Works Contract - VAT and Service Tax Planning By CA S Ranga Swamy -ID: rangaswamy_singa@yahoo.co.in Cell Phone No.

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1 Works Contract - and Service Tax Planning By CA S Ranga Swamy Even after about 30 years of 46 th Amendment to the Constitution of India, taxation of Works Contract is a subject matter of interpretations, controversies and complexities. It was expected to resolve the legal disputes by introduction of levy of on material element and Service Tax on service element of a Works Contract, but it has further aggravated the situation and there are number of judgments which are contradicted by another judgment on the same issue. The term Works Contract has a wide scope and different from General Sale. There is a transfer of property in definite form and the goods remain same before or after the delivery in General Sale under Supply Contract, whereas the form of goods may be different before the delivery and after incorporation under Works Contract. Works Contract Tax and Taxable Event The 46th Amendment to the Constitution of India in 1983, by insertion of clause (29A)(b) of Article 366, introduced a new definition to the word Sale which has enlarged the scope of tax on sale or purchase of goods by inclusion of a provision for tax on transfer of property in goods (whether as goods or in some other form) invoked in the execution of Works Contract being a deemed sale. Following Guidelines are drawn from various court judgments to ascertain taxable event of Works Contract: There must exist an indivisible works contract and divisible contracts are outside scope. Both goods and services must be involved in execution of works contract. Transfer of goods must be in tangible property and pass on either in the same form or in other form when incorporated in work. Form of goods has no relevance. In case goods are consumed and their identity is lost then no transfer of property occurs in those goods. Example:- electrodes, lubricants, power, fuel, gas, waste cotton etc., Passing of property under Works Contract The property in goods passes under the theory of Accretion, Accession or Blending when materials are incorporated in execution of works contract and not on bringing of goods to project site. Bills may be raised as and when materials are brought on site or by stages at agreed terms & conditions, but it will not have any effect on the above principle of passing of property in goods as explained below- Accretion: A Contractor constructs a building on the land of Contractee using his own steel, bricks, sand, cement etc., which belongs to him till the stage of incorporation. But once the cement pasted and bricks are applied on the land, these ingredients fasten themselves to the land and not possible to remove without fundamental damage. Thus the ownership in these materials gets transferred to contractee by inference through Accretion. Accession: A Car Garage undertakes the work of painting a car of Customer. The paint belongs to Car Garage till the stage of application on car. But once the paint is applied on car, the liquid paint gets attached on the metal of car and it is not possible to remove it without fundamental damage. Thus ownership in paint gets transferred to Customer by inference through Accession. Blending: Another situation of Works Contract could be a case where multiple movable goods owned by Contractor are blended together to create new movable goods which are non-marketable in nature. For example, a printer who uses paper and ink to print cheque books for a bank. Aspects of Works Contract Contractor can discharge on of materials incorporated under the following three options: i. : Under, material can be arrived either by Value Mode (or) Value Addition Mode as explained below: Value Mode Under this mode, taxable of materials will be arrived after allowing the deductions towards labor charges; payment to Sub-contractor for labor/services; charges for planning, designing & architect; Charges for obtaining on hire the machinery & tools; cost of consumables such as water, 1

2 Works Contract - and Service Tax Planning By CA S Ranga Swamy electricity, fuels etc., and other similar expenses or cost of establishment relatable to supply of labor/services. Tax is payable at applicable rate to those taxable materials under State Tariff. State can also levy uniform rate of tax on of materials incorporated in work under a separate item in Tariff and such rate may be different from applicable rate to materials individually. States like Assam, Delhi, Karnataka, Kerala, West Bengal etc., have specified a uniform rate on materials other than Declared Goods as specified under CST Act,1956. Value Addition Mode Under this mode Contractors can arrive material by adding cost of goods, cost of conversion and all other expenses such as loading/unloading, transport etc., plus margin of profit on them. Tax cost will be less under when compared to other options since is payable only on actual of materials incorporated in the work after adjustment of Input Credit. However, Contractor has to maintain proper books of accounts and other records to identify of materials and labor. ii. Composition Composition Scheme is simple and convenient for Contractors who cannot maintain proper accounts. Under this method tax is payable on total contract including labor at specified lumpsum rate. In States like Karnataka, Tamilnadu, Orissa, Delhi etc., Composition Option is to be exercised for all Works Contracts executed during financial year and not permissible to opt each contract wise. Input Credit is not available under this option except in Maharashtra State. tax is payable in States like Kerala, Karnataka etc., on interstate purchases but deduction of such turnover is allowed from total turnover and tax is payable on balance turnover only. Composition Option is not permissible in States like Gujarat, Himachal Pradesh, Tamilnadu etc if goods are imported from outside State. Composition may be opted where contract price is inclusive of taxes and consisting of substantial portion of materials with marginal element of labor/services. iii. labor deductions are prescribed under Laws to arrive at taxable based on type of contract. Tax is payable at the specified rate on taxable arrived after standard labor deduction in States like Andhra Pradesh, Jharkhand, Punjab, Assam etc., whereas at applicable rates of such goods in other States like Gujarat, Rajasthan, Maharashtra, Uttar Pradesh, Tamilnadu etc. However input credit is available under this method in most of States except in few States like Andhra Pradesh, Jharkhand & Punjab. Tax cost is high under this option and hence not advisable to adopt it. / CST Planning Before exercising a right option for arriving tax liability, Contractor has to analyze various components like labor/service charges, local/interstate purchase of materials, other expenses and effect of them on tax cost. Award excavation work contracts on Cubic Meter Basis instead of on Hire Charges Basis of earth moving machinery where is chargeable and ineligible item for input credit. Obtain Tax Invoice showing amount separately for availing input credit. Price reduction through passing on input credit can be sought by buyer. CST not payable on freight, delivery charges, erection and commissioning. CST not payable if goods are returned within 6 months. CST Registration Certificate should include all the items on which Contractor is entitled to purchase at concessional rate against issue of C-Form. Service Tax Aspects on Works Contract Service Works Contract has been defined under Section 65B(54) of the Finance Act,1994 as a contract wherein transfer of property in goods involved in the execution of such contract is leviable to tax as 2

3 Works Contract - and Service Tax Planning By CA S Ranga Swamy sale of goods and such contract is for the purpose of carrying out construction, erection,.... of any movable or immovable property.. As per Rule 2A of Service Tax (Determination of Value) Rules,2006, of service portion of a Works Contract can be determined under following options: Option-I: (Service Portion) service portion in execution of Works Contract shall be equivalent to the Gross Amount charged less of property in goods transferred and /Sales Tax on such goods. Gross Amount includes Labor/Service charges as enumerated in above paragraph under aspects of Works Contract-Value Mode. Option-II: Abatement/Composition Service portion can also be determined on Total Amount of works contract as given below: A. At 40% for original works (at 25% where gross amount includes of land for residential unit having carpet area upto 2000 sq. feet or where amount is less than one crore rupees and at 30% for other than above); B. At 70% for maintenance or repair or reconditioning or restoration or servicing of any goods; C. At 60% on works not covered under above (A) and (B), including maintenance, repair, completion and finishing services such as glazing, plastering, floor and wall tiling, installation of electrical fittings of an immovable property. Total Amount means Gross Amount charged plus fair market of materials issued to the contractor by contractee but excludes of materials issued on chargeable basis to the contractor and thereon. Under both the above options, Cenvat credit is available on Capital Goods and input services used for providing output service. Service Tax Planning If the price is inclusive of taxes, then service tax element becomes one of the major cost elements. Service tax cost can be minimized through proper tax planning as given below: (A). In case of separate Supply Contract Service tax is not applicable on supply contract for sale/trading of goods as per Section 66D of Act under Negative List. (B). In case of separate Service Contract Pay on service contract and avail cenvat credit on capital goods/input services. may be deducted in arriving taxable service. If material is also included in taxable service, then excise duty credit on such material can be availed in terms of Rule 2(k) of Cenvat Credit Rules and as per clause (iv) of Notification No.33/ ST dated (C). In case of Works Contract which is Divisible or Separate Contracts issued on split basis for supply and service portions Pay on service portion only as specified in the above option (B). (D). In case of Works Contract which is indivisible Option I-Pay on service portion as specified in above paragraph Option-I. Option II-Pay on specified percentage i.e., 40% or 60% or 70 Total Amount as enumerated in above paragraph Option-II under /Abatement. Option III-Pay on Total Gross Bill Value including both material portion and service portion. Eligible for Cenvat Credit on Capital Goods and Input Services under the above three options. However excise duty credit on inputs is available for Option-III only in terms of Rule 2(k) of Cenvat Credit Rules since tax is paid on material portion also. The net effect of tax liability for construction of a Commercial Building is given in the following tables for the selected States Gujarat & Tamilnadu 3

4 Works Contract - and Service Tax Planning By CA S Ranga Swamy Particulars Plan in material material Gujarat Rs 60 Rate 0.6%* Rs 40 Rate 0.6%* Steel 5% Cement 15% Aggregates 5% Others 15% Labor Total Liability Less: Input Credit CST Steel 50% 50% Cement 50% 50% Aggregates 100% Others 50% 50% Total Credit Net Liability Plan in Tamilnadu material Rs60 material Rs 40 Steel 5% Cement 14.5% Aggregates 5% Others 14.5% Labor Total Liability Less: Input Credit When Labor Value- Rs 40 CST Option- I On Service portion Option-II On 40% III-On 100% When Labor Value- Rs 60 Option- I On Service portion Option-II On 40% I. When Labor Portion is 40% or 60% and Portion is 60% or 40% Service Tax Plan Rate Option- % Option- III On 100% Labor Total Tax Liability Less : Cenvat Credit cement, steel etc., Capital Goods Service Tax Credit ** 6.67 Total Cenvat Credit Net Tax Liability Steel 50% 50% Cement 50% 50% Aggregates 100% Others 50% 50% Total Credit Net Liability

5 Works Contract - and Service Tax Planning By CA S Ranga Swamy II. When Labor Portion is 30% or 70% and Portion is 70% or 30% Service Tax Plan Rate Value Option- I Option-II Option-III Value Option-I Option-II Option- -On Service -On 40% -On 100 On On 40% III Particulars Labor portion Rs 30 Value Labor Rs 70 Service portion Value On 100% Labor Total Tax Liability Less : Cenvat Credit cement, steel etc., Capital Goods Service Tax Credit ** 7.79 Total Cenvat Credit Net Tax Liability Plan in material material Gujarat Rs 70 Rate 0.6%* Rs 30 Rate 0.6%* Steel 5% Cement 15% Aggregates 5% Others 15% Labor Total Liability Less: Input Credit CST Steel 50% 50% Cement 50% 50% Aggregates 100% Others 50% 50% Total Credit Net Liability Plan in Tamilnadu material Rs 70 material Rs 30 Steel 5% Cement 14.5% Aggregates 5% Others 14.5% Labor Total Liability Less: Input credit CST Steel 50% Cement 50% Aggregates 100% Others 50% Total Credit Net Liability

6 Works Contract - and Service Tax Planning By CA S Ranga Swamy The following interpretations have been made for the workings given in above tables: Cenvat Credit is worked on 90 Cost of Excisable s/input Services and on capital goods as Rs 0.25 for Turnover of Rs100/-. (**Clarification By author: Not part of original Article ) It is clarified that in the examples given in the article the CEN credit amount can be changed by adopting the alternative methods under service tax and there is no restriction under Service Tax Law in adopting alternative methods either by main contractor or subcontractor. The main contractor may opt "Option-I" but the subcontractor may opt "Option-II" vice versa and the main contractor can avail service tax credit accordingly based on service tax invoice issued by the subcontractor. The amount of Rs 4.45 has been arrived based on assumption that the subcontractor has also opted "Option-II" (Composition Scheme) and worked out accordingly i.e., 90 output tax of Rs In case it is assumed that the main contractor has opted "Option-II" but the subcontractor has opted "Option-I" then the amount of Rs 6.67 can be taken as service tax credit instead of Rs 4.45 and in such case surplus service tax credit or refund will arise. Similarly if main contractor has opted "Option-I" and the subcontractor has opted "Option-II" then service tax credit is to be taken as Rs 4.45 instead of Rs 6.67 and accordingly net tax liability will get change. Hence the net tax liability will get change based on assumptions. A portion of materials are purchased within the State and input credit is worked out at applicable rates taking purchase cost as 90 Sale Value. Labor is allowed at 30% on Civil Work and is payable on balance at applicable rates to goods. s from outside State are not permissible in Gujarat & Tamilnadu under Composition and hence assumed that materials are procured within State. The Finance Manager has to consider the following points which were emerged from the above analysis for selection of a suitable option for tax payment- In case of Turnkey Projects or EPC Contracts, is beneficial by payment of service tax on service portion and on material portion. Option-I is beneficial for service tax payment on Contract which consists of material portion more than 60% and service portion less than 40%. Option-II is beneficial in case material portion is less than 60% and service portion is more than 40%. Hence it is advisable to obtain the breakup of supply portion and service portion in a contract to exercise a suitable option. Conclusion Till GST Law is introduced it is essential to use the tool of integrated and Service Tax Planning in order to minimize tax cost. Exercising a suitable option for payment of and Service Tax is critical in tax planning which varies from one type of contract to another type of contract. It is difficult to frame one formula which is suitable to all situations. It is depending upon so many factors such as type of contract/project or service, /CST purchases, deploying own assets or hiring of equipments etc. Since the profit margin will be marginal and varies from 3% to 10% depending upon various factors in respect of construction industry, sometimes the element of tax cost may change the profit margin if not planned properly. Hence integrated and Service Tax planning helps the management in minimization tax cost. In this process, the Finance Manager plays a decisive role. 6