Recently, in the case of Larsen & Toubro, the Larger Bench ruled that Value Added Tax (VAT) would apply on “under-construction property”, and upheld two earlier decisions from the Supreme Court and the Bombay High Court.

The judgement essentially dealt with VAT applicability on building contracts, a species of works contract, which has been a matter of constant dispute/ litigation.

Like in the earlier case of Raheja Development Corporation, L&T developed the property of a landowner under an arrangement to provide 25 per cent of the developed space to the owner, with the rest going to the company. Based on a power of attorney, L&T entered into sale agreements with prospective buyers, who would gain possession of a fully-built flat along with an undivided interest in the land.

The point to consider was whether such a sale agreement would attract VAT as a tax on transfer of property in the goods involved in the execution of the works contract. The main grievance was that the construction of flats/ apartments was not at the behest of the buyer but on the developer/ owner’s account. Hence, even if there is a transfer of property in the goods used in the construction, it is to the self and not the prospective buyer on the basis of the accretion principle. Also, what is eventually conveyed is an immovable property.

However, Revenue authorities contended that the judgement in the Raheja case was correct, and that after the 46th Constitutional Amendment, the tax on sale of goods to include transfer of property in goods involved in the execution of works contract, whether as goods or in some other form, was wide enough to cover the value of goods involved in immovable property.

While upholding the Revenue department’s arguments, the Larger Bench laid out/ reiterated several legal positions, including

The term ‘works contract’ in Article 366(29-A)(b) is not restricted to what is traditionally understood — that is, only contracts involving labour or service.

In a composite contract comprising works contract and transfer of immovable property, sales tax can be levied on value of material involved in the execution of works contract.

The dominant nature test does not apply to cases involving works contract, even though the dominant intention of such a contract could be provision of service or conveyance of immovable property. The dominant intention theory should still apply to determine whether the composite contract not involving work contract is a sale contract or service contract. For example, during a medical implant surgery there is an incidental transfer of property.

Importantly, it is held that taxing the sale of goods is permissible even after its incorporation in the immovable property, provided the tax is directed only to the value of goods during incorporation.

Very importantly, it is clarified that works contract would arise only from the stage at which the developer enters into a contract with the flat buyer. Thus, tax is chargeable only on the value of the materials involved and transferred after an agreement is entered into with the buyer. This would be difficult to implement. What will happen to the composition methods of taxation, calculated on the entire contract value? Can the taxpayer rework the contract value to a lower value after entering an agreement to sell? In Tamil Nadu, the general practice is to charge (though not explicitly shown as not permitted to recover) the composition rate on the total value or even in other schemes — namely, the merit route or ad hoc route — to pay tax on the entire value of material involved, irrespective of whether it is before or after the construction agreement. Is this to be revisited?

Finally, as held in the Raheja judgement, there will be no works contract if the agreement is entered into after the flat or unit is already constructed. The question over when a flat or unit is already constructed can again become contentious.

While the judgement has provided finality on the taxability of under-construction property, it has left a trail of other issues to be resolved.

The author is Tax Partner, EY

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