Pronounced on 26 September 2013, the Judgement of Supreme Court (SC) in the case of Larsen and Toubro , changes the concept of “works contract” and significantly expands scope of taxation of transactions involving transfer of property in goods involved in execution of “works contracts”. It will have significant bearing on the manner of its implementation going forward.
 
Hitherto, at least till the decision of SC in the case of Raheja Developers (which was believed to be differentiable on facts and in law), “works contracts” as referred to in Article 366(29A)(b) of the Constitution were generally, understood to be those transactions where the work was performed on the property of the customer/buyer and the property in the goods, in any form, passed to the customer by theory of accretion/accession; where the customer had proprietary interest in the works whether it was repair or modification or renovation of goods/immovable property or construction of building on customer’s land.
 
The interpretation adopted by the SC has, in essence, done away with this aspect of proprietary interest. SC has now explained “works contract” to mean a transaction where, as a result, “work(s)” is/are created irrespective of whether the property on which the work is carried out belongs to the customer or not and even if the property in the resulting movable or immovable property passes to the customer subsequent to the completion of the “works”.
 
Effectively, therefore, transactions where goods are made to order will need to be carefully examined for applicability of works contract tax. The same will also be true of service contracts involving transfer of property in goods, even if such transfer is incidental or ancillary to the execution of the works contract.
 
It will be interesting to see how State Governments formulate rules for determining taxable value in case of contracts involving sale of flats in under construction buildings as value, in each case, could be different based on the stage of completion of the work at the point of time when the agreement is entered into. Supreme Court has clearly held that the taxability, as works contract, arises only after the agreement is entered into. This means, in each case, taxable value will need to be determined based on the proportion of the consideration allocable to the work carried out after the date of entering into the agreement.
 
An important implication of this judgment is that the VAT chain will now get extended, to some extent, to the ultimate buyer of the under construction properties. Developers pay works contract tax to the contractors and they, in turn, will charge works contract tax to the customers. This will require State Governments to work out appropriate mechanism to enable credit flow to avoid double taxation. It will also be interesting to see whether this chain is further extended (completed) by allowing input tax credit to the buyers of properties who use it for business purposes and are paying output VAT. That would be the true VAT – a complete pass through for businesses!!!

Its an excellent judgment. The judges have considered all aspects of the matter and in great depth and have come to a clear conclusion that the provisions of law are constitutionally valid. They have also decided that agreements under MOFA have some elements of a Works Contract and hence the state is entitled to levy VAT. It is an extremely erudite judgment.

The larger bench judgment of Supreme Court upholding levy of VAT on sale of under construction projects would be a big blow for the real estate industry which is already suffering due to the down turn in the current economic environment. Now, in addition to stamp duty and service tax, these projects would be exposed to VAT as well. Further, given its a Supreme Court judgment revenue authorities may try to raise demand of VAT on the real estate players even for the past period. It will be interesting to see if the developers would be able to pass on the burden of VAT to the ultimate buyer specially in case the demand is raised by the revenue authorities for the past period. Real estate developers would need to analyse the impact of the Supreme Court judgment in various States given the specific VAT provisions of each State and due to different models for sale of properties followed in different Sates. Another important aspect for real estate developers would be to appropriately factor input VAT credits wherever VAT needs to be paid on sale of under construction properties

While the SC has laid down the law as regards the taxability, a new pandora’s box has been opened in so far as it concerns the value on which tax is to be paid especially for the period from June 2006 to March 2010 for the state of Maharashtra. The SC has made 2 very important observations:
 
1. VAT would be payable only on the value addition to the goods transferred after the date of agreement with the customer and
 
2. Rule 58 (1A) has been read down to an extent and the State of Maharashtra has been asked to bring in clarity to bring in line the rule to the manner in which the SC has laid down its rationale.
 
It would be worthwhile for the State to provide for an optional blanket rate for covering even the period prior to 1.4.2010 to avoid the issues and bring clarity to builders. Also an amnesty for interest and penalty should be declared considering the current state of the real estate industry and also the fact that VAT being an indirect tax it would still affect the customers who have purchased apartments during this period.

Essentially SC has affirmed and upheld the State Govt’s right to levy tax on transactions in relation to construction of immovable property like residential or commercial premises. This now enables State Govts to levy and collect VAT in case of contracts for construction of immovable property or for under construction property otherwise in the nature of and acquires the character of immovable property when completed. This decision is in respect of Maharashtra and Karnataka but in my view this decision more or less settles the position that levy of VAT by State Govts from past periods say from 2006 in Maharashtra is correct as these type of agreements or contracts are in the nature of Works contracts until they are completed and acquires the character of immovable property and not taxable. The liability of VAT is on seller i.e. builder or developer to pay it to State Govts. He may recover the same from customer if it is contractually provided.

A) This decision is one defining the line of termination between taxing works contract and not taxing immovable property. It reiterates once again that States are not empowered to tax transfer of immovable property as works contract. However, States are not denuded with the Power if a transaction has dimensions of both a works contract and an immovable property.
 
B) Both works contract and immovable property cannot co-exist but the decision brings out a new legal blend in enforcing the principle that the tax is only on works contract though it is an immovable property. How does it do it?
 
C) Technically speaking, the transaction involves three parties and two contracts. The first leg is between the owner and the developer and the second leg is with the customer. Though tripartite, the conceivable position before the judgment was, the execution between the owner and the developer is actually in the nature of works contract but does not suffer a tax as it is a mere barter. The owner exchanges the land for the Flats to be built by the developer. Qua the customer, which is the second leg of the transaction, the transfer is by way of an immovable property and therefore outside the realm of Article 366(29A) of the Constitution.
 
D) The decision no longer allows the dissection. It reads both the legs of the transaction as one straight line and proceeds to conclude that it is the customer who pays for the Flats though the construction of the Flats takes place on the lands of the owners, yet to be conveyed. It is immaterial as to who owns. The construction takes place on behalf of the customer on the land of the owner. Since it is done on behalf of the customer, the stage of levy still remains only as works contract as the tax is on the transfer of goods in the execution of the works contract.
 
E) It therefore proceeds to conclude that the tripartite agreement has two faces. The construction is on behalf of the ultimate customer and under Article 366(29A) it is a works contract by the developer. When the built Flat gets registered it is an immovable property and the transfer is only between the owner and the customer and no levy exists at that point of time as it is an immovable property.

The ratio as summarized by the court is found in para 101 of the judgment reads as follows:
 
"In light of the above discussion, we may summarise the legal position, as follows:
 
(i) For sustaining the levy of tax on the goods deemed to have been sold in execution of a works contract, three conditions must be fulfilled: (one) there must be a works contract, (two) the goods should have been involved in the execution of a works contract and (three) the property in those goods must be transferred to a third party either as goods or in some other form.
 
(ii) For the purposes of Article 366(29-A)(b), in a building contract or any contract to do construction, if the developer has received or is entitled to receive valuable consideration, the above three things are fully met. It is so because in the performance of a contract for construction of building, the goods (chattels) like cement, concrete, steel, bricks etc. are intended to be incorporated in the structure and even though they lost their identity as goods but this factor does not prevent them from being goods.
 
(iii) Where a contract comprises of both a works contract and a transfer of immovable property, such contract does not denude it of its character as works contract. The term “works contract” in Article 366 (29-A)(b) takes within its fold all genre of works contract and is not restricted to one specie of contract to provide for labour and services alone. Nothing in Article 366(29-A)(b) limits the term “works contract”.
 
(iv) Building contracts are species of the works contract.
 
(v) A contract may involve both a contract of work and labour and a contract for sale. In such composite contract, the distinction between contract for sale of goods and contract for work (or service) is virtually diminished.
 
(vi) The dominant nature test has no application and the traditional decisions which have held that the substance of the contract must be seen have lost their significance where transactions are of the nature contemplated in Article 366(29-A). Even if the dominant intention of the contract is not to transfer the property in goods and rather it is rendering of service or the ultimate transaction is transfer of immovable property, then also it is open to the States to levy sales tax on the materials used in such contract if such contract otherwise has elements of
works contract. The enforceability test is also not determinative.
 
(vii) A transfer of property in goods under clause 29-A(b) of Article 366 is deemed to be a sale of the goods involved in the execution of a works contract by the person making the transfer and the purchase of those goods by the person to whom such transfer is made.
 
(viii) Even in a single and indivisible works contract, by virtue of the legal fiction introduced by Article 366(29-A (b), there is a deemed sale of goods which are involved in the execution of the works contract. Such a deemed sale has all the incidents of the sale of goods involved in the execution of a works contract where the contract is divisible into one for the sale of goods and the other for supply of labour and services. In other words, the single and indivisible contract, now by Forty-sixth Amendment has been brought on par with a contract containing two separate agreements and States have now power to levy sales tax on the value of the material in the execution of works contract.
 
(ix) The expression “tax on the sale or purchase of goods” in Entry 54 in List II of Seventh Schedule when read with the definition clause 29-A of Article 366 includes a tax on the transfer of property in goods whether as goods or in the form other than goods involved in the execution of works contract.
 
(x) Article 366(29-A)(b) serves to bring transactions where essential ingredients of ‘sale’ defined in the Sale of Goods Act, 1930 are absent within the ambit of sale or purchase for the purposes of levy of sales tax. In other words, transfer of movable property in a works contract is deemed to be sale even though it may not be sale within the meaning of the Sale of Goods Act.
 
(xi) Taxing the sale of goods element in a works contract under Article 366(29-A)(b) read with Entry 54 List II is permissible even after incorporation of goods provided tax is directed to the value of goods and does not purport to tax the transfer of immovable property. The value of the goods which can constitute 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 works even though property passes as between the developer and the flat purchaser after incorporation of goods."
 
With respect the court has correctly laid down the law - I have nothing more to add 

This decision will be seen as a setback by the industry. These contracts are seen by the industry as sale of flats and not contracts for building flats. This issue will be agitated in future.