India: Assessment of Sales Tax vis-à-vis Works Contract Tax - Contract Tax - Indian context

Last Updated: 18 June 2002
Article by Shivaji Rao

Proposition of law holding the field: in the matter of works contracts:

The entire article is sourced and based on the judge made law and on the clause (29A) was introduced in Art. 366 of the Indian Constitution by 46th amendment. The readers are requested to bear with complexity of the text of the article as the author was not inclined to adopt shortcuts with a view to present the true picture and proposition of law the holds the field under context.

Even after the said amendment in the Constitution of India on the subject under context, there still persists a dispute between the corporate world and the Tax authorities. Time and again the either parties disputes related to the subject under context being referred to the courts of law for adjudication. As stated above this is how the present article has been drafted based on the judgments.

In the Builders Association of India and others etc. etc., Petitioners v. Union of India and others etc. case of etc., AIR 1989 SC 1371.The Apex court has observed as under:

The 46th Amendment of the Constitution made it possible for the State to levy sales Sales Tax on the price of the goods and materials used in works contracts as if there was a sale of such goods and materials. In this Land mark decision it has been held, by the Hon'ble Supreme Court that the Sales Tax laws passed by the Legislatures of States levying taxes on the transfer of property in goods (whether as goods or in some other form) involved in the execution of the works contract, are subject to the restrictions and conditions mentioned in each clause or sub-clause of the Art. 286 of the Constitution.

By the 46th Amendment a new clause, namely clause (29A) was introduced in Art. 366 of the Constitution. The Constitutional Amendment in Art. 366(29A) read with the relevant taxation-entries has enabled the State to exert its taxing power in an important area of Social and economic life of the community. The object of the new definition introduced in clause (29A) of Art. 366 of the Constitution is, therefore, to enlarge the scope of 'tax on sale or purchase of goods' wherever it occurs in the Constitution so that it may include within its scope the transfer, delivery or supply of goods that may take place under any of the transactions referred to in sub-clauses (a) to (f) thereof wherever such transfer, delivery or supply becomes subject to levy of sales tax. Art. 286 is also amended. The 46th amendment also validated laws levying tax as also collection by way of tax under such law subject to the conditions mentioned therein.

On the passing of the 46th Amendment the State Governments after making necessary amendments in their laws commenced to levy sales tax on the turnover of the works contracts entered into by the building contractors for constructing houses, factories, bridges etc. In some States taxable turnover was determined by deducting the money spent on labour engaged in connection with the execution of the works contracts from the amount received by the contractor for the execution of the works contracts. In some other States a certain fixed percentage of the total turnover was deducted from the total turnover as labour charges before arriving at the taxable turnover. Each State adopted its own method of determining taxable turnover either by framing rules under its sales tax law or by issuing administrative directions. The methods adopted by the States for determining taxable turnover relating to works contracts for purposes of levy of sales tax were such that sales tax to be paid by the building contractors not merely on the value of materials supplied by them in connection with the works contracts but also on the expenditure they had incurred in securing the services of architects and engineers who had supervised the execution of the works and also on the amount which they were entitled to receive for supervising the execution of the works. While levying sales tax on the price of the material supplied for the construction of houses, factories, bridges etc. the sales tax authorities of the States did not take into account the conditions and restrictions imposed by Art. 286 of the Constitution and the provisions of the Central Sales Tax Act, 1956. The assessing authorities did not make any attempt to ascertain whether the sales of the goods involved in a execution or works contract had taken place in favour of the person who had assigned the contract outside the State in which the works contract was being executed or whether any part of the goods so used in a works contract had been imported from abroad on account of the person who had assigned the contract or whether any part of the goods, such as, iron and steel etc. which were declared goods, had already suffered sales tax at an earlier point in the State and whether on such goods the tax which was being levied exceeded the limit prescribed by Section 15 of the Central Sales Tax Act, 1956. They did not also take into consideration whether the sale of the goods in question had been exempted under the sales tax laws of the State from payment of sales tax or whether it had already suffered payment of tax earlier where the sales tax of the State had prescribed that the sale of such goods could be subjected to the levy of sales tax at a single point.

In this case the petitioners challenged the levy of sales tax on the turnover relating to works contracts. The Hon'ble Court held that the sales tax laws passed by the Legislatures of the States levying tax on the transfer of property of goods (whether as goods or in some other form) involved in the execution of a works contract are subject to restrictions and conditions mentioned in each clause or sub-clause of Art. 286 of the Constitution. It was also observed by the Hon'ble Court that after the 46th Amendment it is not possible to accede to the plea of the State that what is transferred in a works contract is the right in the immovable property. On passing of the 46th amendment it could not be said that the Constitution had conferred on the States a larger freedom than what they had before in regard to their power to levy sales tax under Entry 54 of the State list. The 46th amendment does no more than making it possible for the States to levy sales tax on the price of goods and materials used in works contracts as if there was a sale of such goods and materials.

The Hon'ble Court also observed that in exerting this power particularly in relation to transfer of property in goods involved in the execution of "works contracts" in building activity, in so far as it affects the housing projects of the under privileged and weaker sections of the society, the State might perhaps, be pushing its taxation power to the peripheries of the social limits of that power and, perhaps, even of the constitutional limits of that power in dealing with unequals. In such class of cases "Building-Activity" really relates to a basic subsistential necessity. It would be wise and appropriate for the State to consider whether the requisite and appropriate classifications should not be made on such building activity attendant with such social purposes for appropriate separate treatment.

Works contract - Transfer of property in goods involved in its execution - Levy of Sales Tax thereon - Valid. - - The Sales Tax laws passed by the Legislatures of States levying taxes on the transfer of property in goods (whether as goods or in some other form) involved in the execution of a works contract are subject to the restrictions and conditions mentioned in each clause or sub-clause of Art. 286 of the Constitution. In view of the passing of the property in goods which are involved in works contract and the legal fiction created by cl. (29-A) of Art. 366 of the Constitution it cannot be said that the properties that are transferred to the owner in the execution of a works contract are not the goods involved in the execution of the works contract, but a conglomerate, that is the entire building that is actually constructed. After the 46th Amendment it is not possible to accede to the plea of the States that what is transferred in a works contract is the right in the immovable property. It cannot be said that on the passing of the 46th Amendment the Constitution had conferred on the States a larger freedom than what they had before in regard to their power to levy sales tax under Entry 54 of the States List. The 46th Amendment does no more than making it possible for the States to levy sales tax on the price of goods and materials used in works contracts as if there was a sale of such goods and materials. The sub-cl. (b) of Art. 366(29-A) could not be read as being equivalent to a separate entry in List II of the Seventh Schedule to the Constitution enabling the States to levy tax on sales and purchases independent of Entry 54 thereof. As the Constitution exists today the power of the States to levy taxes on sales and purchases of goods including the "deemed" sales and purchases of goods under cl. (29-A) of Art. 366 is to be found only in Entry 54 and not outside it.

After the 46th Amendment the works contract which was an indivisible one is by a legal fiction altered into a contract which is divisible into one for sale of goods and the other for supply of labour and services. After the 46th Amendment, it has become possible for the States to levy sales tax on the value of goods involved in a works contract in the same way in which the sales tax was leviable on the price of the goods and materials supplied in a building contract which had been entered into in two distinct and separate parts. It could not have been the contention of the revenue prior to the 46th Amendment that when the goods and materials had been supplied under a distinct and separate contract by the contractor for the purpose of construction of a building the assessment of sales tax could be made ignoring the restrictions and conditions incorporated in Art. 286 of the Constitution. If that was the position can the States contend after the 46th Amendment under which by a legal fiction the transfer of property in goods involved in a works contract was made liable to payment of sales tax that they are not governed by Art. 286 while levying sales tax on sale of goods involved in a works contract? They cannot do so. When the law creates a legal fiction such fiction should be carried to its logical end. There should not be any hesitation in giving full effect to it. If the power to tax a sale in an ordinary sense is subject to certain conditions and restrictions imposed by the Constitution, the power to tax a transaction which is deemed to be a sale under Art. 366 (29-A) of the Constitution should also be subject to the same restrictions and conditions. Ordinarily unless there is a contract to the contrary in the case of a works contract the property in the goods used in the construction of a building passes to the owner of the land on which the building is constructed, when the goods or materials used are incorporated in the building. The contractor becomes liable to pay the sales tax ordinarily when the goods or materials are so used in the construction of the building and it is not necessary to wait till the final bill is prepared for the entire work.

In exerting the power under Art. 366 (29 A) particularly in relation to transfer of property in goods involved in the execution of 'works-contracts' in building activity, in so far as it affects the housing-projects of the under-privileged and weaker sections of society, the State might perhaps, be pushing the taxation-power to the peripheries of the social limits of that power and, perhaps, even of the constitutional limits of that power in dealing with unequals. In such class of cases 'Building-Activity' really relates to a basic subsistential necessity. It would be wise and appropriate for the State to consider whether the requisite and appropriate classifications should not be made of such building-actions attendant with such social purposes for appropriate separate treatment. These of course are matters for legislative concern and wisdom.

The views of the Apex court once again reiterated in M/s. Rainbow Colour Lab and another, Vs. State of M.P. and others AIR 2000 SC 808 as - - Prior to the Amendment of Article 366, the States could not levy sales-tax on sale of goods involved in a works contract because the contract was indivisible. All that has happened in law after the 46th Amendment is that it is now open to the States to divide the works contract into two separate contracts by a legal fiction (i) contract for sale of goods involved in the said works contract and (ii) for supply of labour and service. This division of contract under the amended law can be made only if the works contract involved a dominant intention to transfer the property in goods and not in contracts where the transfer in property takes place as an incident of contract of service. The Amendment, has not empowered the State to indulge in microscopic division of contracts involving the value of materials used incidentally in such contracts. What is pertinent to ascertain in this connection is what was the dominant intention of the contract.

Every contract, be it a service contract or otherwise, may involve the use of some material or the other in execution of the said contract. State is not empowered by the amended law to impose sales-tax on such incidental materials used in such contracts. Thus, it is clear that unless there is sale and purchase of goods, either in fact or deemed, and which sale is primarily intended and not incidental to the contract, the State cannot impose sales-tax on a works contract simpliciter in the guise of the expanded definition found in Article 366(2-A)(b) read with Section 2(n) of the State Act.

In the case of M/s Hindustan Aeronautics Ltd., Vs. State of Orissa, AIR 1984 SC 753 the Apex court had occasion to examine the definitions of "sale" "works contract" -- There is no rigid or inflexible rule applicable alike to all transactions which can indicate distinction between a contract for sale and a contract for work and labour. But the tests indicated in the several decisions of the Supreme Court merely focused on one or the other aspect of the transaction and afforded some guidance in determining the question, but basically and primarily, whether a particular contract was one of sale or for work and labour depended upon, the main object of the parties in the circumstances of the transactions. In a contract for sale, the main object of the parties is to transfer property in and delivery of possession of a chattel as a chattel to the buyer. In the case of M/s. Hindustan Shipyard Ltd. Vs. State of A.P. AIR 2000 SC 2411

Clauses (n) and (t) of Section 2 of the A.P. General Sales Tax Act, 1957 respectively define 'sale' and 'works contract' as under :-

" 'Sale' with all its grammatical variations and cognate expressions means every transfer of the property in goods (Whether as such goods or in any other form in pursuance of a contract or otherwise) by one person to another in the course of trade or business, for cash or for deferred payment or for any other valuable consideration or in the supply or distribution of goods by a society (including a co-operative society), club, firm or association to its members, but does not include a mortgage, hypothecation or pledge of, or a charge on goods."

" 'Works Contract' includes any agreement for carrying out for cash or for deferred payment or for any other valuable consideration, the building construction, manufacture, processing, fabrication, erection, installation, fitting out, improvement, modification, repair or commissioning of any movable or immovable property."

The distinction between a contract of sale and a works contract is not free from difficulty and has been subject-matter of several judicial decisions. No strait-jacket formula can be made available nor can such quick-witted tests devised as would be infallible. It is all a question of determining the intention of the parties by culling out the same on an overall reading of the several terms and conditions of a contract. In State of Gujarat v. Variety Body Builders, (1976) 38 STC 176 : (AIR 1976 SC 2108 : 1976 Tax LR 1928) the Supreme Court observed that there is no standard formula by which one can distinguish a contract of sale from a contract for work and labour. There may be many common features in both the contracts, some neutral in a particular contract, and yet certain clinching terms in a given case may fortify a conclusion one way or the other. It will depend upon the facts and circumstances of each case. The question is not always easy and has for all times vexed jurists all over.

In the case of State of Orissa and others, Vs. Titaghur Paper Mills Company Limited and another, AIR 1985 SC 1293, The Apex court observed with regard to works contract "A works contract is a compendious term to describe conveniently a contract for the performance of work or services in which the supply of materials or some other goods is incidental. The simplest example of this type of contract would be where an order is given to a tailor to make a suit from suiting supplied by the customer This would be a contract of work or services in which the supply of materials, namely, thread, lining, and buttons used in making the suit, would be merely incidental. Similarly, if an artist is commissioned to paint a portrait, it would be a contract of work and services in which the canvas on which the portrait is painted and the paint used in painting the portrait would be merely incidental". In Commr of Sales Tax., M. P v Purshottam Premji (1970-26- STC 38), this Court pointed out the distinction between a works contract and a contract for the sale of goods as follows (at page 41) "The primary difference between a contract for work or service and a contract for sale of goods is that in the former there is in the person performing work or rendering service no property in the thing produced as a whole notwithstanding that a part or even the whole of the materials used by him may have been his property In the case of a contract for sale, the thing produced as a whole has individual existence as the sole property of the party who produced it, at some time before delivery and the property therein passes only under the contract relating thereto to the other party for price."

The Apex court has clarified all the doubts which may arise, in its catena of judgments that if the dominant purpose of contract between the parties is predominantly for labour and service in nature, and the deployment / transfer of goods are incidental in nature, then by virtue of Article 366 (26 A) read with respective entries in the center and state lists of the Constitution, the appropriate govts., may impose applicable tax on works contract. IF NOT, an assessee will be made liable to remit applicable tax on two counts viz;

  1. sales tax for deemed / factual sale of goods
  2. tax for works contract for the services rendered.

The issue of making up a case of dominant purpose of the contract is "for labour and service in nature, and the deployment / transfer of goods are incidental in nature" is depends on facts and circumstances of each and every case .

Incidentally, in the case of state of Gujarat Vs. Elecon Engineering Co. (Sales Tax Cases Vol.90, 1993 – page 74) the Gujarat High court has observed that

"the fact that the price for equipment and the price for the services were shown separately, it is also indicative of the fact that though it was a composite contact it was divisible. It consisted of two contracts – one of the sale of equipments and another for erection and other such incidental services."

Notwithstanding the said observations, whatever nature of words, terms phrases deployed in the agreements and deeds, to decide the dominant purpose and nature of the contract depends upon constituent factors viz: the entirety , purpose, nature of work drawn in, volume of work to be done by the supplier (service oriented – supply of material is incidental). Therefore, it is suggested that if at all any person(s) save themselves from the Sales Tax and to make out the case of works contract, the following are imperative on their part:

  1. To establish dominant purpose of the contract is works contract , as quoted supra.
  2. Supply / transfer of material is incidental to the dominant purpose.
  3. It is a composite / umbrella contract and it is distinct contract for services. Supply of material is incidental and it is not divisible.
  4. Other such reasons to show it as works contract, contract cannot be divisible etc.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.

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