Whitepaper - Service Tax on Works Contract

Transcription

1 Whitepaper - Service Tax on Works Contract Ms. Radha Arun, Consultant to Udyog Software (India) Ltd. This document contains a brief on service tax on works contracts involving goods and services, in the light of recent rulings on the subject Udyog Software (India) Ltd. Hyderabad, Telangana, India September 03, 2015

2 Service Tax on Works Contracts The taxation of composite contracts involving services and goods has always been complex and prone to litigation because of the manner in which the power to tax these two elements is divided between the centre and the states. While the power to tax is disparate, the contract is unitary. This poses a problem to the respective taxing authorities. Difference of opinion on vivisection of works contracts: Works contracts are the most prominent genre of composite contracts. Six months back, the issue of service tax on works contract created a strong polarisation in the CESTAT Larger Bench in the case of Larsen & Toubro Limited and Kehems Engineering Private Limited. While the judicial members opined that a works contract could not be vivisected to levy service tax on the service component prior to 2007, the technical members overruled them in a forcefully worded majority decision holding that the service component of works contracts could be extracted and taxed under available entries even prior to the introduction of a specific entry for works contracts in 2007 (service tax appeals of 2013 and 550 of 2007 and 662 of 2007 in the Delhi bench of CESTAT). The minority stand, however, was vindicated in a subsequent judgment of the Supreme Court. Powers to tax services / sale of goods: The controversy has its roots in the federal structure of the Indian polity, in which the law-making powers are divided between the states and the centre by the Constitution of India. Under this division of powers, the legislature of each state makes law to tax sale of goods within the state, as per List II to the Seventh Schedule. For sale of goods across state borders, the central legislature (Parliament) makes law but the collection has been allotted to the states. Thus taxation of sale of goods is entirely in the hands of the states. On the other hand, the states do not have power to tax services. Parliament, as the central legislative body, derives power to tax services from the residual entry 97 in List I (the union list) of the Seventh Schedule of the Constitution of India, which covers any subject not specified in List II or III or elsewhere in list I. Under this power, service tax was first introduced in India in 1994, and till 2012 it was levied only specified services. If the service was not specified as taxable, it was not taxed. From July 2012, all services were taxable, if no exception or exemption was provided under law. 46th constitutional amendment: sales tax on works contracts: Works contracts are a species of contract in which the transfer of property in goods takes place by accretion in the course of the activity contracted and not by sale of the goods per se. As there is no sale of goods, the transaction did not attract sales tax. There was no tax on services before 1994, and thus the contracts of this nature escaped taxation altogether. In order to plug this anomaly, the Constitution was amended by the 46th amendment in 1982 to provide that a tax on sales would include a tax on the transfer of property in goods involved in execution of a works contract. Udyog Software (India) Ltd. Monday, 03 September 2015 Page 1

3 This was done by insertion of clause (29A) in Article 366. Pursuant to this, the states enacted laws to tax the transfer of property goods in such contracts and also to provide the machinery provisions to segregate the value of goods from the rest of the value of the contract. Service tax on construction and related services: After service tax was introduced in 1994, the list of specified services was expanded each year. Construction and related services were covered as follows: Erection, commissioning and installation: 2003 Commercial and industrial construction: 2004 Construction of complex: 2005 Service component of works contracts: 2007 The controversy before the Larger Bench of the CESTAT was whether, before works contracts were introduced as a specific taxable category, the service component of a works contract would be available for extraction and taxation. Minority view in CESTAT Larger Bench decision in L&T case: The judicial members in the split ruling in the L&T reference opined that the construction-related services specified as taxable in 2003, 2004 and 2005 were taxable if delivered as services simplicitor. But if they were part of a works contract, they could not be extracted and taxed without any statutory authority to do so. This was elaborated as follows. A works contract is a hybrid involving goods and services. By virtue of the 46th amendment of the Constitution, the states were empowered to extract a part of this hybrid for taxing it as sale of goods. At the same time the mechanism for doing so was also specified. Service tax, being leviable under entry 97 which is for residual matters not covered elsewhere, has to be careful that no part of what it is taxing is covered elsewhere. This demarcation has to be stringent and done under statute, not by broad inference. Thus, though it may broadly be said that the remainder after what was taxed as deemed sale in a works contract must be service, this was not sufficient to levy a tax on the remainder, because the federal separation of powers required that to levy a tax on service, the determination of service must be done under service tax law. The judicial members opined that a vague/overbroad definition of a taxable service coupled with an ambiguous charging and an indeterminate valuation provision, would not suffice or pass judicial muster in this context. The Union s legislative intention to levy tax only on the labour / service context must be categorically expressed in the charging provision or in the charging provision read with the definition of the taxable service and the valuation rules. If this was not done, the levy could be struck down as ultra vires the Constitution. Therefore, if there was any ambiguity, the law must be saved by reading down the levy as pertaining to service simplicitor only and not to works contracts. The minority opinion in the Larger Bench decision in L&T did this, by holding that the levy of service tax on erection, commissioning and installation service, industrial and Udyog Software (India) Ltd. Monday, 03 September 2015 Page 2

4 commercial construction service and construction of complex service referred to such services when delivered as services simplicitor, and not when they formed a part of a works contract. Majority view (of the Technical members) in CESTAT LB decision in L&T case: The three technical members of the CESTAT, whose view prevailed over, outnumbered, and overruled the judicial members opinion, held that even prior to works contracts being specified as a specific taxable category, the services rendered as part of works contracts could be levied to service tax. Their reasoning was that a works contract is essentially a contract for service, in which property in goods gets transferred by accretion in execution of the contract. Once the property element is removed and taxed to sales tax or VAT by the states, the remaining part is available for the levy of service tax. Therefore if the service fits the description of the taxable services specified in the Finance Act 1994 there is no hurdle to levying service tax on it. Supreme Court on works contracts prior to 2007: In a view that carries resonances of the minority view in the CESTAT larger bench case referred to above, the Supreme Court (supra) observed as follows in paragraph 24 of its judgment: 24. A close look at the Finance Act, 1994 would show that the five taxable services referred to in the charging Section 65(105) would refer only to service contracts simpliciter and not to composite works contracts. This is clear from the very language of Section 65(105) which defines "taxable service" as "any service provided". All the services referred to in the said sub-clauses are service contracts simpliciter without any other element in them, such as for example, a service contract which is a commissioning and installation, or erection, commissioning and installation contract. Further, under Section 67, as has been pointed out above, the value of a taxable service is the gross amount charged by the service provider for such service rendered by him. This would unmistakably show that what is referred to in the charging provision is the taxation of service contracts simpliciter and not composite works contracts, such as are contained on the facts of the present cases. It will also be noticed that no attempt to remove the non-service elements from the composite works contracts has been made by any of the aforesaid Sections by deducting from the gross value of the works contract the value of property in goods transferred in the execution of a works contract. Thus the Supreme Court pointed to the fact that prior to 2007 the levy of service tax was on the gross value of the taxable service. Applying this, if we take works contracts as a taxable service under the category of construction, the levy would be on the whole value of the works contract for construction. There was no statutory provision to exclude the value of goods that were transferred and that were taxable to sales tax by the states. Therefore, the Supreme Court concluded that it was clear that the levy of service tax was only on services simplicitor and not to services that were part of a works contract. Udyog Software (India) Ltd. Monday, 03 September 2015 Page 3

5 In contrast, the specific entry to tax works contracts in 2007 explicated the intention to tax the service element, and simultaneously rules were also framed on how to extract this service element from the hybrid contract. The judicial discussions and pronouncements are enlightening on the need for treading with extreme caution in matters concerning the federal division of powers. To that extent their scope extends not only backward, to the pre-2007 period, but also into the future scenario of the proposed Goods and Services Tax. ********************************************************************************************************** Please connect with us at: Web: Udyog Software (India) Ltd. Monday, 03 September 2015 Page 4