Putting work contracts under the lens

The real estate sector is a sunrise one in terms of its explosive growth prospects. It has attracted significant investments as well. It is also an important contributor to government revenues.

From an indirect tax perspective, the builder or developer, who is a key person in the supply chain, has been the focus of government attention in recent times. Typically, the transactions undertaken by a developer are two-fold. On the one hand, he arranges land for development and undertakes construction thereon either through third party contractors or by himself .

On the other hand, he enters into sale agreements with the buyers of the constructed units. While the purchase of land by a developer is chargeable to stamp duty, which is chargeable on sales of immovable property, the construction work, if undertaken by him through third parties, is chargeable to VAT as well as service tax, as it constitutes a transaction of works contract. Finally, the sale of complete constructed units is chargeable again to stamp duty, as it constitutes sale of immovable property. However, the construction and sale of units on behalf of buyers is the subject matter of dispute under tax laws.

The indirect taxation of the transaction of sale of "under construction" units by a developer has become moot, after the recent judgment of the Supreme Court in the case of K Raheja Development Corporation versus the State of Karnataka [2005] 2 STT 178 (SC). The judgment was based on the provisions of the Karnataka Sales Tax Act, 1957, and mainly clarified the scope of the definition of "works contract" contained in that Act.

The facts of the case were that the appellant, who carried on the business of real estate development and allied contracts, entered into development agreement with the owners of land. He obtained plan sanctions and, after approval, constructed residential apartments and/or commercial complexes on the land.

The agreements provided that on completion of the construction, the residential apartment or the commercial complex, as the case may be, would be handed over to the purchasers, who would obtain an undivided interest in the land as well. The owner of the land would transfer ownership thereof directly to a society which was being formed under the relevant statute. The question before the Supreme Court was whether the appellant was a dealer and liable to pay turnover tax under the Karnataka Sales Tax Act, 1957, in relation to the above agreements entered into with the purchasers, as "works contracts".

The court held that where a builder/ developer sold a flat under construction, for amounts to be received in installments, such transactions amounted to works contracts, as the developer was essentially constructing the flat on behalf of the purchaser. It was, however, clarified that if it was a case of sale of a fully-constructed flat, it would not be a case of works contract and hence no tax would apply. Thus, according to this decision, the question of whether a contract would comprise a works contract or not would depend upon the facts of the case and a determination of when the sale or the transfer of property in goods had happened.

While the above judgment was in the context of the definition of the term "works contract" under the Karnataka Sales Tax Act, 1957, and was based on the specific facts of the case, various state governments like Uttar Pradesh, West Bengal and Maharashtra considered it to be propounding a general principle and consequently issued trade notices to purportedly clarify the definition of works contract in their respective statutes in order to charge to tax the transactions of sale of units by a developer in particular situations.

Parallely, following the decision in K Raheja, the director general, Service Tax, issued a circular to state that given the underlying principles of the above decision, it would equally be the case that should the agreements for sale of constructed units be entered into prior to the completion thereof, service tax would be chargeable on such contracts under the appropriate heading of "construction of residential complex". Of course, the aforesaid circular was only in relation to the above heading, which was the only applicable one at the time, but the principle would now equally apply to all situations of works contracts, as per the newly introduced definition in relation thereto.

It is now thus the situation that builders/developers are faced with the real threat of a potential double taxation of works contracts under both the state sales tax/VAT and the central service tax. Of course, the two taxes operate in their respective domains and only apply to the material and the service/labour component of works contracts, respectively.

However, the problem is that typically there is overlap, in terms of the methodologies prescribed in either of the two statutes to charge such contracts to the respective taxes, and it is here that the threat of double taxation of the same underlying base value becomes real.

Interestingly, the aforesaid state governments, which had issued clarificatory circulars based on the decision in the K Raheja case, have chosen to interpret it differently and consequently the applicability of the sales tax/VAT has been determined on different bases. The UP government has held that if an agreement to sell immovable property was entered into prior to the construction of the property or completion of construction of the property, it would constitute a works contract.

On the other hand, the West Bengal government states that the activities carried out by a developer after entering into an agreement with the intended purchaser will be considered a works contract. While explaining the term "intending purchaser", the circular states that as and when any prospective purchaser of a building or a flat participates in the offer by paying advance money, he acquires a right to become an intending purchaser.

The circular further states that in case an intending purchaser enters into an agreement to buy the property with the developer after partial completion of construction, the value of the incomplete portion of the property would constitute the value of the works contract. The State of Maharashtra has amended the Maharashtra VAT Act to define "sale" on the lines similar to that contained in the Karnataka VAT Act, so as to include therein transfers of property in goods involved in the execution of works contracts of any movable or immovable property.

The aforesaid developments have led to a situation where a particular transaction of sale of building units by a developer to prospective buyers could be treated differently in different states and hence the tax consequences could vary as well.

A recent judgment of the Allahabad High Court, in the case of Assotech Realty Private Limited versus the State of Uttar Pradesh [2007(7) STR 129], constitutes another important development in law. In this case, the court held that the mere fact that an agreement to buy a constructed unit had been entered into prior to completion of its construction, and the fact that payment for its purchase had been made in installments, would not make the transaction a works contract.

The Assotech Realty decision is, therefore, a welcome clarification of K Raheja decision. It would now be possible to appropriately structure the agreements for sale of immovable property in a manner as to preclude the applicability of any indirect taxes, which are limited to movable goods alone. Thus if appropriately structured, transactions for sale and purchase of immovable property would continue to be chargeable to just the applicable stamp duty and not to sales tax/VAT or to service tax.