limitations of the power of the States to levy sales tax on lease of goods, hire-purchase, supply of food and drinks in a hotel or restaurant, etc. was the Constitution (46th Amendment) Act, enabling the States to levy sales tax on such transactions by deeming them as sale. All the States, except Delhi, were quick to amend their State Sales Tax enactments levying tax on such deemed sales.

Works contract has always been considered by all the States as a major source of revenue. Definition of Works Contract in all the States is almost the same and reads as under:

“Works contract includes any agreement for carrying out for cash or for deferred payment or for valuable consideration, the building construction, manufacture, processing, fabrication, erection, installation, fitting out, improvement, repair or commissioning of any movable or immovable property;”

A works contract may relate to movable or immovable property. A works contract relating to movable may also involve consideration of several legal issues such as whether the contract is divisible or indivisible; whether it is inside a State or outside a State or in the course of inter-State trade or commerce; amounts to be deducted towards labour and other expenses of like nature; tax to be deducted and so on. But this being not the subject of present discussion is being left out for consideration at some other time.

Where the contractor is constructing for the owner of the land for consideration, there is no doubt that he would be liable. What about the liability of a real estate developer who enters into a collaboration agreement with the owner of the land or who himself being the owner of the land or a permanent lessee or even as a collaborator, enters into agreements with the prospective buyers of property even before the commencement of construction or during the construction but before the completion?

The liability of the real estate developers needs to be considered from three angles – i) as purchasers of materials including capital equipment required for construction; ii) as collaborators with the owners of land, and iii) as developers of property with the prospective buyers.

i) Liability of Real Estate Developers as purchasers of materials

A real estate developer has to purchase the material including the capital equipment required for construction after payment of VAT. Where he sells the building or part thereof, after completion, it is a sale of immovable property. The tax paid by him on his purchases is a part of his cost of construction. However, where he is considered as a dealer under the VAT law, he would be entitled to claim input tax credit of the tax paid by him on his purchases within the State of materials as well as the capital equipment, except non-creditable equipment, and adjust the same against his liability on sales deemed to have been effected by him. It is also conceivable that he may have awarded sub-contracts for development of the property. In such cases, he should obtain tax invoice from the sub-contractor to enable him to claim input credit, unless the particular State law provides that the amount of sub-contract awarded by him shall not form part of his turnover.

The developer may also have to make certain purchases in the course of inter-State trade and commerce. Where he is constructing the property for himself and would sell the same after completion thereof, he shall have to make the purchases in the course of inter-State trade at full rate and cannot purchase at concessional rate even if he is a registered dealer because the material purchased cannot be said to be required by him for resale or for use in the manufacture or processing of goods for sale as what he would be selling after completion of the building would be immovable property. However, where he is deemed as a dealer liable to pay VAT, he would be entitled to make the purchases at concessional rate of goods specified in his certificate of registration as the same are deemed to have been sold by him. Of course, like any other dealer, he cannot claim input credit of the tax paid in the course of inter-State trade or commerce. He may also received stocks on transfer against declaration in form F from his head office or branch in other State.

Liability of Real Estate Developer being the collaborator qua the owner of land

Many a times, a developer of real estate, enters into a collaboration agreement with the owner of the land. The collaboration agreement may take number of shapes but, generally, under the collaboration agreement he agrees to construct the building – give part of the building to the owner as well as some amount as cash consideration and gets the rights over the defined portion of the land and building. Sometimes, apart from a share of portion in the land and building, the owner gives him cash as well for construction of the building. The aspect, which has not received the attention of the courts and the revenue authorities so far, is: Can the developer or collaborator, based on K. Raheja’s case be said to be constructing for and on behalf of the owner of land and be held liable? Can the collaboration agreement be said to be for sale of part of the land by the owner in favour of the developer and construction of the part of the building to go to the owner by the collaborator for the owner? Can it be said to be a case of extinction of one debt against the other? These issues need to be debated and discussed.

Liability of Real Estate Developer qua the prospective purchaser

Then came the judgment of the Supreme Court in K. Raheja Development Corporation vs. State of Karnataka (2005) 141 STC 298 (S.C.). The legal fraternity, particularly, the ones practising on the tax side have, so far, not been able to digest this judgment which has been grabbed by the revenue authorities to initiate proceedings against the developers and builders of the property. In K. Raheja’s case the Supreme Court noted and held that:

1. The definition of ‘works contract’ in section 2(1)(v)(i) of Karnataka Sales Tax Act was very wide and not restricted to works contract as commonly understood. It included within its ambit any agreement for carrying out either for cash or for deferred payment or for any valuable consideration the building and construction of any movable or immovable property. The definition took within its ambit any type of agreement wherein the construction of a building took place either for cash or for deferred payment or for valuable consideration.

2. That even an owner could be regarded as works contractor in so far as he entered into an agreement to carry out the construction activity on behalf of someone else for cash, deferred payment or other valuable consideration. In such case he would be carrying out a works contract and would become liable to pay turnover tax on transfer of goods involved in such works contract.

3. That there was no distinction between construction of residential flats and construction of commercial units for the purposes of works contract.

4. That the provisions of the Karnataka Ownership of Flats (Regulation of Promotion, Construction, Sales, Management & Transfer) Act, 1974 were not relevant for the purpose of considering whether the agreement amounted to works contract or not.

5. That the appellant had undertaken to build for the prospective purchaser on payment of price in various installments set out in agreement. The construction was for and on behalf of the purchaser and, therefore, the agreement remained a works contract within the meaning of the said terms as defined in the Act. So long as the agreement was entered into before the construction was complete, it would be a works contract.

6. A clause in the agreement which provided for the termination of the agreement if a breach was committed by the purchaser and authorized the appellant to dispose of the unit in such an event, who claimed lien on the property, did not make a difference and the agreement on that account did not cease to be a works contract.

7. That, however, if the agreement was entered into after the flat or unit was already constructed there would be no works contract.

The aforesaid judgment is not easily palatable to a large section of legal community. However, it must be remembered that the judgment was delivered on the peculiar facts of the case. The single most factor which weighed with the Court was the clause in the agreement in which K. Raheja had undertaken to construct for and on behalf of the prospective buyers.

On the basis of the aforesaid judgment of the Supreme Court in K. Raheja’s case the States initiated action against developers and builders of properties and wanted to bring them within the tax net in all such cases where the developers and builders of properties had entered into the agreement with prospective buyers either before the commencement of construction or during the construction of the building. In almost all the States, the dealers have the option to adopt the cash method or mercantile system of accounting for purposes of sales tax. Some of the issues which were raised before the State authorities in Delhi were:

(1) Is the VAT return to be filed on the basis of payment received from the prospective buyer or the buyers during the tax period or is it to be filed on the basis of the material used in the construction of the building during the tax period?

A. In case the return is to be filed on the basis of payment received during the tax period:

1. In case the VAT return is to be filed on the basis of payment received from a prospective customer during the tax period, such payment being towards cost of land as well as cost of construction, is the developer entitled to adjust initial payment received from the prospective buyer against the proportionate cost of land?

2. Where agreement with the prospective buyer is entered into after the construction has been started, can the part of the payment received be adjusted against the building already completed on which there would be no liability as the material involved in the construction of such completed building becomes part of immovable property?

3. Would the collaborator be liable for the payment received which is relatable to the construction after the receipt of the payment?

4. In case payment is received after the construction of a particular part has been completed, would there be any liability?

5. In case the agreement with the prospective buyer is cancelled during the construction itself and the payment received from such prospective buyer is refunded to him, can the collaborator claim refund or adjustment of VAT already deposited by him?

B. In case the return is to be filed on the basis of material used for the construction during a tax period:

1. In case at the time when the material is used in the construction of building, there is no agreement with the prospective buyer, would there be any liability?

2. How to ascertain the value of material involved as in the case of some building consisting of several flats there may be several agreements, some entered into prior to the construction or some after commencement of construction and some after the completion of the construction?

3. Even in those cases where the agreements with the prospective buyers are entered into after the commencement of the construction, how to work out the value of the material for different flats because in some cases construction of flats with a prospective buyer may have been completed though the building itself is not complete?

4. Construction of some of the flats may be in progress and construction of some of the flats in the same building may not yet have started.

5. Major part of the price to be received from the prospective buyer is towards cost of land. In every project of development of immovable property, there is element of profit. Major part of element of profit is towards the cost of land as the appreciation in the land prices is higher than the appreciation in the value of the material. How to apportion the cost of land and the cost of construction?

The State have no answer to the aforesaid issues. State like Delhi amended the Rules to provide for deduction on account of cost of land. However, most of the issues still remain unanswered.

In K. Raheja’s case the revision petition of K. Raheja was dismissed by the Karnataka High Court in view of its judgment in Mittal Investment Corporation vs. Additional Commissioner of Commercial Taxes reported in (2001) 121 STC 3 (Kar). After K. Raheja was granted leave to appeal, a review application was made in Mittal Investment Corporation’s case and the case was to some extent reviewed by the Karnataka High Court in (2001) 121 STC 14 (Kar). In view of the review order of Karnataka High Court, K. Raheja wanted its case to be sent back to the Karnataka High Court. When the Hon’ble Judges of the Supreme Court put a query to K. Raheja as to whether it was accepting principles laid down in Mittal Investment Corporation’s case, K. Raheja submitted that it wanted to agitate all the grounds including that there was no works contract. In view of this stand of the appellant, Hon’ble Supreme Court decided to hear and dispose of the matter itself.
Since K. Raheja’a case was blindly being applied by the States to all agreements relating to real Estate developments, some of the developers filed petition before the Allahabad High Court. Recently, the Allahabad High Court in Assotech Reality (2007) 8 VST 738 (All) has held:

1. There must be an agreement, express or implied.

2. But if the activity of construction is undertaken by a person for self it would not amount to works contract.

3. In the case before the Court the builder was empowered to mortgage land as well as apartment.

4. The allottees got the rights in the property only on execution of sale.

5. The builder could change the plan and specification.

6. Construction was not for and on behalf of the prospective buyers.

Under the circumstances, the Court held that the builder could not be said to be a works contractor and was not liable to pay tax.

From a reading of the judgment of the Supreme Court in K. Raheja one feels as if the Court was determined to come to a conclusion that a builder is liable to pay tax as a works contractor. Similarly, from a reading of judgment of Allahabad High Court in Assotech Reality, one gets a feeling that the Court wanted to reach a conclusion that a builder of real estate was not liable to pay sales tax.

The conclusion arrived at by the Allahabad High Court is correct. However, the correct reasoning for reaching the said conclusion is that the parties to the contract in such a case, namely, the builder or the developer of property as well as the prospective buyer do not intend to buy or sell the material involved in the execution of works contract nor do they ever envisage that the builder is constructing for and on behalf of the prospective buyer. In essence, the parties are ad idem that it is an agreement for sale and purchase of immovable property. Immovable property not being the subject matter of sales taxation would be outside the purview of VAT legislation.

Whenever I read H. Anraj, I always felt as if the court was determined to come to a conclusion that Lottery Tickets are goods. That was a judgment which held the field for more than 20 years and in fact, led to an expansive meaning being given to the term ‘goods’. However, even while relying on the said judgment it was always at the back of my mind that it is as if a forced decision. Now, I am glad, that after 20 years, the Constitution Bench on our appeals overruled H. Anraj, gets a similar feeling when one reads K. Raheja.

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