India: The L&T judgment - a Pandora's Box

Dinesh Kumar Agrawal
Khaitan & Co., India 

Dinesh Kumar Agrawal is an Executive Director at Khaitan & Co in India.

The Supreme Court of India has handed down a ground-breaking judgment that will redefine the current application of VAT laws in the property market. The ruling has established a wider interpretation of a "works contract" to encompass construction activities previously outside the boundaries of VAT, serving as a clear signal to property developers and buyers alike to act with caution.

The landmark decision of the Supreme Court of India in the case of L&T,1 has been by far the most long-awaited ruling, and the controversial judgment will have significant ramifications not only for the real estate industry but also for other industries at large. In this case, the Supreme Court upheld the constitutional validity of the state-imposed sales tax or valued added tax (VAT) on the sale of flats in under-construction buildings while affirming its earlier decision in K Raheja2 and the decision of the Bombay High Court in MCHI3. The Supreme Court heard a series of appeals from developers and builders from Karnataka and Maharashtra challenging the levy of VAT on the sale of flats in under-construction projects on the grounds that such contracts were a contract for sale of completed flats as immovable property and not a "works contract".

I. Background

A. Legislative scheme

States have the power to levy tax on the sale of goods under Entry 54 of List II of the Seventh Schedule of the Constitution, and stamp duty on the conveyance of immovable property under Entry 63 of List II. VAT and stamp duty contribute approximately 30 percent and 5 percent of the State's revenue respectively. The sale of flats in under-construction projects are subject to VAT as well as stamp duty on conveyance amounting to double taxation.

B. Constitutional amendment

Tax on the transfer of property in goods (whether as goods or in some other form) involved in the execution of a works contract as included under Clause 29-A(b) of Article 366 was brought within the ambit of a sales tax by the 46th amendment to the Constitution. The amendment was necessitated due to the Gannon Dunkerley-I4 decision wherein the Supreme Court had held that in a building contract which was one and entirely indivisible, there was no sale of goods and it was not within the competence of the state legislature to impose tax on the supply of materials used in such a contract treating it as a sale.

C. Constitutional challenge

The constitutional validity of the 46th amendment was upheld by the Supreme Court in Builder's Association.5 In this case, the Supreme Court held that following the 46th Amendment, an indivisible building contract can be divided into one for sale of goods and the other for supply of labour and services.

Powers of taxation on building contracts were once again challenged in K Raheja2. In this case, the appellant entered into development agreements with land owners to construct residential apartments. As per the agreement, the developer and land owner each were to receive a fixed share of the developed area. In most cases before the construction of apartments, a tripartite agreement of sale would be established with the intended purchaser who, on completion of the project, would receive the apartment and an undivided share of land. The owners of the land would then transfer ownership directly to the housing society. It was submitted by the appellants that they were constructing apartments for themselves and then selling the apartment without any works contract. The Revenue argued that the developer was undertaking construction of the building/apartment for and on behalf of the prospective purchaser, therefore goods used in construction of such flats were liable to VAT under a works contract. The Supreme Court found that the activity did constitute a works contract.

Subsequently, in the L&T6 referral case, another bench of the Supreme Court questioned the decision in K Raheja2 on the premise that by applying such a ratio, there would be no difference between a works contract and a contract for the sale of a chattel as a chattel.

II. Judgment

The Supreme Court held that when the agreement between the promoter or developer and the flat purchaser is to construct a flat and eventually results in the sale of the flat with the fraction of land, it is obvious that such a transaction involves the activity of construction inasmuch as it is only when the flat is constructed then it can be conveyed. The Supreme Court observed that the ultimate transaction between the parties may be the sale of the flat but it cannot be said that the characteristics of a works contract are not involved in that transaction. Goods which have become, by incorporation, part of any immovable property are deemed as "goods" under Clause 29-A(b) after the 46th Amendment. Further, the definition of a "works contract" is wide enough to include any contract for carrying out building or construction activity for cash, deferred payment or other valuable consideration. A contract between the promoter or developer and the flat purchaser to construct and eventually sell the flat with the fraction of land is a "works contract".

A. Definition of "goods" under a works contract

The Supreme Court examined the expression "goods" and "in some other form" and held that "goods in some other form" would mean goods which have ceased to be chattels, movables or merchandise and become attached or embedded to earth. In other words, goods which have by incorporation during the execution of a works contract become part of immovable property are deemed as goods under Clause 29-A(b).

B. Essential conditions

The Supreme Court laid down three conditions which must be fulfilled for sustaining the levy of VAT on goods deemed to have been sold in the execution of a works contract viz:



1. there must be a works contract

2. the goods should have been involved in the execution of the works contract and

3. the property in those goods must be transferred to a third party as goods or in some other form.

The term "works contract" under Clause 29-A(b) covers all genre of works contract and it is not limited to one specie of the contract. The Supreme Court observed that in a contract to build a flat there will necessarily be a sale of goods element. Works contracts also include building contracts and therefore building contracts are species of the works contract.

C. Dual nature of the transaction

The Supreme Court further held that 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 a works contract. 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 also open to the State to levy a sales tax on the materials used in such contracts if it would otherwise have elements of a works contract. The Supreme Court agreed with the contention of the States that taxation of different aspects of the same transaction as separate taxable events is permissible.

D. Valuation

The Supreme Court observed that effectively and de facto it is the developer who constructs the building for the flat purchaser. The developer does so for monetary consideration. Reiterating the decision in Gannon Dunkerley-II,7 the Supreme Court held that the value of the goods for levy of the tax would be the value of the goods at the time of incorporation of goods in the works even though property in goods passes later between the developer and the flat purchaser, after incorporation of goods.

This judgment also refers to another decision in L&T8 wherein it was held that once the work is assigned by a contractor to its subcontractor, the contractor ceases to execute the works contract in the sense contemplated by Clause 29-A(b) because property passes by accretion and there is no property in goods with the contractor which is capable of a re-transfer whether as goods or in some other form.

The Supreme Court clarified that activity of construction undertaken by the developer would be a works contract only from the stage the developer enters into a contract with the flat purchaser. The value addition made to the goods transferred after the agreement is entered into with the flat purchaser can only be made chargeable to tax by the State.

E. Completed projects

The Supreme Court categorically stated that if, at the time of construction and until the construction was completed, there was no contract for construction of the building with the flat purchaser, the goods used in the construction cannot be deemed to have been sold by the builder since at that time there is no purchaser. Thus, there cannot be any tax on the sale of the flat in completed projects.

III. Impact analysis of the judgment

A. Taxable value While upholding the levy of VAT on the building contracts, the Supreme Court categorically stated that tax can only be levied on the value of the goods at the time of incorporation of goods in the works and directed the States to bring clarity on the valuation mechanism. Generally, States have allowed certain deductions to the sale price of a flat for levy of VAT. In other words, tax was sought to be levied with reference to the value of a flat rather than the value of goods incorporated therein.

For example, consider a builder selling flats at different rates in the same under-construction project. As per the existing taxation scheme, each flat would be subject to different levels of tax, as this is levied with reference to the sale price of the flat. As a result of the decision, now all flats would be subject to the same amount of tax as it would be levied on the value of goods at the time of incorporation. Therefore, States may have to revise their valuation mechanism to meet the said criteria. Further, as clarified by the Supreme Court, there cannot be any VAT on the value of goods which have been incorporated prior to the date of the contract for the sale of flats in the under-construction buildings.

B. Subcontract

If a developer has engaged a third party contractor to undertake actual construction of the building, and if no goods are purchased by the developer other than the one transferred by the contractor, then the developer would not be subject to any VAT.

C. Tax incident

As a taxable event of a deemed sale under Clause 29-A(b) would be at the time of incorporation of goods in the works, VAT cannot be collected prior to such a taxable event. Thus, collection of VAT at the time of registration of a contract for the sale of a flat would not be legally sustainable.

D. Termination

When the contract for the sale of a flat in an under-construction building is terminated and the flat is retained by the developer, there would be no works contract. However, there is no clarity as to whether the developer would still be eligible to claim a refund of tax paid prior to the termination of the contract.

E. Service tax

Under Section 66E(b) of the Finance Act, 1994, construction of a complex, building, civil structure or a part thereof, including a complex or building intended for sale to a buyer, wholly or partly, except where the entire consideration is received after issuance of a Completion Certificate by the competent authority, and under Section 66E(h), the service portion in the execution of a works contract has been declared as a taxable service for the purpose of a service tax. Tax is payable on the consideration received or receivable for the service provided or to be provided. Although theL&T1 judgment is in the context of VAT laws, the ratio laid down in the judgment to the effect that there cannot be any VAT on the value of goods which has been incorporated prior to the date of sale of flats in the under-construction buildings may also be applicable in the service tax. Thus, there should not be any service tax on part of the value of the flat attributable to a completed portion of the contract.

IV. Before concluding

The L&Tjudgment is ground breaking because it has widened the scope of a "works contract" under Clause 29-A(b). It is also ground breaking because it has the potential to create fresh disputes not only on computation of taxable value for VAT but also for service tax. We have no choice but to agree that from time immemorial fiscal laws were meant to be complicated so that they provide employment to those who sit in judgment over their interpretation and deliver learned judgments.

Dinesh Kumar Agrawal is Executive Director at Khaitan & Co in India. He is a fellow member of the Institute of Chartered Accountants of India. He joined the firm in 2006 after serving at the Indian Customs and Central Excise Department for more than 156 years in senior positions. He has vast hands-on experience with more than 20 years in indirect tax from the Department as well as industry perspectives.

NOTES 1 L&T Limited v. State of Karnataka(Civil Appeal No. 8672 of 2013).

2 K Raheja Development Corporation v. State of Karnataka ((2005) 5 SCC 162).

3 Maharashtra Chamber of Housing Industries v. State of Maharashtra (2012) 51 VST 168 (Bom).

4 State of Madras v. Gannon Dunkerley & Co. - IX STC 353 (SC).

5 Builder's Association of India v. Union of India (1989) 2 SCC 645.

6 L&T Limited v. State of Karnataka (SLP(C) No. 17741 of 2007).

7 Gannon Dunkerley & Co. v. State of Rajasthan [(1993) 1 SCC 364].

8 State of Andhra Pradesh v. Larsen & Toubro Ltd. [(2008) 9 SCC 191].