Service Tax - Statute Update

Maintenance Contract – Whether Work Contract Or Service

It is a contentious issue today that whether the Comprehensive Annual Maintenance Contracts (popularly known as AMC) are covered under Value Added Tax being of Works Contract or under Service Tax being in the nature of service. The contractors taking Comprehensive AMC for maintenance of computers, air-conditioning plants and other equipments are under dilemma that which tax is applicable on such AMC. To be on the safer side and not to default, they pay VAT and Service Tax both on the AMC amounts. An attempt is made in this article to deal with this issue.

It is of everybody’s knowledge that sale of goods is covered under local Sales Tax Act. Incase of transfer of property in goods (whether as goods or some other form) involved in execution of works contract, is covered as deemed sale of goods by virtue of 46th Constitutional Amendment and consequential amendment in the State laws. On the other hand, Incase of contract for service, service tax is applicable under Chapter V of the Finance Act (No.2), 1994 (Service Tax). In the former case, i.e. sales of goods, the State Legislature is empowered to levy tax and accordingly Maharashtra Value Added Tax (MVAT) levy tax on sales of goods including deemed sales as defined under the Act. Incase of service, the Parliament is empowered to levy tax under Entry 92 C of List I of the Seventh Schedule of the Constitution.

To determine that whether the State’s law on sales tax is applicable or the Central law on service tax is applicable on a comprehensive Annual Maintenance Contract, one has to understand the intention of the parties as reflected in the terms of the contract. Such contracts are often known as composite contracts under tax statutes. The Hon’ble Supreme Court in the recent landmark decision of Bharat Sanchar Nigam’s case has termed this as the dominant nature test, or as “the substance of the contract’ to decide whether a contract falls into one category or the other. We shall come back to this beautiful averment of the apex court in the later part of this article.

Terms of Contract and intention of parties

It is therefore necessary to refer to the terms of such comprehensive contracts. As per the normal terms, the contractor is expected to service and overhaul the equipment at site on periodical basis or as and when required to ensure that normal wear and tear does not affect functionality of the equipment. Such contract include free replacement of spare parts for any damage on account of wear and tear. Here it is important to note that normally the contract amount is received in advance at the time of signing such contract.

Under a normal comprehensive AMC, it can be made out from the terms of contract that the intention of the party is to maintain the equipment in a proper working condition. For this purpose, the purchaser or user of an equipment engage the service of the Maintenance Contractor to service the equipment periodically and to reasonably ensure that the equipment perform its functions without any fault. Such preventive maintenance is the core intention of the parties. During such preventive maintenance, some spare parts may be required to be repaired or replaced. Replacement of spare parts, if required, is provided by the contractor free of cost which is regarded as provision of spare parts during the course of rendering service. It is a contingency for the contractor and a sort of insurance for the client. It is also possible that during the course of contract period, no replacement is done at all. The customer or contractee is not interested in purchasing any spare part from the contractor. Hence, the pre-dominant intention of the parties is of provision of service and not sale or purchase of parts. Even at the time when the contract is entered and contract amount is paid in advance for a period of contract of service, it is not known that whether or not any spare part would be required to be provided by the contractor. Such spare parts are not identified and earmarked for sale at the time of entering into contract. Even there is no payment for any sale at the time of replacement of such spare parts as there is no sale price contemplated for such spare parts. In the contingent event of provision of such part, the price is regarded as embodied in the contract value, which however remain same with or without provision of such part. The contractor may also undertake repairs of the equipments which is not due to normal ware and tare. However, such repairs are outside the scope of comprehensive AMC and are not dealt with here.

Legal provisions – relevant definition

Having understood the principle terms of the comprehensive maintenance contract, It is necessary to look into the definition of sale and sale price. For this purpose, we look to the Maharashtra Value Added Tax, 2002 to which we are more familiar with and also meaning of service under the provisions of Chapter V of the Finance Act (No2), 1994, popularly known as Service Tax Act.

“sale” means a sale of goods made within the State for cash or deferred payment or other valuable consideration but does not include a mortgage,  hypothecation, charge or pledge; and the words “sell”, “buy” and “purchase”, with all their grammatical variations and cognate expressions, shall be construed accordingly;

Explanation.— For the purposes of this clause,-

1. a sale within the State includes a sale determined to be inside the State in accordance with the principles formulated in section 4 of the Central Sales Tax Act, 1956 (74 of 1956);
    

2. (i) the transfer of property in any goods, otherwise than in pursuance of a contract, for cash, deferred payment or other valuable consideration;

(ii) the transfer of property in goods (whether as goods or in some other form) involved in the execution of a [works contract namely, an agreement for carrying out for cash, deferred payment or other valuable consideration, the building, construction, manufacture, processing, fabrication, erection, installation, fitting out, improvement, modification, repair or commissioning of any movable or immovable property];

(iii) a delivery of goods on hire-purchase or any system of payment by instalments;

(iv) the transfer of the right to use any goods for any purpose (whether or not for a specified period) for cash, deferred payment or other valuable consideration;

 (v) the supply of goods by any association or body of persons incorporated or not, to a member thereof for cash, deferred payment or other valuable consideration;

 (vi) the supply, by way of or as part of any service or in any other manner whatsoever, of goods, being food or any other article for human consumption or any drink (whether or not intoxicating), where such supply or service is made or given for cash, deferred payment or other valuable consideration;

(vii) [* * *]

shall be deemed to be sale

(It is important to note that maintenance is not covered in Explanation (b) ii above)

“sale price” means the amount of valuable consideration paid or payable to a dealer for any sale made including any sum charged for anything done by the seller in respect of the goods at the time of or before delivery thereof, other than the cost of insurance for transit or of installation, when such cost is separately charged.

Explanation I.— The amount of duties levied or leviable on goods under the Central Excise Act, 1944 (1 of 1944) or the Customs Act, 1962 (52 of 1962) or the Bombay Prohibition Act, 1949, (Bom. XXV of 1949) shall be deemed to be part of the sale price of such goods, whether such duties are  paid or payable  by or on behalf of, the seller or the purchaser or any other person.

Explanation II.— Sale price shall not include tax paid or payable to a [seller] in respect of such sale.

Explanation III.—Sale price shall include the amount received by the seller by way of deposit, whether refundable or not, which has been received whether by way of a separate agreement or not, in connection with or incidental or ancillary to, the said sale of goods;

Explanation IV.—The amount of valuable consideration paid or payable to a dealer for the sale of Drugs specified in entry 29 in Schedule C shall be the  maximum retail price printed on the package containing the Drugs.]
Definition of “Service”

The term service is not defined under Service Tax which is why difficulty arises in most of the situations today. However, different taxable services are defined under S.65 of the Act, which means any service which is not defined under S.65 is not taxable under the Act. It is necessary that there should be recipient of service and a provider of service and the service should be defined as taxable service in the Act, for the purpose of taxability under the Act.

Juridical Pronouncements

We shall now look upon certain decisions of the Apex Court and some other High Courts and Tribunals and try to ascertain the applicability tax statute to the comprehensive maintenance contracts. It is heartening to note that the judiciary has attempted to fill the vacuum by giving meaning to the expression of intention in the contract and to distinguish, ascertain and interpret the provisions of different tax laws causing ambiguity on account of plurality of the laws and their overlapping nature.

The recent decision of Hon’ble Supreme Court in case of Bharat Sanchar Nigam Ltd reported in JT 2006 (6) SC 114, discuss and appear to bring finality to the subject by referring and reviewing host of earlier decisions, may be considered as torch bearer in this regards and relied upon in every such situations of ambiguity of applicability of tax statutes in like circumstance.

Bharat Sanchar Nigam Ltd. (JT 2006 (6) SC 114 )

In this case, the Hon’ble Supreme Court has held that the State can levy tax on sale only if necessary elements of the sale are present in the transaction and the sale is distinctly discernible, even in those composite contracts which are by legal faction deemed to be divisible under Article 366(29-A). In the words of Hon’ble SC :

“The reason why these services do not involve a sale for the purposes of Entry 54 of List II is, as we see it, for reasons ultimately attributable to the principles enunciated in Gannon Dunkerley’s case, namely, if there is an instrument of contract which may be composite in form in any case other than the exceptions in Article 366(29-A), unless the transaction in truth represents two distinct and separate contracts and is discernible as such, then the State would not have the power to separate the agreement to sell from the agreement to render service, and impose tax on the sale. The test therefore for composite contracts other than those mentioned in Article 366 (29A) continues to be - did the parties have in mind or intend separate rights arising out of the sale of goods. If there was no such intention there is no sale even if the contract could be disintegrated. The test for deciding whether a contract falls into one category or the other is to as what is ‘the substance of the contract. We will, for the want of a better phrase, call this the dominant nature test.”(emphasis supplied)

“What are the “goods” in a sales transaction, therefore, remains primarily a matter of contract and intention. The seller and such purchaser would have to be ad idem as to the subject matter of sale or purchase. The Court would have to arrive at the conclusion as to what the parties had intended when they entered into a particular transaction of sale, as being the subject matter of sale or purchase. In arriving at a conclusion the Court would have to approach the matter from the point of view of a reasonable person of average intelligence.”

“The same transaction may involve two or more taxable events in its different aspects. But the fact that there is overlapping does not detract from the distinctiveness of the aspects”. No one denies the legislative competence of States to levy sales tax on sales provided that the necessary concomitants of a sale are present in the transaction and the sale is distinctly discernible in the transaction. This does not however allow State to entrench upon the Union list and tax services by including the cost of such service in the value of the goods. Even in those composite contracts which are by legal fiction deemed to be divisible under Art. 366(29A), the value of the goods involved in the execution of the whole transaction cannot be assessed to Sales Tax. As was said in Larsen & Toubro Vs. Union of India (supra):- “The cost of establishment of the contractor which is relatable to supply of labour and services cannot be included in the value of the goods involved in the execution of a contract and the cost of establishment which is relatable to supply of materials involved in the execution of the works contract only can be included in the value of the goods”.

Gujrat Ambuja Cements Ltd vs. UOI (2005) (4) SCC (214)

The Apex court with regard to mutual exclusivity of taxing entries observed that “This mutual exclusivity which has been reflected in Article 246(1) means that taxing entries must be construed so as to maintain exclusivity. Although generally speaking, a liberal interpretation must be given to taxing entries. This would not bring within its purview a tax on subject-matter which a fair reading of the entry does not cover. If in substance the statute is not referable to a field given to the State, by any principle of interpretation allow a statute not covered by it to intrude upon this field.”

Kerala Colour Lab Association ( 2003-TIOL-19-HC-KERALA-ST)

This case is approved by the Hon’ble Supreme Court. In this case, it is held that incase of photography contract, the contract is of service and not of sale of photography material like colour photographic paper or the films. Such contracts are subjected to service tax and are not liable for sale tax or work contract tax. In the words of Hon’ble Kerala High Court :

“once it is determined that the taxable event is the service rendered, and not the sale of goods, irrespective of whether it was a works contract or a contract for sale of goods, the taxable event would occur. The taxable event occurs because of the service rendered. It was correctly held that once the taxing event is of rendering service and entire activity of the assessee answers the description of taxable photography service, it is the service which will be liable to service tax and the agreement can not be considered as that of sale of photographic material”

Kone Elevators reported in 2005 (140) STC 022

In this case, the Hon’ble SC has explained the distinction between contract of sale and contract for work. In the words of Hon’ble SC :

“It can be treated as well settled that there is no standard formula by which one can distinguish a “contract for sale” from a “works-contract”. The question is largely one of fact depending upon the terms of the contract including the nature of the obligations to be discharged thereunder and the surrounding circumstances. If the intention is to transfer for a price a chattel in which the transferee had no previous property, then the contract is a contract for sale. Ultimately, the true effect of an accretion made pursuant to a contract has to be judged not by artificial rules but from the intention of the parties to the contract. In a “contract of sale”, the main object is the transfer of property and delivery of possession of the property, whereas the main object in a “contract for work” is not the transfer of the property but it is one for work and labour. Another test often to be applied to is : when and how the property of the dealer in such a transaction passes to the customer : Is it by transfer at the time of delivery of the finished article as a chattel or by accession during the procession of work on fusion to the movable property of the customer ? If it is the former, it is a “sale”; if it is the latter, it is a “works-contract”. Therefore, in judging whether the contract is for a “sale” or for “work and labour”, the essence of the contract or the reality of the transaction as a whole has to be taken into consideration. The pre-dominant object of the contract, the circumstances of the case and the custom of the trade provides a guide in deciding whether transaction is a “sale” or a “works-contract”. Essentially, the question is of interpretation of the “contract”. It is settled law that the substance and not the form of the contract is material in determining the nature of transaction. No definite rule can be formulated to determine the question as to whether a particular given contract is a contract for sale of goods or is a works-contract. Ultimately, the terms of a given contract would be determinative of the nature of the transaction, whether it is a “sale” or a works-contract. Therefore, this question has to be ascertained on facts of each case, on proper construction of terms and conditions of the contract between the parties”

Hindustan Shipyard Ltd. 2001 (119) STC 533

This judgment is an authority on how to distinguish a ‘contract of sale’ from a ‘works contract’. It says that there cannot be a straightjacket formula for deciding whether a contract is for sale of goods or a works contract as the intention of the parties is to be ascertained by an overall reading of the several terms and conditions of the contract, and no one of them is decisive. In the words of Hon’ble SC :

“if the thing to be delivered has any individual existence before the delivery as the sole property of the party who is to deliver it, then it is a sale. If the bulk of material used in construction belongs to the manufacturer who sells the end-product for a price, then it is a strong pointer to the conclusion that the contract is in substance one for the sale of goods and not one for labour. However, the test is not decisive. It is not the bulk of the material alone but the relative importance of the material qua the work, skill and labour of the payee which also has to be seen. If the major component of the end-product is the material consumed in producing the chattel to be delivered and skill and labour are employed for converting the main components into the end-products, the skill and labour are only incidentally used, the delivery of the end-product by the seller to the buyer would constitute a sale. On the other hand, if the main object of the contract is to avail the skill and labour of the seller though some material or components may be incidentally used during the process of the end-product being brought into existence by the investment of skill and labour of the supplier, the transaction would be a contract for work and labour.”

Daelim Industry Co. Ltd 2003(155) ELT 457

In this case, the Hon’ble Supreme Court has dismissed the petition filed by the Department against the decision of Delhi Tribunal holding that the work contract can not be vivisected and part of it can not be subjected to service tax.

Idea Mobile Communication Ltd (2006 TIOL 857 CESTAT –B’lore)

As a sequel to the Hon’ble SC decision in BSNL’s case the Tribunal has held that service tax is not leviable on the item (sim card) on which sales tax has been collected and paid to the treasury and the same has not been contested by the party.

M/s. Tata Infotech Ltd. – DDQ No. WC-2000/DDQ-5/Adm-12/B-740 dated 3-10-2000

In this case the question posed was “whether any sale as contemplated under the Works Contract in respect of free replacement of parts under the Annual Maintenance Contract undertaken by the applicant for M/s. Citibank NA?

The Commissioner observed that the applicant had undertaken to maintain the equipment supplied to Citibank in working condition and for that purpose agreed to repair and service the machine without charging for the replacement of parts is required and therefore had not recovered per se any price for replacement of the parts. The use of the parts was incidental to the main obligation of the applicant for maintenance of the equipment for which applicant received an agreed fixed charge for each equipment.

It was finally held that the said Annual Maintenance Contract is a service contract and not a work contract where dominant object was to repair and service the equipment so as to keep it in uninterrupted working condition.

Conclusion

In view of the judicial pronouncements on the subject, it appears that one can not but opine that the tax treatment of comprehensive maintenance contract has achieved reasonable finality that such contracts should be termed as pure service contract and not of the nature of work contract.