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.
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