CONTENTS INTRODUCTION......................................................1 VIVISECTION OF COMPOSITE CONTRACTS: MARCH OF LAW.......................2 1958 – GANNON DUNKERLEY V. STATE OF MADRAS.........................2 1958-1982 – SNOWBALLING EFFECT OF GANNON DUNKERLEY..................3 1982 – 46 TH CONSTITUTIONAL AMENDMENT...............................4 1994 – INTRODUCTION OF SERVICE TAX................................4 2006 TILL DATE – THE TRIPLE TESTS OF BSNL V. UOI...................6 SUMMARY OF THE TIMELINE OF THE LAW.................................8 DETAILED ANALYSIS OF CERTAIN SPECIFIC COMPOSITE CONTRACTS................8 I. WORKS CONTRACTS.............................................. 8 II..................................PRINTING & PHOTOGRAPHIC SERVICES 11 VALUATION OF COMPOSITE CONTRACTS....................................14 PART A – COMPOSITE CONTRACTS NOT FALLING UNDER THE HEAD OF WORKS CONTRACT SERVICES...................................................... 14 PART B – WORKS CONTRACT SERVICES.................................18 SCHEME OF SERVICE TAX IN COMPOSITE CONTRACTS..........................21 TAX IMPLICATIONS ON COMPOSITE SERVICES...............................23 INTRODUCTION Contracts which involve transfer of goods as well as services generally fall into three categories. First, the contracts can be distinct in nature, wherein one contract deals exclusively with
PART B – WORKS CONTRACT SERVICES....................................................................................18
SCHEME OF SERVICE TAX IN COMPOSITE CONTRACTS...................................................................21
TAX IMPLICATIONS ON COMPOSITE SERVICES................................................................................23
INTRODUCTION
Contracts which involve transfer of goods as well as services generally fall into three categories.
First, the contracts can be distinct in nature, wherein one contract deals exclusively with the sale
of goods and one contract deals with the performance of services. Second, the parties may enter
into one contract only, but it creates two separate obligations, one for the transfer of goods and
the other for provision of services. These contracts are called divisible contracts. The third
category is called indivisible contracts. In these contracts, the transfer of goods and services are
part of the same contract, and they are so interlinked with each other that it becomes impossible
to distinguish the sale from the service. In such contracts, attribution of the sale element and the
service element is difficult and thus, they are treated as an indivisible contract.
Under all three types of contracts, taxes will be levied. In the first type, where two distinct
contracts are entered into, there is no difficulty as the two contracts shall be treated separately,
and on one sales tax shall be levied, and on the other service tax. The problems and the
controversies arise only on the other two types of contracts. A constitutional amendment, various
judicial pronouncements and many more CBEC clarifications have not yet resolved the issue
completely. From way back in 1958 till date, assessees, practitioners and judges alike are all
unclear on the exact law relating to taxation of composite and indivisible contracts. The
Government has not identified key issues in composite contracts, and while attempts are being
made to clarify the law relating to taxation of composite contracts, latest developments and
innovative advancements in society has caused further complications.
Some of the important examples of composite contracts, for the purpose of this paper, are
contracts involving provision of diverse spectrum of services, or provision of services involving
ancillary use of goods, like for example a catering contract; or performance of work involving
use and/or transfer of goods. This paper shall address all these issues and many more and
identify the current law regarding taxability of these contracts.
VIVISECTION OF COMPOSITE CONTRACTS: MARCH OF LAW
1958 – GANNON DUNKERLEY V. STATE OF MADRAS.
Prior to the Supreme Court ruling in the Gannon Dunkerley case,1 various states had included the
transfer of materials in a works contract within the meaning of sales. The effect of this was that
in any works contract, the transfer of materials was chargeable to sales tax under the relevant
state legislation. In this case, the Madras General Sales Tax Act, 1939, Section 2(h) which
provided for the definition of “sale” was enlarged so as to include “a transfer of property in
goods involved in the execution of works contract.” Similar definitions were found in Sales Tax
laws of other states, and it was ultimately resolved by the Apex Court.
1 Gannon Dunkerley v. Madras, AIR 1958 SC 560
The Supreme Court finally held in this case that there is no sale as such of materials used in a
building contract, and that the Provincial Legislatures had no competence to impose a tax
thereon under Entry 48 of List II. It was also clarified by the Supreme Court that the above
conclusion has reference to works contracts only, which are entire and indivisible. It is possible
that the parties might enter into distinct and separate contracts, one for the transfer of materials
for money consideration, and the other for payment of remuneration for services and for work
done. In such case, there are really two agreements, though there is a single instrument
embodying them, and the power of the State to separate the agreement to sell, from the
agreement to do work and render service and to impose a tax thereon cannot be questioned.
Thus, the Supreme Court held that in a composite works contract, there is no sale, and entire
contract is to be treated as a contract for work. The reason for this was that a works contract is
predominantly a contract for construction of building, in which the intention of both parties is not
for sale of materials, but rather to construct the building. Here, the sale is only incidental and
ancillary to the work performed and thus, the Supreme Court held that in such cases, the
Department must not dwell too deep and vivisect the contract.
1958-1982 – SNOWBALLING EFFECT OF GANNON DUNKERLEY
The penultimate paragraph of the judgment rendered in Gannon Dunkerley specifically mentions
that this decision shall apply to works contracts alone. However, within the period of 1958 to
1982, it was used to negate the sales tax on a variety of transactions. Some of the prominent ones
were:
Transfer of food, drinks, etc. by a restaurant
Interstate consignment of goods
Leasing of intellectual property
Thus, the decision of Gannon Dunkerley snowballed to such a great level, that tax on sales could
only be levied if there was an actual sale and the parties intended there to be a sale.
In the case of State of Punjab v. Associated Hotels of India,2 the Supreme Court held that
charges for room were indivisible from amount of food provided to tenants and thus, the charges
for the rooms in a hotel cannot be split up as sale of food items separately and provision of room
separately. Similarly, in Northern India Caterers (India) Ltd. v. Lt. Governor of Delhi,3 it was
held that the service of meals to visitors in the restaurant is not taxable, and this is so whether a
charge is imposed for the meal as a whole or according to the dishes separately ordered. A
review petition against this order was also dismissed by the Chief Justice of India.4
Both these cases relied heavily on Gannon Dunkerley when then went on to hold that sale of
food and beverages in a hotel or a restaurant is not a sale as the intention of parties is not to buy
or purchase food products, rather it is to enjoy the ambience. Applying the similar logic,
interstate consignment of goods was not taxable as there was no actual sale. Likewise, lease of
movie print to a theatre was also not taxable, all due to the decision rendered in Gannon
Dunkerley. The decision thus caused the Revenue to lose out on a lot of taxes, as a lot of
transactions were held not to be sales.
1982 – 46TH CONSTITUTIONAL AMENDMENT
To cure the problem created by Gannon Dunkerley, the legislature amended Article 366 by way
of the 46th Amendment. This Amendment inserted a clause 29A within Article 366, which
defined the term “taxes on sale and purchase of goods.” It read:
(29A) "tax on the sale or purchase of goods" includes-
(a) A tax on the transfer, otherwise than in pursuance of a contract, of property in any goods for
cash, deferred payment or other valuable consideration;
(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;
(c) A tax on the delivery of goods on hire-purchase or any system of payment by installments;
2 State of Punjab v. Associated Hotels of India, AIR 1972 SC 11313 Northern India Caterers (India) Ltd. v. Lt. Governor of Delhi, AIR 1978 SC 15914 Northern India Caterers (India) Ltd. v. Lt. Governor of Delhi, AIR 1980 SC 674
(d) A tax on the transfer of the right to use any goods for any purpose (whether or not for a
specified period) for cash, deferred payment or other valuable consideration;
(e) A tax on the supply of goods by any unincorporated association or body of persons to a
member thereof for cash, deferred payment or other valuable consideration;
(f) A tax on the supply, by way of or as part of any service or in any other manner whatsoever, of
goods, being food or any other article for human consumption or any drink (whether or not
intoxicating), where such supply or service is for cash, deferred payment or other valuable
consideration,
By way of this amendment, all those transactions that were not held to be sales earlier, were all
reversed and they were to be treated as deemed sales. For example, the transactions involved in
the “Associated Hotels” and in the “Northern India Caterers” cases would now fall under sub-
clause (f) of Article 366(29A). Lease of intellectual property would now be construed as a
deemed sale under Article 366(29A)(d). Transfer of material under a works contract would now
be taxable as a deemed sale by virtue of Article 366(29A)(b).
1994 – INTRODUCTION OF SERVICE TAX
The 46th Constitutional Amendment seemed to smother all disputes concerning transactions that
may or may not have been sales. The broad definition given under Article 366(29A) appeared to
have covered every kind of dispute, as the various sub clauses, although broad in language, were
still clear and concise enough to not cause any ambiguity. For a period of twelve years there
were hardly any cases concerning the question of sale or deemed sale, and the law was pretty
much settled in this period.
In 1994, Service Tax was introduced in India by Chapter V of the Finance Act, 1994. The
scheme of service tax is found from Section 64 onwards of the Finance Act, 1994. Section 65 of
the Act, which is the definitions clause, defines “taxable service”, and gives an exhaustive list of
all those services that are taxable.
The introduction of the service tax regime began another round of controversies as the Act had
not made clear as to applicability of service tax in a composite contract, containing sales as well
as services elements. This controversy came to light in the case of State of UP v. UoI,5 wherein
the Court held that on providing telephone connection to subscriber(s) by the Department of
Telecom (DoT) the DoT constitute a ‘dealer’ and thus transaction fall within the meaning of sale
and it is obliged to file sales tax return notwithstanding the fact that service tax was already
imposed.
On a prior occasion, in the case of Rainbow Colour Lab v. State of M.P.,6 the Court held that in a
works contract which is predominantly for provision of services, goods that are sold incidental to
the contract are not considered to be sales and the 46th Amendment cannot apply in this regard. In
this case, the question before the Court was applicability of sales tax on materials sold in a
contract for photography services. The Court held that such contract was for use of skill and
labour by photographer to bring about desired result, and after 46th Constitutional Amendment it
was now open to State to divide 'works contract' into two separate contracts by legal fiction –
first, contract for sale of goods in said 'work contract' and second, for supply of labour and
service. According to the Court the division of contract can be made only when 'work contract'
involved dominant intention to transfer property in goods and not in contracts where transfer of
property takes place as incidental to contract of service. This decision was however overruled
later, and the correct position of law was restored, but it shall be dealt with in the later chapters.
2006 TILL DATE – THE TRIPLE TESTS OF BSNL V. UOI
Despite the fact that there was a clear constitutional mandate requiring the State to split the
contract into sale of goods and provision of services, contradictions still persisted. However, all
this was put to rest in 2006 by the Supreme Court in the decision of BSNL v. UoI.7
The question before the Court in BSNL was whether a sale of a sim card is chargeable to sales
tax. The Revenue, applying the decision of State of UP v. UoI,8 contended that sale of sim cards 5 State of UP v. UoI, (2003) 3 SCC 2396 Rainbow Colour Lab and Anr. v. State of M.P. and Ors., (2000) 2 SCC 3857 BSNL v. UoI, 2006 (3) SCC 18 Supra n. 5
are both sales as well as service. Thus, both taxes should apply. The Court however took a
different stance. The Court laid down the triple test to determine taxability of composite
contracts. First, the assessee must check if his composite contract falls under any of the clauses
of Article 366(29A). If it does so, then the contract must be vivisected and sales tax to be paid on
the sales portion and service tax on the service portion. If the contract does not fall under Article
366(29A), then one has to move to the second test. The second test deals with intention of
parties. If the intention of parties was to create separate obligations regarding sales and service,
then the contract must be split and taxed independently. However, if there is no intention also
then the assessee must determine the dominant nature of the contract. If the dominant nature is
for sale, then sales tax must apply on the entire contract and if the dominant nature if for service,
then service tax must apply to the entire contract. The difference between the second test and the
third test is of intention v. nature. While in the second test, the intention of the parties is assessed,
the third test determines the nature of the contract.
In this case, the Court found that sale of sim cards do not fall under any of the sub-clauses
mentioned under Article 366(29A). The Court then moved on to the second test. Here the Court
suggested that the second test can only be applied on a case by case basis and sent back the
matter to the Tribunal. If the facts of each case showed that the sale of sim cards created an
intention of sale as well as service, then independent taxes would apply, and if not the Tribunal
was required to apply the third test. For example, if a dealer of sim cards purchased them from
the service provider, then there may be two different obligations here; one for sale of sim cards
as goods, and one for activation of telephony services when the dealer sold the sim cards to
ultimate consumer. Thus, in these cases, sales tax may apply. However, if the sim cards are sold
to the ultimate consumer, there may not be any separate obligation of sale, and thus the dominant
nature must be seen. The dominant nature of the contract for sale of sim cards to the ultimate
buyer is of services alone, and not one of sale. Thus, in this case sales tax would not apply. The
Court, taking all this into consideration, sent back the matter to the Tribunal after laying down
the triple test.
This test was also upheld recently by the Supreme Court itself in the case of Imagic Creative v.
CCT.9 The Court held that the test therefore for composite contracts other than those mentioned
in Article 366(29-A) continues to be: Did the parties have in mind or intend separate rights
arising out of the sale of goods. If there was no such intention there is no sale even if the contract
could be disintegrated. The test for deciding whether a contract falls into one category or the
other is to as what is the substance of the contract. For the want of a better phrase, it was called
the dominant nature test.
The Supreme Court observed, a distinction must be borne in mind between an indivisible
contract and a composite contract. If in a contract, an element to provide service is contained, the
purport and object for which the Constitution had to be amended and clause 29A had to be
inserted in Article 366, must be kept in mind. A legal fiction is created by reason of the said
provision. Such a legal fiction, as is well known, should be applied only to the extent for which it
was enacted. It, although must be given its full effect but the same would not mean that it should
be applied beyond a point which was not contemplated by the legislature or which would lead to
an anomaly or absurdity. They further held that payments of service tax as also the VAT are
mutually exclusive. Therefore, they should be held to be applicable having regard to the
respective parameters of service tax and the sales tax as envisaged in a composite contract as
contradistinguished from an indivisible contract. It may consist of different elements providing
for attracting different nature of levy. It is, therefore, difficult to hold that in a case of this nature,
sales tax would be payable on the value of the entire contract; irrespective of the element of
service provided.
9 Imagic Creative v. Commissioner of Commercial Taxes, (2008) 2 SCC 614
SUMMARY OF THE TIMELINE OF THE LAW
DETAILED ANALYSIS OF CERTAIN SPECIFIC COMPOSITE CONTRACTS
I. WORKS CONTRACTS
For more than fifty years, no composite contract has seen as much clamor as that of works
contract. The issue regarding works contract started all the way back in 1958, with the Gannon
Dunkerley, and still the position of law is not clearly settled. The jurisprudence on works
contract up to the introduction of Service Tax in 1994 has already been discussed. What
transpired after that shall be called, for want of a better phrase, The Daelim Dilemma.
Although service tax was introduced in the year 1994, works contract was not made a taxable
service till 2007. However, since the introduction of service tax, the services performed under a
works contract, like “designing and engineering” services, or “pre-designed service/project
report basic design engineering and detailed design engineering” services were classified as
taxable services and charged separately. Article 366(29A) requires the works contract to be split
into sales and service aspects, and thus, in any works contract the service element, i.e. those
mentioned above, would be taxed and only the sales portion would be taxable to sales tax. Or so
it seemed.
In the year 2003, the Delhi CESTAT Tribunal was faced with a simple question of taxability of
materials sold under a works contract. The Tribunal completely ignored the mandate of Article
366(29A), and instead relied on Associated Hotels case,10 and delivered a judgement per
incuriam. The Tribunal held:
Thus, a perusal of the clauses of the contract leaves no doubt that the appellant
contract with IOC was a work contract on turnkey basis and not a consultancy
contract. It is well settled that a work contract can not be vivisected and part of it
subjected to tax. The impugned orders have proceeded to do precisely that.
Therefore, they are required to be set aside.
An appeal filed by the department against this order of the CESTAT was dismissed in the
Supreme Court.11
In the year 2006, the same issue was put forth before CESTAT – Mumbai as to whether the
transfer of materials in a works contract amounts to sale.12 This case, CCE v. L&T was decided
by the Mumbai Tribunal just twenty (20) days after the Supreme Court decided on the BSNL
case, and yet the CESTAT bench completely misread the ratio of BSNL. Where on one hand
BSNL held intention of parties to be relevant only if a contract does not fall under Article
366(29A), the Tribunal in this case misunderstood BSNL to the point where Article 366(29A)
became redundant. The Tribunal in L&T held that intention of parties is of paramount
importance, and Article 366(29A) cannot be used to override such intention. Further, they also
distinguished between BSNL and the present case on the ground that BSNL did not dwell into
splitting of works contract; rather it focused on splitting a contract of sale of sim card.
10 Supra n. 211 CCE v. Daelim Industrial Ltd. 2004 (170) ELT A181 (SC)12 CCE v. Larsen & Toubro Ltd. & Ors., 2006 (4) STR 63 (CESTAT-MUM)
Towards the end of the same year, the issue again came up for deliberations before the Delhi
bench of the CESTAT in the case of CCE, Raipur v. BSBK Ltd.13 The issue this time was
applicability of service tax on a works contract. The Commissioner (Appeals) had passed an
order in consonance with the ratio of Daelim and held that a works contract cannot be vivisected
and those services performed under the works contract that are subject to service tax, cannot be
split from the main contract and made chargeable to service tax. According to this order, the
services like “designing and engineering” services, or “pre-designed service/project report basic
design engineering and detailed design engineering” services which were indeed taxable
services under Section 65 of Finance Act, 1994, could not be taxed as they formed part of a
larger works contract that could not be vivisected. Against this order, an appeal was filed and
thus the matter was before the Tribunal.
The CESTAT differed significantly from the decision in Daelim, but not because of Article
366(29A), or due to the decision in BSNL, but because the contract here was divisible in nature.
The Tribunal held that this works contract is severable in nature. They defined severable contract
to mean a contract that includes two or more promises each of which can be enforced separately,
so that failure to perform one of the promises does not necessarily put the promisor in breach of
the entire contract.
Ahead of the BSBK case reaching the Supreme Court, another case came up before the Mumbai
bench of the CESTAT. This case, Indian Oil Tanking v. CCE,14 noted the fact that there were
two conflicting decisions, in the form of Daelim and BSBK, and in order to resolve the dispute
once and for all, it was referred to a larger bench. In the meanwhile, the BSBK case had reached
the Supreme Court, where it was set aside on the ground that it was an ex parte order and was
remanded back to the Tribunal.15 Thus, when the Indian Oil Tanking case was posted for hearing
before the larger bench, there were no conflicting decisions as BSBK was made in fructuous by
the Supreme Court. The larger bench held:
13 CCE, Raipur v. BSBK Ltd, 2006 (113) ECC 320 (CESTAT-DEL)14 Indian Oil Tanking v. CCE, 2007-TIOL-1600-CESTAT-MUM15 BSBK P. Ltd. v. CCE, Raipur, 2008 (9) S.T.R. J29 (S.C.)
“We note that by order dated 30-11-2007 the Apex Court has set aside the
Tribunal's order in the case of BSBK (P) Ltd. on the ground that it was an ex
parte order and remanded the case to the Tribunal and directed the parties to
appear before the Tribunal on 18-1-2008. Therefore, as of today, no conflict
exists by way of varying or divergent orders of the Tribunal. Hence, no orders are
called for by a Larger Bench on the issue referred to it.”
Finally, in the year 2008, BSBK again came up before the Tribunal, and this time after fulfilling
all the procedural formalities. It was decided by the Delhi bench of CESTAT, and for the first
time since Daelim, the BSNL case as well as Article 366(29A) was referred.16 This was the first
case in a long history of cases that set out the proper position of law. The Tribunal held:
“Only that part of the contract which falls under Clause (b) of Article 366(29A) -
amounting to ‘deemed sale’ will constitute sale contract on which sales tax can be
levied. What will happen to the rest of the contract? Whether it will go out of the
net of the service tax? Answer again, will be in the negative.”
Although the correct position of law was spelt out, the Tribunal could not leave it at this stage
because the decision of Daelim still lingered, and it had to be rectified. Thus, the matter was
referred to a larger bench, and a decision is still awaited. If the larger bench accepts the judgment
delivered by the CESTAT Delhi bench, then it will finally put to rest a long and disputed chapter
in the history of indirect taxation.
II. PRINTING & PHOTOGRAPHIC SERVICES
The issue of taxation of photographic services arose for the first time in the case of Everest
Copier v. State of Tamil Nadu.17 This case was decided after the 46th Amendment, and again
similar to works contract, it started out with a wrong interpretation of Article 366 (29A). The
dispute that arose in Everest Copiers related to the taxability of materials sold in a printing and
photo copying contract. The question, simply put, was whether the paper on which printing and
photo copying took place, and which was ultimately sold to the consumer, is a sale or not? Thus,
16 CCE, Raipur v. BSBK Ltd, 2009[13]S.T.R.2617 Everest Copier v. State of Tamil Nadu (1996) 5 SCC 390
the question was can a printing contract be so vivisected such that the transfer of paper be held as
a sale, and the remaining value be treated as a service.
The Supreme Court in this case held that a printing contract is a contract of work or service, not a
contract of sale upon which sales tax is eligible. The fallacy in this judgment is that if a contract
is held to be a works contract, then the conditions of Article 366(29A) have to be met. Article
366(29A)(b) mandatorily requires that a works contract be vivisected and the transfer of
materials on such a contract be subject to sales tax. Since the Court accepted that a printing
contract is a works contract, it cannot overlook the mandate of Article 366(29A) and go straight
to the test of ‘dominant nature’.
At the dawn of the new millennium, a case came up before the Supreme Court that related to sale
of materials in a contract for photographic services. In Rainbow Colour Lab. and Anr. v. State of
M.P. and Ors,18 the question involved was whether the job rendered by the photographer in
taking photographs, developing and printing films would amount to a “work contract” as
contemplated under Article 366(29A)(b) of the Constitution read with Section 2 (n) of the M.P.
General Sales Tax Act for the purpose of levy of sales tax on the business turnover of the
photographers. The Court answered the questions in the negative because, according to the
Court:
“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. What is pertinent to ascertain in this
connection is what the dominant intention of the contract was.”
18 Rainbow Colour Lab and Anr. v. State of M.P. and Ors., (2000) 2 SCC 385
Thus, it can be seen that not for the first time, the judiciary misinterpreted the mandate of Article
366(29A). Instead of giving preference to the explicit language of Article 366, the Courts up till
now preferred giving first priority to dominant intention of the contract, and only then go to the
mandate of Article 366.
This conclusion was doubted in Associated Cement Companies Ltd. v. Commissioner of
Customs,19 saying:
“The conclusion arrived at in Rainbow Colour Lab case, in our opinion, runs
counter to the express provision contained in Article 366(29A).”
The Court in Associated Cement Companies held that Article 366 must be given primary
consideration, and only then can the issue of dominant nature be applied. Similarly, in BSNL case
the triple test laid down ranked Article 366 at the top, and then intention of parties, and only then
the issue of dominant nature arose. The case of Associated Cement Companies overruled the
decision of Rainbow Color Labs on the ground mentioned above.
Finally, in the case of Shilpa Colour Labs v. CCE,20 the issue of service tax of photography
services was finally resolved. The Bangalore Tribunal followed the decision of Associated
Cement and held that photography services being a contract for work will be liable to vivisection
in accordance with Article 366(29A). Thus, on a photography contract, the transfer of material
shall be charged sales tax, and service tax shall be levied on the remaining part of the contract in
accordance with Section 65(105)(zb) of the Finance Act, 1994. Although the issue of printing
contract was never discussed, it follows the same principle as that of photography contracts.
19 Associated Cement Companies v. Commissioner of Customs, AIR 2001 SC 86220 Shilpa Colour Labs v. CCE, [2007] 8 STT 102, CESTAT, Bangalore
VALUATION OF COMPOSITE CONTRACTS
PART A – COMPOSITE CONTRACTS NOT FALLING UNDER THE HEAD OF WORKS CONTRACT
SERVICES
The determination of service tax liability on composite contracts is a complicated process in
itself. The determination of liability is not only governed by the Finance Act, 1994, but also by
various rules, along with a couple of notifications. This process has further been complicated
when works contract was introduced as a taxable service in the year 2007. Works contract is
treated on a different footing as compared to other composite services, and there are separate
methods of determining tax liability for these services. All these rules, notifications, circulars, etc
have given assesses plenty of options to determine the tax liability by choosing the most
favorable method. As shall be seen in this chapter, an assessee who provides any service under a
composite contract, other than works contract service, has three options open to him; whereas a
provider of works contract service has two options within which he may decide his tax liability.
The years 2006-2007 marks a landmark year in the aspect of valuation of services in any
contract, composite or otherwise. These were the years in which Section 67, which provides for
valuation of services, was substantially amended and for the first time, there existed specific
rules on determination of value of services.
Prior to 2006, Section 67 of the Finance Act, 1994 defined value of taxable service as the gross
amount charged for services subject to specified exclusions & inclusions. The list of exclusions
specifically mentioned:
Cost of parts or accessories, or consumable sold to the customer during the course of
service or repair of motor cars,
Cost of unexposed photography film sold to the client during the course of providing the
service,
Cost of parts or other material, if any, sold to the customer during the course of providing
commissioning or installation service
Thus, as per the old Section 67 the cost of materials involved in a contract will be excluded. In
any composite contract the value of materials sold, or the sales element, was automatically
excluded by virtue of Section 67 and thus, all composite contracts were vivisected at the first
instance only.
This section however, underwent a substantial change by the Finance Act, 2006 by which the list
of exclusions and inclusions was removed and now made even more confusing. Along with this
amendment, the Parliament also approved the Service Tax (Determination of Value) Rules,
2006. The Valuation Rules does not specifically provide for removing value of goods sold during
the course of service. Due to this, some confusion still remains as to whether the sale of these
goods is to be included in value of service or not. To resolve this confusion, one must look at a
notification issue in the year 2003, which was titled Notification 12/2003.
The salient feature of this notification is that it allows an exemption of value of all the taxable
services, as is equal to the value of goods and materials sold by the service provider. Thus, by
way of this notification, an assessee may discount the value of sale involved in a composite
contract and pay service tax on the remaining portion of the contract.
Further, in the year 2006, along with the amendment and the Valuation Rules, the Government
also passed a notification on March 1st 2006, titled Notification No. 1/2006.21 This notification
lists out various composite services, and against each service, a specific abatement rate is
mentioned. In the year 2006, when the notification was issued, there were only ten (10) services
that mentioned there under. However, subsequent notifications have amended and added to that
list, and now there are 13 services that fall within this scheme.
The scheme, also known as abatement scheme, works on the principle of deemed percentage. For
example, in a case of outdoor catering contract service it is deemed that 50% of total value of the
contract is sales and the remaining portion is service. Thus, the assessee only has to pay service
tax on the service element as calculated from the deemed percentage method. Similarly, in a chit
fund service, 70% is deemed to be sales and service is only 30%.
21 Notification No. 1/2006, dated 1st March, 2006, available at < http://indiabudget.nic.in/ub2006-07/cen/st0106.pdf>, last visited on August 14, 2009
The method prescribed in Notification 1/2006 is an optional scheme and not compulsory. The
assessee has an option of following the method under Notification 12/2003, however, the rider
being that for utilizing the scheme of 12/2003 complete records must be shown. If it is not
possible to show all the records then the assessee cannot use 12/2003, rather he has to use the
scheme of 1/2006. If all the records do exist, the assessee has an option of either 12/2003 or
1/2006 depending on whichever is more beneficial to him. Apart from these two schemes, the
assessee also has an option of following the regular scheme of paying service tax on the entire
contract.
All these three options have their own pros and cons, which can be listed as under
1. Pay service tax on entire amount of contract (Regular Scheme)
Under this method, the service tax will be levied on a higher amount, and thus the tax liability is
higher. However, the upside of this scheme is that CENVAT credit can be availed of all input
goods and services under Rule 3 of CENVAT Credit Rules, 2004.
2. Avail benefit of 2003 notification (Specific Value of services)
In this method, as mentioned above, the value of goods and materials sold under the contract is
excluded and only the services are taxable. Thus, tax liability is bound to be lower than that
determined under method 1. However, there are two limitations on this scheme. First, this
scheme can only be availed if the assessee has complete records of all the transactions that
clearly distinguish between sale aspects and service aspects. Second, the assessee is only allowed
to take CENVAT credit of input services and not input goods.22
3. Avail benefit of 2006 notification (Deemed Percentage)
22 Proviso to Rule 1 of Notification No. 12/2003-Service Tax, added by way of Para 6 of Notification No. 12/2004-Service Tax, available at <http://www.servicetax.gov.in/notifications/notfns-2k4/st12-2k4.htm>, last visited on August 14, 2009
As discussed above, availing benefit of notification 1/2006 can be done at the option of the
assessee. There is no need to maintain any specific records to show exact sale transaction and
service transaction, and this is convenient to the assessee. The downside is that CENVAT credit
cannot be claimed, either on input goods or on input services.
PART B – WORKS CONTRACT SERVICES
The rules regarding valuation of works contract services are significantly different from that of
other services. Prior to 2007, works contract was not a taxable service within the ambit of
Finance Act, 1994 and only by way of The Finance Bill, 2007 was works contract introduced as
a taxable service. Sub-clause (zzzza) to clause (105) of Section 65 states:
“(zzzza) to any person, by any other person in relation to the execution of a works
contract, excluding works contract in respect of roads, air ports, railways,
transport terminals, bridges, tunnels and dams.”
Prior to clause (zzzza), the services performed under a works contract were chargeable to service
tax independently. Thus, services like erection, commissioning and installation services,23
construction services,24 consultancy or technical assistance in engineering services,25
architectural services,26 real estate services,27 site formation and clearance, excavation and
earthmoving and demolition services,28 etc were all to be taxed separately. However, after 2007,
all these services, if the prerequisites are fulfilled, were all treated under one head called works
Hitherto, the term works contract was never defined in any law or under any notification.
Explanation to section 65(105)(zzzza) makes a modest attempt to define the term “works
contract.” It reads:
Explanation – For the purposes of this sub-clause, “works contract” means a
contract where in,
(i) transfer of property in goods involved in the execution of such contract is
leviable to tax as sale of goods, and
(ii) such contract is for the purposes of carrying out,—
a) erection, commissioning or installation of plant, machinery, equipment or
structures, whether pre-fabricated or otherwise installation of electrical and
electronic devices, plumbing, drain laying or other installations for transport of
fluids, heating, ventilation or air-conditioning including related pipe work, duct
work and sheet metal work, thermal insulation, sound insulation, fire proofing or
water proofing, lift and escalator, fire escape staircases or elevators; or
b) construction of a new building or a civil structure or a part thereof, or of a
pipe line or conduit, primarily for the purposes of commerce or industry; or
c) construction of a new residential complex or a part thereof; or
d) completion and finishing services, repair, alteration, renovation or
restoration of, or similar services, in relation to (b) and (c); or
e) turnkey projects including engineering, procurement and construction or
commissioning (EPC) projects”
Thus, after this definition, only those contracts relating to transfer of property in goods involved
in the execution of such contract which is leviable to tax as sale of goods and being contracts of
the nature specified in clauses (a) to (e) above are covered under the definition.
This raises an important issue with respect to printing contracts, and other such contracts. Article
366(29A) deals with works contract in sub-clause (b) and the recent cases of Shilpa Color
Labs,29 and Associated Cements,30 have held that printing and photography contracts are part of
works contract. However printing contracts, dyeing contracts, maintenance contracts, electrical
29 Supra n. 2030 Supra n. 19
or structural contracts etc., are not in the nature of services specified under the explanations and
yet they are works contract for the purpose of Article 366(29A). Despite the fact that these above
mentioned contracts are works contract in general parlance, they will still not be treated as one
for the purpose of Finance Act, 1994.
The assessee, who is a service provider of works contract service, has only two options with him
regarding determination of tax liability. The first option is provided for within the Service Tax
(Determination of Value) Rules, 2006 itself. Rule 2A of the valuation rules provides that the
value of the works contract services shall be equivalent to the gross amount charged for works
contract less the value of transfer of property in goods involved in the execution of works
contract. As always, the gross amount charged is a pre tax amount and from this gross value, the
value of sale of materials is excluded.
Apart from this general rule, the explanation to Rule 2A also clarifies that the following charges
have to be included within the value of a works contract.
Labour charges for the execution of the works
Amount paid to the sub contractors for labour and services
Charges for planning designing and architect’s fees
Charges for obtaining machinery tools etc whether on hire Or otherwise for the execution
of the works contract
Cost of consumables such water electricity fuel etc used in the execution of works
contract
Cost of establishment of the contractor relatable to supply of labour and services
Other similar expenses relatable to supply of labour and services and
Profit earned by the service provider relatable to supply of labour and services
Thus, it can be seen that Rule 2A has effectively clubbed all the individual services involved in a
works contract, and brought it under one roof.
The alternative option that is open to the assessee after 2007 is the composition scheme. The
Government by way of notification introduced the Works Contract (Composition Scheme for
Payment of Service Tax) Rules, 2007.31 Under the composition scheme, a flat rate of 4% is
levied on the entire sum of works contract as a service tax. The assessee is not required to
maintain any data or records which clearly distinguish sales element from service aspects. The
rate of 4% is significantly lesser than the 10% rate that is applied in the first method, but the
proviso being that the 4% is applied on entire contract, where as 10% is applied only on the
service portion.
There are two disadvantages to this method in the sense that first, an assessee once opted for this
method of valuation, cannot opt out of this method until the contract is completed.32 Second, the
assessee shall not be entitled to receive any CENVAT credit on input goods. 33 However, the
duties paid on input services are available for credit under the CENVAT Credit Rules, 2004.
31 Notification No. 32/2007-Service Tax, dated the 22nd May, 2007, available at <http://www.servicetax.gov.in/notifications/notfns-2k7/st32-2k7.htm>, last visited on August 14, 200932 Rule 3(3) of Works Contract (Composition Scheme for Payment of Service Tax) Rules, 200733 Rule 3(2) of the Works Contract rules prevents an assessee from claiming CENVAT credit of duty paid on inputs, but does not mention about input services. The definition of “inputs” under CENVAT Credit Rules, 2004 is restricted to goods alone (Rule 2(k) of CENVAT Credit Rules), and services are defined under the term “input service.” Thus, when Rule 3(2) of Works Contract Rules restricts the disability to inputs only, it is assumed that only duty paid on input goods are not available for credit, whereas duty paid on input services are available for credit.
SCHEME OF SERVICE TAX IN COMPOSITE CONTRACTS
To sum up, the taxability of a transaction has to be determined on the bedrock of the triple test
laid down in BSNL. The first question that must be posed when confronted with any issue on
composite contracts, as shown below, is whether the contract is covered by Article 366(29A). If
the contract is covered, then it must be necessarily vivisected and sales tax and service tax must
be levied on the respective portions of the contract. However, if the answer to the first question is
negative, then the intention of the parties must be seen. Did the parties intend to create different
obligations of sale and service? If yes, then it must be vivisected as per parties’ intentions and tax
accordingly. If there is no intention that can be shown, then the dominant nature of the contract
must be examined, and the contract must be classified into a sales or service contract. Once this
is done only one tax can be levied, either sales tax or service tax, depending on the nature of the
contract.
If the contract is vivisected, then sales tax in the form of VAT or Central Sales Tax, as the case
may be, has to be levied on the value of materials sold in the course of the contract. Thus, sales
tax shall apply on the sale aspect only. Service tax shall then be applied as per Section 67 of the
Finance Act, 1994.
Section 67 of the Finance Act, 1994 read with the Valuation Rules, provides various options to
the assessees in determining the tax liability. If the contract involves a works contract, then Rule
2A of the Valuation Rules, 2006 determines the tax liability of the assessee. The assessee also
has an option of determining tax liability by way of the composition scheme, framed under the
Works Contract Rules.
If the contract is for performance of any other service, not being a works contract service, then
the assessee has three options for valuation of service. First, he may pay service tax on the entire
contract, and avail CENVAT credit of all duty paid on input goods and services. Alternatively,
he may determine the value in accordance with Notification 12/2003 provided he has complete
records of all the materials transferred in the course of the contract. Last, he may choose an
abatement scheme, where the value of service is calculated on the basis of a deemed percentage
as specified in notification 1/2006.
TAX IMPLICATIONS ON COMPOSITE SERVICES
The paper so far has discussed various implications of composite contracts involving sale of
goods as well as provision of services. However, an uncertainty arises when an assessee enters
into a composite contract involving provision of two or more services. If both the services are
taxable, then the effect is not going to change, as which ever way it is classified, or even if it is
vivisected, service tax will be paid at the standard rate of 10% on the entire contract. The
predicament arises if one service is taxable, and the other is not.
A perusal of the Act reveals that this problem was never envisaged. Section 65A which deals
with classification of taxable services states in clause (2), that:
65A. Classification of taxable services –
(1) …;
(2) When for any reason , a taxable service is prima facie, classifiable under two
or more sub-clauses of clause (105) of section 65, classification shall be effected
as follows:-
(a) the sub-clause which provides the most specific description shall be preferred
to sub-clauses providing a more general description;
(b) composite services consisting of a combination of different services which
cannot be classified in the manner specified in clause (a), shall be classified as if
they consisted of a service which gives them their essential character, in so far as
this criterion is applicable;
(c) when a service cannot be classified in the manner specified in clause (a) or
clause (b), it shall be classified under the sub-clause which occurs first among the
sub-clauses which equally merits consideration;
Thus, section 65A deals only with a situation where a contract consists of two or more taxable
services. It does not address the situation wherein one service is not taxable, and the other is
taxable. To determine this issue, recourse must be taken to the various circulars and TRU34
letters.
In a TRU letter dated 28th February, 2006,35 it was clarified that:
“Often services provided consist of more than one service. In such cases, it is
important to decide, for the purpose of classification of services, whether each
element of the transaction should be treated separately or as a single composite
transaction, albeit, made up of two or more separate services. A composite
service, even if it consists of more than one service, should be treated as a single
service based on the main or principal service and accordingly classified. The
decision is to be made on question of facts and law. It will not make a difference if
the tax rates of the components are the same as that of the principal service. The
problem may arise when some elements are taxable and others are exempt. While
taking a view, both the form and substance of the transaction are to be taken into
account. The guiding principle is to identify the essential features of the
transaction.”
Thus, in a composite contract containing more than one service, the essential characteristic of the
contract must be seen, and if and only if that service is taxable can the contract be taxed.
Additionally, on February 29, 2008 the TRU issued another letter to clarify the position of law
regarding composite services. According to this letter the essential characteristics of a contract
34 Tax Research Unit, Department of Revenue, Ministry of Finance35 D.O.F.No.334/4/2006-TRU; para 3.2, available at <http://indiabudget.nic.in/ub2006-07/cen/dojstru2.pdf>, last visited on August 13, 2009
shall always indicate towards the principal service provided and not any other ancillary or
incidental service. A service, which does not constitute for a customer an aim in itself but a
means of better enjoying the principal supply, is considered as a supply ancillary to the principal
supply.36 In the same year, a circular was issued, in which the tests laid down by the above
mentioned TRU letters were applied to the case of Goods Transporting Agency (GTA)
services.37
Thus, in any contract for composite services, where one service is taxable, and one is not, the test
of the two TRU letters has to be applied in determining the taxability of the contract.
36 D.O. F. No.334/1/2008-TRU, dated 29.2.2009, available at <http://allindiantaxes.com/pdf/96224c8f.pdf>, last visited on August 13, 200937 Circular No. 104/07/2008-ST, dated 06/08/2008, available at <http://www.servicetax.gov.in/circular/st-circular08/st-circ-104-2k8.htm>, last visited on August 14, 2009
