Taxation of works contract services under Service Tax

Definition of works contract service: Service tax under works contract services has been imposed on the service element involved in the works contracts. It should be noted that unlike VAT laws in various States service tax is applicable only on a fewer kinds of works contract as defined in section 65(105)(zzzza). Works contracts relating to Roads, Airports, railways, transport terminals, bridges, tunnels and dams are outside the purview of service tax.

Definition of Works Contract under section 65(105)(zzzza) runs as under:

Any service provided or to be provided to any person, by any other person in relation to the execution of a works contract, excluding works contract in respect of roads, airports, railways, transport terminals, bridges, tunnels and dams.

Explanation- For the purposes of this sub-clause, "works contract" means a contract wherein, 

(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 prefabricated 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 pipeline 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) turn key projects including engineering, procurement and construction or commissioning (EPC) projects It appears from the definition above that if a contract is treated as works contract for the purpose of levy of VAT/Sales tax, such contract shall also be treated as works contract for the purpose of levy of service tax.

However only fewer kinds of works contracts are livable to service tax like works contract for carrying out erection, commissioning or installations; works contract for commercial or industrial constructions; works contract for the construction of residential complex, works contract for turnkey projects including EPC contracts i.e Engineering Procurement and Construction contracts etc.

Value of Taxable services: Since service tax is applicable only on the service element involved in works contract. Now the question is how service element is to be calculated in a works contract. Section 67 of the Finance Act, 1994 provides that value of taxable services involved in the execution of works contract provided or to be provided by any person shall be the gross amount charged for providing such services. Thus it means that works contract will be vivisected into material part and service part and the service tax will be payable on such service element vivisected. The procedure of determining such service element in a works contract has been provided in Rule 2A of Service Tax (Determination of Value) Rules, 2006.

Schemes available: It should be noted hereby that there are two schemes for payment of service tax in a works contract service, one is paying service tax on actual value of services after determining the same as per section 67 read with Rule 2A of Service Tax (determination of values) Rules, 2006 and second is paying under Composite scheme under Works contract (Composition scheme for payment of Service Tax) Rules, 2007. Payment of service Tax on actual value: Rule 2A of Service Tax (Determination of Value) Rules, 2006.provides that Value of works contract service determined shall be equivalent to the gross amount charged for the works contract less the value of transfer of property in goods involved in the execution of the said works contract.

Rule 2A(1)(ii) provides that Where Value Added Tax or sales tax, as the case may be, has been paid on the actual value of transfer of property in goods involved in the execution of the works contract, then such value adopted for the purposes of payment of Value Added Tax or sales tax, as the case may be, shall be taken as the value of transfer of property in goods involved in the execution of the said works contract for determining the value of works contract service under clause (i). Thus where the service provider is paying VAT/sales tax under the respective State VAT/sales tax law on the actual value of goods in such works contract then such actual value of goods shall be deducted from the gross amount charged for such works contract to arrive at the service element on which service tax is payable.

However there may be a case that the service provider is paying VAT/Sales tax not on the actual value of goods involved in the execution of works contract but under a composite scheme then service element will consist of following(as per explanation (b) of the Rule 2A of said Rules):

(i) labour charges for execution of the works;

(ii) amount paid to a sub-contractor for labour and services;

(iii) charges for planning, designing and architect's fees;

(iv) charges for obtaining on hire or otherwise, machinery and tools used for the execution of the works contract;

(v) cost of consumables such as water, electricity, fuel, used in the execution of the works contract;

(vi) cost of establishment of the contractor relatable to supply of labour and services;

(vii) other similar expenses relatable to supply of labour and services; and

(viii) profit earned by the service provider relatable to supply of labour and services;

Comments: In State VAT laws usually a lump scheme for payment of VAT on works contract is also provided wherein a fixed percentage for deduction of labour charges from the gross value of works contract is provided, for those assesses who do not maintain proper books of account so as to determine the correct value of goods incorporated in such works contract. It is to be noted that no such scheme is being made available under service tax. If a person has not maintained proper books of accounts he has only option to go for composition scheme. If the service provider wants to pay service tax on the actual value of service element involved in a works contract then he will have to maintain books of accounts so as to arrive at the service element liable for service tax as enumerated in explanation (b) above.

VAT/sales tax to be excluded from gross value: Explanation (a) to Rule 2A of the Service Tax (Determination of Value) Rules, 2006 specifically provides that VAT/sales tax paid on the transfer of property in goods involved in the execution of the said contract shall not be included in the gross amount so charged. It means that if gross value of a works contract is Rs. 1000 and the material value involved in it is Rs. 600 and the VAT paid is Rs. 100 then service tax will be payable on Rs. 300 only. It should also be noted hereby that the word used is "paid" thus no deduction will be allowed for VAT/sales tax payable and only the deduction for actual tax paid will be allowed.

Composition scheme: Calculating service element by vivisecting the works contract may not be an easy task especially in cases where proper books of accounts are not maintained and it may give rise to litigation. To avoid such litigation and be on a safer side a composition scheme for works contract services is also available. Works Contract (Composition Scheme for Payment of Service Tax) Rules, 2007 have been legislated to introduce such scheme. The said Rules contain only 3 rules and Rule 3 of the said Rules primarily deal with such composition scheme. Rule 3 of the said rules starts with non-abstained clause i.e.:

“Not withstanding anything contained in section 67 of the Act and rule 2A of the Service (Determination of Value) Rules, 2006, the person liable to pay service tax in relation to works contract service shall have the option to discharge his service tax liability on the works contract service provided or to be provided, instead of paying service tax at the rate specified in section 66 of the Act, by paying an amount equivalent to 1 [four per cent]. of the gross amount charged for the works contract.”

Thus Rule 3 of the said Rules overrides the provisions of section 67 and rule 2A of Service Tax (Determination of Value) Rules, 2006. Under the composition scheme the service provider in a works contract services has the option to pay service tax on the gross amount charged for the works contract @ 4% instead of paying at the normal rate on the actual service element.

In composition scheme the gross amount charged for works contract includes:

(i) the value of all goods used in or in relation to the execution of the works contract, whether supplied under any other contract for a consideration or otherwise; and (ii) the value of all the services that are required to be provided for the execution of the works contract;

But excluding-

(i) the value added tax or sales tax as the case may be paid on transfer of property in goods involved; and

(ii) the cost of machinery and tools used in the execution of the said works contract except for the charges for obtaining them on hire:

No CENVAT credit of Inputs in composition scheme: Rule 3(2) provides that the assessee who opts for composition scheme shall not be eligible to take the CENVAT credit of excise duties and cess paid on “inputs” used in or in relation to the execution of such works contract under the CENVAT Credit Rules, 2004.

The Government in its Master Circular 96/7/2007-ST, dated 23-08-2007 in para 097.01 has clarified that” there is no restriction under notification No. 32/2007, Service Tax, dated 22-05-2007 to take CENVAT credit of duty paid on capital goods and service tax paid on input services”.

Thus CENVAT credit of inputs used in the execution of works contract is being debarred but credit of service tax paid on input services and that of excise duty and cess paid on capital goods will be available. Sub-rule 2A of rule 3 of the said Composition scheme rules further limits the CENVAT credit of service tax paid on three taxable services namely Erection, commissioning, or installation service, Commercial or Industrial construction services and Construction of Residential Complex Services to the extent of 40% of the service tax paid on such services when service tax has been paid on the full value of the services after availing Cenvat credit on inputs.

Option once exercised cannot be changed/withdrawn afterwards: Rule 3(3) of the said Composition scheme rules further provides that the person who opts to pay service tax under these rules shall exercise such option in respect of a works contract prior to payment of service tax in respect of the said works contract and the option so exercised shall be applicable for the entire works contract and shall not be withdrawn until the completion of the said works contract.

It means that option to pay under Composition scheme in respect of a works contract once exercised cannot be changed/withdrawn afterwards. The word used in rule 3(3) is “a works contract” which implies that one person may choose composition scheme for one works contract and may not choose for the other works contract.

To opt composition scheme declared value of contract should not be less than gross amount charged:

Rule 3(4) of said rules provides that the option to pay composition scheme shall be permissible only where the declared value of the works contract is not less than the gross amount charged for such works contract. The said rule has been inserted to plug-in the loophole wherein a contractor may bifurcate a single contract into contract for supply of material and contract for supply of material and labour and thereby reducing the gross amount of works contract for paying service tax under composition scheme.

For example: if a works contract of total value of Rs. 100 is bifurcated in such way that supply of value of goods in execution of such contract worth Rs. 30 is treated as separate contract and remaining part of contract of value of Rs. 70 (including labour and some material also) is treated as works contract. In such case Rule 3(4) will come in picture and the service provider will have to pay service tax @ 4% on Rs. 100 and such bifurcation will not be allowed so as to pay service tax on Rs. 70/-.

Note at the end: The taxation of works contract in service tax involves a lot of issues which might not have been touched hereinabove. In this article an attempt has been made only to make understand the provisions relating to taxation of works contract services.