April 24, 2019


The urge to tax more and more between the state and the Centre on the subjects within their respective subject list was obviously the reason which lead to the jurisdiction war between the Centre and the States.  If one has to look into the genesis of the problem initially in Dunkerley’s case, as reported in State of Madras v. Gannon Dunkerley & Co. (Madras) Ltd., 1959 SCR 379. A Constitution Bench of the apex Court 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 Provincial Legislature to impose a tax on the supply of materials used in such a contract, treating it as a sale. The above statement was founded on the premise that a works contract is a composite contract which is inseparable and indivisible, and which consists of several elements which include not only a transfer of property in goods but labour and service elements as well. Entry 48 of List II to the 7th Schedule to the Government of India Act, 1935 was what was under consideration before this Court in Gannon Dunkerley’s case. It was observed that the expression “sale of goods” in that entry has become “nomen juris” and that therefore it has the same meaning as the said expression had in the Sale of Goods Act, 1930. In other words, the essential ingredients of a sale of goods, namely, that there has to be an agreement to sell movables for a price, and property must pass therein pursuant to such agreement, are both preconditions to the taxation power of the States under the said entry. The Court, after considering a large number of judgments, ultimately came to the following conclusion :-

“To sum up, the expression “sale of goods” in Entry 48 is a nomen juris, its essential ingredients being an agreement to sell movables for a price and property passing therein pursuant to that agreement. In a building contract which is, as in the present case, one, entire and indivisible — and that is its norm, there is no sale of goods, and it is not within the competence of the Provincial Legislature under Entry 48 to impose a tax on the supply of the materials used in such a contract treating it as a sale.” (at page 425)

However, in relation to works contract, even before the Service Tax came into existence through levy on services by Finance Act, 1994, the States had started levy Sales Tax on the goods portion of a works contract on a notional basis seeking to levy only goods portion. The reason for this was 46th Constitutional amendment. The Constitutional amendment so passed was the subject matter of a challenge in Builders’ Assn. of India v. Union of India, (1989) 2 SCC 645. This challenge was ultimately repelled and this Court stated :-

“… 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 as stated above.” (at para 36)

Since such a levy on goods portion was held to be constitutional and not ultravires to the powers of the State under the Constitution, the Centre also sought to levy tax on the service portion contained in the works contract.  The same was also held to be within the power of the Centre.  Therefore, we had situations where for the same works contract the goods portion came to be subjected to tax under the Sales Tax/State VAT and Services portion under the Finance Act, 1994 what applied to works contract came to ipso facto was made applicable to Construction Contract and Services also.  Same being nothing but a species of a Works Contract with a prominent difference that it also involved a transaction of transfer of property along with construction services, which was subjected to Stamp Duty on transfer as an immovable property by the State.  Even in 2012 when Negative List was introduced, composite contracts were sought to be subjected to levy under the Finance Act, 1994.  There can be three types of composite contracts (1) One those which involve more than one services and are to be subjected to levy according to dominant nature of the service (2) those which involved components of goods and services and were therefore were composite in the sense that goods portion could be levied to tax only in the state domain while service portion could be subjected to Central levy under Finance Act, 1994 and (3) those which had component of sale of property along with construction component.

As the Central and State levies on the subject evolved, persons subjected to levy were given an option either to maintain separate accounts for goods portion and services portion or alternatively were subjected to a valuation of 1/3 rd portion being generally considered as service portion by the Centre and 2/3 rd portion normally notionally considered as being goods portion in a works contract. While there was no basis for such a division other than notional basis, it however by and large ensured that transaction was not subjected to arbitrary levy or double taxation.

On July, 2012, when the Negative List came in into existence in the Finance Act, 1994, the composite contracts which involved element of construction services and immovable property came to be taxed in relation to construction contracts, though for immovable property component of the composite contract an abatement of 75% was provided by way of a Notification but not through mandate of Finance Act, 1994 or Rules made there under.  As far as Service Tax Valuation Rules are concerned Rule 2A, though spelt out the mechanism for valuation of  Works Contract relating to Goods and Services, did not do so in relation to specific construction contracts involving both sale of  landed property as well as construction services. In Suresh Kumar Bansal & Others Vs. Union of India & Others – W. P. (C) No.2235/2011 and W. P. (C) No.2971/2011 (the judgment was delivered on 3rd June, 2016), inter-alia, a challenge was made to the levy of construction  contracts involving both sale of immovable property as well as construction services in a composite contract, Hon’ble Delhi High Court after going through various Constitutional Provisions as well as the latest decision of Hon’ble Supreme Court in the case of C. C. Ex. Vs. Larson & Toubro Ltd. reported in 2015 (39) STR 913 (S. C.) in which it held that  Parliament can only tax service element and States can only tax transfer of property in goods . These two elements have to be completely segregated – If some element of transfer of property in goods remains when Service Tax is levied, it would be unconstitutional, pronounced that a notification, circular or other instructions cannot meet the requirements regarding constitutionality as laid down by the apex court in L&T case ( cited supra) and that the concept of ascertaining value must necessarily flow form the Charging Provision as well as the machinery provision of the Act. On the aforesaid basis, the H`ble Delhi H.C. upheld the challenge to levy of Service tax on construction services provided by a builder to flat buyers , as introduced in the Finance Act, 2010( and as continued even on introduction of negative list by Finance Act,2012) by insertion of Explanation to Section 65(105) (zzzh) of the Finance Act,1994.

Somesh Arora

(The author is Advocate and Chief Consultant (Amicus Rarus), Former Commissioner of Customs & Excise and a prolific author on tax and budgetary matters)

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