L&T judgment opens a Pandora's box

Early implementation of Goods and Services Tax can help do away with uncertainty of tax costs for the real estate sector

Recently, the larger Bench of the apex court in the case of L&T vs state of Karnataka, held that any agreement to sell immovable property entered into prior to construction would fall within the purview of the term 'works contract', allowing state governments the power to levy value-added tax (VAT) on such contracts.

This issue has been a hot debate since the Raheja Development apex court judgment in 2005, which was with respect to real estate transaction structures in south India, wherein the sale of land was separate from the sale of flats unlike in most other parts of India.

The issue was also hotly contested in recent years by the real estate sector in Maharashtra, and in 2012, the Bombay High Court ruled that such real estate transactions wherein an agreement to sell immovable property was entered into prior to construction is subject to levy of VAT as 'works contract'. In fact, in recent months, states like Haryana have sought to issue trade notices to bring under purview such agreements to sell immovable property, entered into prior to construction within the purview of VAT as 'works contract'.

The L&T judgment has considered both the above judgments in arriving at the conclusion that states have the power to levy VAT on such transactions as 'works contracts'.

In the facts of this case, the main object/substance of the tripartite agreement was to sell and convey fraction of land with a fully constructed apartment. At no point was the construction for and on behalf of the purchaser, the apartment was to be sold as an apartment and not as an aggregate of its component parts. Even in the Bombay High Court case of MCHI, the agreement for sale is an agreement to transfer immovable property with no element of works contract.

Facts and well settled arguments such as even if there is a construction activity undertaken by a developer, he does not construct on behalf of the apartment owner; the owner of the apartment has no say in conceptualising the project or any control; that the ownership of materials used in construction in such cases remain with developer; and, that the accretion to the goods happens in the hand of the developer, allude to the fact that such an activity cannot be treated as a works contract. The fact and settled arguments that in a conventional sale, property of goods gets transferred as intended by the parties while in a works contract property in goods are transferred through accretion, have all been negated in coming to the conclusion by the apex court.

The apex court observes that though the ultimate transaction between parties may be a sale of flat, it cannot be said that characteristics of works contract are not involved in such a transaction. Hence, when a contract comprises both - a works contract and transfer of immovable property - it does not denude it of its character of 'works contract' and that Article 366(29-A)(b)) contemplates situations where goods may not be transferred in the form of goods, but maybe transferred in some other form which can even be in the form of immovable property.

This apex court judgment would be a matter of intense debate for years and will have wide implications on real estate transactions across states. The judgment is a challenge for the real estate industry and would bring about a plethora of complications on the ground for an industry already reeling from a slowdown and high interest rates.

The judgment will result in VAT authorities looking for recoveries from the industry within applicable limitation period. Further, this judgment is likely to trigger new valuation issues as the court has held that only the value addition made post-execution of an 'agreement to sell' an under construction flat would be subject to levy of VAT giving rise to practical difficulties in implementing at the ground level. Like in the case of Maharashtra, a practical solution can be a composition scheme with lower tax incidence of one per cent, though this judgment can embolden states to fix higher composition rates. Further, in situations where possession has been handed over by the developers against full and final settlements, the taxes may have to borne by the developer. This highlights the challenges of a long-drawn process of litigation in the country, which can produce outcomes creating a huge amount of uncertainty of tax costs for the industry, which may not be possible to recover.

Now a sale of an apartment would suffer stamp duty and VAT, both levied by state along with service tax levied by the Centre, making such apartments more expensive. The early implementation of the goods and service tax can be the only solution to such multiplicity of taxes and we hope the polity at large is seized of its importance.
Harishanker Subramaniam is partner and national leader, indirect tax services, EY. Views expressed are personal