CONSTRUCTION CONTRACTS (WORKS CONTRACT) – FROM THE POINT OF VIEW OF VALUE ADDED TAX
& SERVICE TAX
CA. P. Paul Thangam –paul@paulthangam.com
INTRODUCTION:
There general accepted principle is that when a transaction is liable for value added tax(VAT), then the
same transaction will not be liable for the service tax. Similarly when service tax is paid on a transaction
there will not be any liability under the VAT. But there are some transactions where there is overlapping
of VAT and service tax. VAT being a tax levied by the state government, the state government in order
to augment its revenue wants to collect VAT on most of the transactions. Service tax being the levied by
the central government, the service tax department is not worried about the VAT demand by the state
government department. In between demands of state government and central government the poor
tax payer is saddled with the service tax and VAT demand on the same transaction. The transaction of
these type are software, Royalty received from franchisees, right to use the goods, works contract etc.,
Though in both laws clear demarcation is available, in some cases there is a overlapping of service tax
and VAT. Works Contract falls under this category.
Construction contract is one type of works contract. There are many types of works contract like dyeing
contracts, vehicle repair contracts, electrical contracts, Annual Maintenance contracts for computers
etc., Though the title is given as Construction contract, it equally applies to all kinds of works contract.
ORIGIN OF SALES TAX ON CONSTRUCTION CONTRACT:
The, then, Madras State was the first state to levy tax on the sale of goods. This was governed by the
Madras General Sales Tax Act, 1939. An amendment was made to this act vide Madras General Sales Tax
(Amendment) Act (No. XXV of 1947) to widen the definition of sale. The definition of sale enlarged so as
to include "a transfer of property in goods involved in the execution of a works contracts". There was a
definition for the works contract also. But this levy was challenged before the honorable supreme court
in the case of The State of Madras v. Gannon Dunkerley & Co. (Madras) Ltd. [1958] 009 STC 0353
The Hon’ble Supreme Court held 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, as in the present case, one, entire and
indivisible-and that is its norm, 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 treating it as a sale.
To get over this decision and other decisions which prohibited the collection of sales tax on the hotels,
hire purchase agreement, mutual associations, THE CONSTITUTION (Forty-sixth Amendment) Act, 1982
was passed by the parliament. Usually in any act the definitions are contained in section 2. But in the
Constitution the definition is contained in Article 366. A new definition was introduced in the Article 366
of the constitution. According to Clause (29A) of the Constitution "tax on the sale or purchase of goods"
includes(a)………………..;
(b) a tax on the transfer of property in goods (whether as goods or in some other form) involved in the
execution of a works contract;
This definition only paved way for the taxation of goods involved in the execution of works contract.
After this constitutional amendment most of the state governments introduced definition for works
contract and the widened the definition of sale and goods, so as to tax the goods involved in the
execution of works contract. From this point only the sales tax on the construction contracts were
levied.
TAXATION OF WORKS CONTRACT UNDER TAMIL NADU VALUE ADDED TAX ACT(TNVAT Act):
Under TNVAT Act the Works contract is taxed under two sections. The relevant section are section 5
and section 6 of the TNVAT Act. Section 5 deals with the levy of tax on the goods involved in the
execution of works contract. Section 6 is a simplified system of payment of VAT on the works contract.
These two sections are mutually exclusive. Both the sections will not apply at the same time.
SECTION 5 OF THE TNVAT Act:
According to this section the dealer shall pay a tax on his taxable turnover, relating to his business of
transfer of property in goods involved in the execution of works contract, either in the same form or
some other form, which may be arrived at in such manner as may be prescribed, at such rates as
specified in the First Schedule. So here the crucial words are “transfer of property in goods involved in
the execution of works contract”. So the tax is only the value of goods. But the rate of tax for each type
of goods involved in the execution of works contract has to be worked out separately. In case of building
contract the separate rate of tax for sand, cement, blue metal, steel, wood, electrical goods, plumbing
material has to be worked out and tax has to be paid. But this is very difficult in construction contracts.
This is due to the fact that construction will be going on in several sites. But the materials will be
purchased in a centralised manner and sent to various sites. This will pose problem of giving itemised bill
to the contractee by the contractor. So the construction companies follows the method of adding a
specified percentage, say 10% or 15%, to purchases made during the month and pay VAT on that
amount. The specified percentage is added to cover the gross profit margin to the contractor. Under this
method the dealer contractor can take input tax on the good purchased by him within the state.
Section 5 says that “the transfer of property in goods involved in the execution of works contract, either
in the same form or some other form, which may be arrived at in such manner as may be
prescribed,…”
So the taxable turnover with regard to goods involved in the execution of works contract has to be
determined with regard to the manner prescribed. This manner is prescribed in rule 8 (5) of TNVAT
rules, 2007. According to this rule from the total turnover of the dealer the following deductions should
be made to arrive at the value of goods involved in the execution of works contract.
(a) All amounts involved in respect of goods involved in the execution of works contract in the course of
export of the goods out of the territory of India or in the course of import of the goods into the territory
of India or in the course of inter-State trade or commerce;
(b) All amounts relating to the sale of any goods involved in the execution of works contract which are
specifically exempted from tax under the Act;
(c) All amounts paid to the sub-contractors as consideration for execution of works contract whether
wholly or partly:
Provided that no such deduction shall be allowed unless the dealer claiming deduction, produces proof
that the sub-contractor is a registered dealer liable to pay tax under this Act and that the turnover of
such amount is included in the return filed by such sub-contractor;
(d) All amount towards labour charges and other charges not involving any transfer of property in goods,
actually incurred in connection with the execution of works contract,
(e) all amounts, including the tax collected from the customer, refunded to the customer or adjusted
towards any amount payable by the customer, in respect of unexecuted portion of works contract based
on the corrections on account of measurements or check measurements.
Sometimes the for the purpose clause (d) above the labour charges can not be correctly ascertained
from the books of accounts maintained by the dealer. In such a case an adhoc deduction for the labour
and other charges as per the following table.
Sl. No.
Type of works contract
1
2
3
4
Electrical Contracts
All structural Contracts
Sanitary Contracts
Watch and/or Clock repair
contracts
Dyeing Contracts
All other Contracts
5
6
Labour or other charges as a
percentage value of the works
contract
15
15
25
50
50
30
SECTION 6 OF TNVAT Act:
Section 6 is a simplified system of collecting VAT on the Works Contract. It is called compounding
system. Under this system the dealer has to pay VAT on the total value of Works Contract. The rate of
tax is prescribed in the section itself.
Sl. No.
Type of works contract
Rate of Tax
1
Civil works contract
two per cent of the total contract value of
the civil works executed.
2
Civil maintenance
works contract
All other works
contracts
two per cent of the total contract value of
the maintenance works executed.
five per cent of the total contract value of
the works executed.
3
The benefit of this compounding system is that dealer is not be required to maintain accounts of his
business under this Act or the rules made thereunder except the records in original of the works
contract, extent of their execution and payments received or receivable in relation to such works
contract, executed or under execution.
CONDITIONS FOR AVAILING THE COMPOUNDING SYSTEM UNDER SECTION 6 OF TNVAT Act:
This simplified system of Taxation of works contract under TNVAT comes with many conditions. If these
conditions are not met with then the assessing officer will try to tax the dealer under section 5 at the
maximum rate of 14.5%. The following are the conditions:
1. The dealer should apply to the assessing authority along with the first monthly return for the
financial year or in the first monthly return after the commencement of the works contract that
he wants to opt for compounding system of tax payment for works contract.
2. The dealer should not make any interstate purchases.
3. The dealer should not collect the tax from the contractee.
4. The dealer should not take input tax credit on the goods purchased by him.
5. The option exercised once shall be final for that financial year.
RELATION BETWEEN THE TNVAT ACT PROVISIONS AND SERVICE TAX LIABILITY:
The reason for explaining the TNVAT Act provisions above is to highlight the relation between the
TNVAT act and the determination of the service tax liability for works contract. The determination of
value of taxable portion under the service tax provisions depends upon whether a person is paying
VAT under section 5 or 6 of the TNVAT act.
When ever a query is put to a tax consultant, as to how the service tax has to be paid for construction
contracts, the immediate answer will be that on the 40% contract value service tax has to be calculated
at 12.36%. But this answer is wrong. Because before answering this question, the consultant should see
how the client is paying VAT tax. Depending upon this method only the service tax liability can be
determined. The method of calculating service tax liability will vary for a person paying VAT under
section 5 of TNVAT act and for a person paying VAT under section 6 of TNVAT act. To high light this
point only in this article an elaborate discussion on the VAT provisions have been discussed above.
SERVICE TAX (DETERMINATION OF VALUE) RULES, 2006.
Service tax is on the value of taxable services. Section 94(1)(aa) of Finance Act, 1994 enables the central
government to make rules determining the value of taxable services for the purpose of section 67 of
Finance Act, 1994.
Rule 2A of the Service Tax (Determination of Value) Rules, 2006 is prescribed to determine the value of
service portion in the execution of a works contract. This rule has got two clauses.
According to clause (i) of Rule 2A, Value of service portion in the execution of a works contract shall be
equivalent to the gross amount charged for the works contract less the value of property in goods
transferred in the execution of the said works contract.
This clause (i) covers the case of an assessee who pays VAT as per section 5 of the TNVAT act. As per
section 5 the value of the goods is charged to VAT as per the rates prescribed in the Schedule to the
TNVAT act. For the purpose of clause (i) of Rule 2A
Service Portion in the execution of works contract = Gross amount charged from the Contractee minus
Value of goods declared in the VAT return
Clause (ii) of Rule 2A only prescribes the following percentage of the total amount charged for works
contract as value of taxable service.
S.No Type of Contract
% considered as
taxable portion
1
Orginal Works
40
2
works contract entered into for maintenance or
70
repair or reconditioning or restoration or servicing
of any goods
3
in case of other works contracts, not covered
60
under serial number (1) and (2), including
maintenance, repair, completion and finishing
services such as glazing, plastering, floor and wall
tiling, installation of electrical fittings of an
immovable property,
This clause (ii) begins with the wordings, “Where the value has not been determined under clause (i),”.
In view of these wordings where the separate determination is not done for the goods and services only,
the clause (ii) will apply. So this clause will apply only when the VAT has been paid under section 6 of
the TNVAT act.
To conclude, if a person pays VAT for works contract as per section 5 of TNVAT Act, then he has to
determine the value of taxable services as per Clause (i) of Rule 2A of Service Tax (Determination of
Value) Rules, 2006.
If a person pays VAT as for works contract under compounding system as per section 6 of TNVAT Act,
then he has to determine the value of taxable services as per Clause (ii) of Rule 2A of Service Tax
(Determination of Value) Rules, 2006.