VAT on Works Contract in Rajasthan and Complicacies in tax computation

Introduction -

Works contract is a contract for carrying out some work for a lump sum consideration. The transfer of property in the goods involved in the execution of the works contract is taxable under State VAT Act. The value of works contract is composed off 'Material Value', 'Labour Value', 'incidental services' and 'profit margin'. The tax under vat is levied on the value of goods in which property is transferred or say tax is levied on the 'Material Value' component of the works contract. The Material Value is further composed off different category of exempted goods as well as of taxable goods which are taxable at different rates of tax according to their classification under vat chedule. Now question is How to determine the value of each component of the works contract and How to split the total value of goods used in the works contract in different tax rate groups i.e. exempted, 5%, 14% etc., according to their classifications as per vat schedule? Since the value of works contract is indivisible various issues are involved in offering the tax liability. There have been confusions and litigations over the years regarding computation of taxable turnover and computation of tax liability thereon and How it is different than Normal sale? All these issues have been discussed in later part of this article.

What is Works Contract (Deemed Sale) and How it is different than Normal Sale?

Under Rajasthan Value Added Tax Act 2003 the "Works Contract" has been defined under section 2(44). According to this section "Works Contract" means a contract for carrying out any work which includes assembling, construction, building, altering, manufacturing, processing, fabricating, erection, installation, fitting out, improvement, repair or commissioning of any movable or immovable property;

As per Section 2(35) RVAT Act 2003 "Sale" includes - 'transfer of property in goods (whether as goods or in some other form) involved in the execution of works contract'; and such transfer, delivery or supply shall be deemed to be a sale and the word "purchase" or "buy" shall be construed accordingly;

To understand the meaning of Works Contract we shall have to differentiate Normal Sale & Works Contract. The works contracts are not normal sales. In the normal sale there is a transfer of property in definite or ascertained goods. The character/identity of goods remain same before and after the delivery of the goods. However, in works contracts it does not happen. The goods before the delivery is in different form/shape/character and after the execution of works contracts it comes or transforms into different form/shape/character. For example, at the site of construction of a building, before the Construction (works contract) commences, the goods like cement, steel, sand etc. are lying but after the Construction a building (immovable goods) comes to an existence. Thus, in case of indivisible works contract whatever is ultimately delivered to the awarder is not in the same form in which it was purchased by contractor. The Contractor neither sold steel, cement, sand etc. to the awarder not he sold the building which he constructed, then the question is what he sold? He transferred the property in the goods and the value of material/ goods consumed in the works contract has been considered to be a "Deemed Sale" under works contract. This is the difference between the ' Normal" sale and the "deemed sale" in the indivisible works contract.

Basic Difference in Normal Sale & Deemed sale under Works Contract :-

Sno.	Normal Sale	Deemed Sale under works contract
1.	Taxed as Actual Sale- Seller & Buyer.	Taxed as Deemed Sale - Contractor & Contractee
2.	Absolute property of the maker when manufactured/produced and later on sold to the buyer	In WC it is never an absolute property of the maker. The goods delivered / final product was never property of the contractor.
3.	Sale is "chattel" as "Chattel" i.e. 'goods' is sold as 'goods'.	In WC, article produced becomes the property of the buyer without first becoming the property of the maker
4.	Primary function is "Supply of material" Incidental - work & service	Primary Function- work & labour Incidental-supply of material
5.	Predominant intention of parties is to sale or purchase the goods	Predominant intention of the parties to sale or purchase the goods contract is not to but to carry out certain work for a lump sum price
6.	The identity of goods remains same before and after delivery	In WC the original identity of the goods is changed after the work is executed and it gets merged, integrated and become part and parcel of the work, say building etc.
7.	TDS provisions are not applicable	TDS provisions are applicable

"In a contract of sale, the main object is the transfer of Property and delivery of the possession of Chattel as a Chattel to the buyer, whereas it is not so in WC, it is a contract of Works & Labour" (Hindustan Aeronautics Ltd. 55-STC 314-SC).

"If the thing to be delivered has any individual existence before the delivery as the property of the party who is to deliver it, then it is a sale. If the main object of the work undertaken is not the transfer of a Chattel qua Chattel, the contract is one for work and labour" (Hindustan Shipyard - 119 STC 533-SC).

"The activity is a sale or works contract depends upon the facts, the terms and conditions and the intention of the parties" (Mekenzis Ltd.-165 STC-58 SC). In normal practice, we can identify many indivisible/composite works contracts namely construction of a Building, erection of Plant & Machinery, Processing jobs, Job works, Repair jobs, Electrical Fittings, Annual maintenance Contracts (AMCs). Installation of Elevators, Air Conditioners, Repairs of Vehicles, Re-trending of old tyres, Customized Printing Jobs, Electro Plating, electro-galvanizing, anodizing etc. We would discuss later, the levy of Sales Tax/VAT on such activities which are indivisible works contracts.

Brief History or back ground of Works Contract/Deemed Sale

Before the 46th Amendment to the Constitution of India, the States were allowed to tax only on the sales covered under the sale of goods Act i.e. 'Normal Sale' and not on the indivisible works contracts. The Supreme Court confirmed this legal status in its land mark judgment in the case of Gammon & Dunkerely (9 STC 353 SC). Due to this legal status, the states were denied to levy Sales Tax on the indivisible works contracts and such contractors were outside the clutches of sales tax laws.

To remove this anomaly Finally, the 46th amendment was made to the Constitution of India on 2nd February, 1983 and a sub-article (29-4) was added - "(b) a tax on the transfer of property in goods (whether a goods or in some other form) involved in the execution of a works contract".

After the said 46th Amendment to the Constitution, the indivisible works contract was brought at par with a contract which is divisible into one for supply of goods and one for service and labour and the States were empowered to levy Sales Tax on that portion of Works Contract which relates to supply of material as if it was a sales, called as "Deemed sales" involved in the execution of works contract. Due to the said amendment, the concept of 'Deemed Sale' was introduced.

After, the said amendment to the Constitution certain States namely Maharashtra & Delhi have come out with separate 'Works Contract' Acts. The other states incorporated the separate provision in State Act to levy Sales Tax on the deemed sales in the works contracts. Now in Vat System All the VAT States have incorporated the provisions of 'Works Contracts' in their respective VAT Act and now there is no WCT Act in force. The Advantage to the Contractors is that under the VAT system, the Contractors like manufacturers can avail VAT set off / Credit of the VAT paid to the local vendors, which was not available in the Pre-VAT Regime but in Rajasthan set off of Tax Paid material was allowed and tax was imposed only on URD purchases.

The important features of deemed sales are as under,

(a) It is not a normal sale as defined under sale of goods Act but a deemed sale of goods subject to sales tax by the States.

(b) In the 'deemed sales' the states can levy Sales tax only on 'the transfer of property in goods' . In other words , the states can levy Sales Tax / VAT only on the 'Material Value' of the works contract and not on the 'labour portion' of the works contract.

(c) If in a contract there is no transfer of property in goods from the contractor to the contractee, then No sales tax is applicable on such contracts, called as " Pure Labour Jobs".

(d) Under the deemed Sale, an artificial break up of indivisible works contract has to be made to arrive at the 'material' value and the 'labour' value of the contract.

Valuation Options under Works Contract -

In VAT System there is a uniformity in all States in respect of provisions relating to works contract. All States has provided three options for computation of Taxable Turnover under works contract. The three options are as under:

Valuation Options under Works Contract
Exemption Fee Method/commonly known as Composition Method	Vat Method-1 Actual Deduction of labour & service Method	Vat Method-2 Standard Deduction Method

Although all States has provided above three options but many States have not provided or prescribed the complete procedure for items to be deducted from total value of works contract for computing the material value of the works contract also not laid down the rules for splitting the material value in different groups according to the classification of goods. However the High Courts and the Supreme Court have suggested methods on "How to arrive at a material value from the total Contract Price". (Gannon Dunkerly's SC Judgement 1993) (88 STC 204). Now we discuss each option one by one as under;

Option 1- Exemption Fee/ Composition Method (Under RVAT Act 2003)

Considering the complexity in computation of taxable turnover as well as tax liability on works contract and in order to grant relief to the dealers from lengthy process of record keeping, filing of quarterly returns and proving the deductions with evidences during the assessment proceedings the State Govt. has announced a simplified scheme to tax the works contract known as Exemption Fees Scheme vide Notification No. F.12(63)FD/Tax-2005/80 dated 11.08.2006 and amended from time to time now it has been replaced by Notification No. F.12(101)FD/Tax/2011-59 dt. 13.08.13. It is also known as Composition Scheme. It is a scheme which causes minimum inconvenience to the contractor as well as to the department in computing and assessing the taxable figure.

What is the Exemption Fees Method

Under this Notification the State Government has notified Exemption Fee at different percentage for different category of works contract according to nature of work. The contactor has to simply pay the Exemption Fee, on the total value of the works contract without any deduction, at the rate which is applicable to its works contract. The rate of Exemption Fee is ranging from .25% to 3%. It can be explained with an example that a contractor has been awarded a works contract for a total value of Rs. 2 crore for construction of Building. The rate of EC on this work is 3% as per notification, therefore the tax liability of contractor under this scheme shall be 6 lakhs being 3% of 2 crore.

Major Features of Exemption Fees Scheme in Rajasthan VAT

1. EC fee is payable at fixed rate on Total Value of works contract.
2. No deduction is available from total value.
3. No set off or credit of input tax available.
4. Only one annual return is required to be filed.
5. No record of material purchased and consumed is required to be maintained.
6. Once option is exercised no exit route is available.

Procedural aspects for availing this scheme

1.	The Contractor has to exercise option of EC fee within 60 days of works order in WT-1.
2.	AO will grant Exemption Certificate in WT-2 within 21 days of application.
3.	Separate application required for separate work order.
4.	If value of work order is enhanced or increased then for revised EC application in WT-4 should be filed within 60 days of communication regarding enhancement.
5.	If application is late, then following late fee is payable:
	Rs. 1000/- : if application is filed within one year of work order
	Rs. 5000/- : if application is filed between one year to two year From the date of work order
6.	No application can be filed after two year from the date of work order.
7.	Rate of Exemption Fee shall be specified in EC certificate and the rate of EC will be that rate which is prevailing on the date of submission of application.

What will be the Status of Sub-Contractor

As per rule 22(2A) of Rajasthan VAT Rules, 2006, if the main contractor has obtained Exemption Certificate in respect of his work and thereafter if he sub-lets whole or part of the work to a sub-contractor, then the sub-contractor shall not be liable to pay tax on such work or he is not required to opt for this scheme as the turnover of such contract will not be included in the taxable turnover of the contractor.

VAT METHOD-1 (deduction of actual labour and services method)

In VAT method, the taxable turnover of the contractor is calculated by deducting the value of labour and services involved in execution of works contract and on the balance amount i.e. the "Material Value" VAT is levied. From this VAT, the contractor can claim the input tax credit of goods purchased by him and pay the balance liability in cash.

How to calculate the value of Taxable Turnover or Material Value

Rule 22 of RVAT Rule 2006 provides for determination of taxable turnover. Sub-Rule (1) of Rule 22 provides that for determining the taxable turnover for levying tax under section 4(1) of the Act following amount shall be deducted from turnover:

(a) on which no tax is leviable under this Act;
(b) which has been exempted from tax;
(c) & (d) ******* not relevant here.

Sub Rule (2) of Rule 22 provides that apart from deductions provided in sub rule (1), the amount of labour shall also be deducted from the total value of the contract.

The provisions of RVAT Act and Rules does not provide clear cut guidelines to identify the items which are not liable to tax and which are to be deducted from the total value of the contract for arriving at the Material Vale or taxable value. Therefore guidance can be taken from the principles laid down by Supreme Court in Gannon Dunkerley (88 STC 204) and Company Vs State of Rajasthan and Larsen & Turbo Vs Union of India and Others (1993) regarding the items which are to be deducted from the total value of works contract for calculating the taxable turnover or the material value. The principles laid down by these verdicts are thoroughly followed while assessing the VAT on contractor if the contractor has not taken the Exemption Scheme route.

Method specified by by SC in Gannon Dunkerley & Company and L & T's case

In this method, the following deductions are made from the gross value of the works contracts performed by the contractor.

Total Value of Works Contract Less: Prescribed Deductions	xxxxxxxxx
(i) Labour Charges for execution of Works Contract	xxxxxxxxx
(ii) Amount paid to sub- contractor for labour and services.	xxxxxxxxx
(iii) Charges for planning and designing and architect's fees	xxxxxxxxx
(iv) Charges paid for obtaining on hire or otherwise the equipments or machinery used for execution of works contract.	xxxxxxxxx
Cost of consumables used in execution of works contract in which property does not pass to the contractee, such as water, electricity, fuel etc.	xxxxxxxxx
Cost of establishment to the extent it relates to supply of labour and services. overhead expenses of the head office and branch office including rents, salary, electricity, telephone charges, etc. and interest charges to bank and financial institutions;	xxxxxxxxx
Other similar expenses relating to supply of labour and services.	xxxxxxxxx
Profits earned by the contractor to the extent it relates to supply of labour and services.	xxxxxxxxx ----------
Balance = Taxable Turnover/material Vale At What rate the Tax will be levied on the Taxable Turnover	xxxxxxxxx ----------

After arriving at the value of taxable turnover as above, the question which arises is, that, at what rate tax will be charged?. For determining the relevant rate of tax, first we shall have to split the taxable turnover into different groups of tariff category e.g. exempted goods, 5% taxable goods and 14% taxable goods category etc.,. Here the question arises how it will be splitted ? It may be splitted into the same proportion as the purchase value of each tariff group bears to the total purchase value of tariff group. Or it may be splitted into the ratio worked out on the basis of material composition as per G-Schedule. After splitting the taxable turnover or the taxable material value tax shall be charged on the value of each group at the same rate to which it's input category correspond in the vat Schedules. Although the State Government has powers to notify different rate of tax than the tax rate of input category but in the absence of any such notification the tax will be charged at the rate which correspond to the input category.

Now let us take an example to understand the manner in which the taxable turnover is computed and the manner in which the taxable turnover is splitted into different group according to different tariff category and the manner in which the tax liability is computed.

Case Study-1 Draft Works Account of a Contractor

Particulars		Amount	Particulars	Amount
To Opening WIP		125000	By Gross Contract Receipts	2500000
			By Closing WIP	125000
To Purchase of Materials		1380000
Taxable at 5%	725000
Taxable at 14%	575000
Exempted Materials		80000
To Wages & Labour		565000
To Equipment Rent		55000
To Sub Contract Labour		65000
To Designing & Planning Charges		15000
To Consumables		30000
To Gross Profit (15.60%)		390000
		2625000		2625000
Details of Input Tax & TDS
Category of Goods		Purchase Value		Input
Taxable at 5%		725000		36250
Taxable at 14%		575000		80500
		Total Input		116750
TDS deducted @ 3%				75000
Calculation of Taxable Turnover
Particulars				Amount
Gross Turnover of Contractor				2500000
Less: Admissible Deductions
Wages & Labour		565000
Equipment Rent		55000
Sub Contract Labour		65000
Designing & Planning Charges		15000
Consumables		30000		730000
				1770000
Less: Profit on labour and services
(18.50% of 730000/- applying the GP rate converted with respect to cost)				135050
Taxable Turnover				1634950

Now the Taxable Turnover will be bifurcated into turnover of different tariff category in the same ratio in which goods of different category purchased bears to the total purchases. After splitting the taxable turnover into different tariff category, out put tax will be calculated and from output tax the contractor will claim input tax credit and TDS credit and the result will the tax payable or refundable.

Purchase of Materials	Amount	As % of Total Purchase	Taxable Turnover	Amount (Applying the same percentage)	Output tax
Taxable at 5%	725000	52.53%	Taxable at 5%	858840	42942
Taxable at 14%	575000	41.66%	Taxable at 14%	681120	95356
Exempted	80000	5.81%	Exempted	94990	0
Total	1380000	100.00%	Total	1634950	138298
Less: Input Tax Credit & TDS Credit (116750+75000)					191750
Refundable to the contractor					53452

This above example is just for simple understanding of the concept; however the computation of tax liability will vary depending upon the facts and circumstances of each case, and there will be many practical difficulties in this method which may be listed as below:

Practical difficulties in this Method

w In this method the contractor is required to maintain complete books of account, site wise stock register.

w The practical scenario is not so easy. In an unorganized sector it is very difficult to obtain the relevant details.

w Since the vat invoice are raised progressively, vat liability has also to be discharged on progressive basis.

w Identification material transferred in each sale invoice is required. It is a very difficult task if the stock inventory is not maintained in order.

w Bifurcation of material in which property is transferred and in which property is not transferred is very difficult.

w The situation will be more difficult when the contractor has 10-12 work orders for different works.

w The contractor will have to prove all the expenses for which deduction is claimed with proof and evidence. It is not so that whatever has been written in books of account will be accepted by the AO.

w There will be problem in splitting the cost of establishment that how much is attributable to labour or service and how much is attributable to supply of material.

w Again the splitting of the taxable turnover or the Material value into different groups according to different tariff category as per schedule is also a much difficult task.

w If the 100% goods are not purchased on the basis of purchase invoice then the split ratio worked out on the basis of purchase invoice will be wrong and will give wrong results.

w If the contractor claims that whatever purchases recorded in the books of account are 100%, how the AO will rely on this statement to split the Material Value of works contract in different groups according to different tariff category.

w In the above example the taxable turnover or the material value of taxable turnover has been determined on the basis of deduction method or say by deducting the amounts on which tax cannot be imposed. It may also be computed directly taking the basis of purchase value and by adding margin therein. E.g. the purchase cost of material is Rs. 13.80 lakhs, by adding margin at the rate of 18.50% in this, the sale value of material will come Rs. 16.34 lakhs which same with the value worked out on deduction method basis. But the problem will be in proving the purchase cost of the materials, whether it is correct or not.

w In this situation sit with the engineer and list out the material used in the works contract in each work order as per G-Schedule, quantify each item of material in terms of value and put them into different group of tariff category in which they falls such as exempted, 5% taxable, 14% taxable etc.. and the work out the ratio of their composition in total value of material. If there are more than one work order then do this process for all work orders and then work out the average ratio or average proportion in which the exempted goods was used, 5% taxable goods was used and 14% taxable goods was used.

w Sit with the site engineer to bifurcate the purchases of goods into transferable and non transferable. For example- wooden material purchased and used for shuttering activity are not transferred to the client and are booked as 'consumables, store and spares'.

VAT Method- 2 (Standard Deduction Method) Cases Where Proper Books of Accounts are not kept by Contractor

In the above calculation, it is presumed that the contractor performing the works contract is maintaining proper books of accounts and other relevant records and he can prove the genuineness of the deductions claimed from the gross turnover before the assessing authority with the inherent difficulties mentioned above.

But however, to deal with the cases where the contractor does not maintain proper books of accounts or the books of accounts produced by him cannot be said to be reliable, then the legislature can prescribe some arithmetic formula by which a certain percentage is specified, for deduction of labour and service which is to be deducted from the value of gross contracts for determining the taxable turnover of the contractor.

In Rajasthan VAT Rules, Explanation to Rule 22(2) deals with such situation. It reads as under.

"Where the amount of labour is not determinable from the accounts of the contractor, or is considered to be unreasonably high in view of the nature of the contract, the deduction towards labour charges shall be allowed by the assessing authority according to the limits laid down in Column 3 for the type of contract specified in Colomn 2 of the table appended hereto;"

In this Rule the Legislature has prescribed different percentage of labour deduction for different category of works contract which ranges from 15% to 30%. However it has not prescribed any formula for deduction of service charges. However, the deduction of labour provided in sub-rule (2) of Rule 22 is a apart from the deductions provided in sub-rule (1). Clause (a) and (b) of Sub-rule (1) of Rule 22 provides for deduction of amount on (a) which no tax is leviable under the act and (b) which has been exempted from tax. Both the clause very well covers the service charges. Although the State Government has not prescribed any percentage of deduction in this regard but a reasonable amount of deduction should be allowed for eight items as suggested by the Supreme Court in the case of Gannon Dunkerley and Company Vs State of Rajasthan and Larsen( 1993 88 STC 204).

Sum up: To sum up it can be said that the material value involved in the execution of the works contract in the property in goods is transferred is a deemed sale under the VAT Act., and there are three methods in almost all States to determine the value of taxable turnover or material value. One Method is Exemption Fee Method which is very simple method in which a flat rate of exemption fee is paid on the total value of works contract and no input tax credit is allowed and the contractor is dispensed with the requirement of or going through lengthy process of record keeping and quarterly returns. Other two methods are VAT Method where the tax is levied only on the material value of the works contract in which property in goods is transferred and the contractor is allowed to take input tax credit in respect of goods purchased within the state from registered dealers of the state. Now which method is to be choosed will depend on the complexity of the issues involved and facts of the case.