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SC Rules On 'Contract of Sale' vs 'Works Contract'

Published on Sat, May 10,2014 | 15:02, Updated at Sat, May 10 at 15:02Source : 

By: Vivek Mishra, ED & Leader- Indirect Tax Practice, PwC India

In a landmark judgment, the larger bench of the Supreme Court, in Kone Elevator India Pvt Ltd v State of Tamil Nadu and ors (2014-TIOL-57-SC-CT-CB) held that the contract for manufacture, supply and installation of lifts in a building is a ‘works contract’ and not a ‘contract for sale’.

In the case, a writ petition was filed by Kone Elevator against the order of the 3-member bench of the Apex Court itself. (Refer State of AP v Kone Elevator India Pvt Ltd (2005-TIOL-30-SC-CT-LB)). The three member bench had held that since the material to be supplied forms the major component of the contract, the skill and labour employed for converting the material into the end product are only incidentally used. Accordingly, the transaction would qualify as sale and not as works contract.

Let us understand the underlying transaction of manufacture, sale and installation of lifts. The Kone elevator sells lifts of different makes and models. The models vary on multiple features such as shapes, size, speed, material used and other specifications. The customer can choose a suitable model in keeping with the type of building in which it is going to be installed. Given the customers specification, the Kone elevator would manufacture the different components of the lift consisting of lift car, motors, rope, rails, etc having their own identity even prior to installation. Preparatory work has to be done taking into consideration as to how the lift is going to be attached to the building. The components of the lifts are then assembled at the site. The installation process requires proper synchronisation of various components of lift with the structure of the building. It involves technical and procedural customisation of lift with respect to different aspects of the building such as the height of the floors, door openings, speed of the lift, safety measures, amount of weight that the lift can carry and the counter weight required to run the lift smooth and safe.

The VAT authorities were predominantly of the view that it is a case of erecting an article of sale on the basis of special order. The lifts are manufactured in the factory and commissioning and assembly at site only completes the manufacturing activity at site. The skill and labour employed at site of installation is simply a component of manufacturing process. Also, as per the terms of the contract, the ownership in the goods passes to the customer only on completion of installation process.

Even the 3-member bench of Apex court while rendering their decision in favor of sale transaction had relied on the fact that the supplied components of the lift had their individual identity prior to installation and were the predominant component of the end product. It had also observed that the substance and not the form of the contract was material in determining the nature of the transaction.

To overrule the decision of 3-memer bench of the Apex Court, the 5-member bench has observed that post the 46th amendment to the Constitution of India, a single contract for supply and labour though indivisible, was allowed to be split into two, through a deeming fiction under clause 29A(b) of Article 366. The Apex Court has relied upon the legal test enunciated by another larger bench of the Apex Court in Larsen & Toubro Limited and anr v State of Karnataka and anr (2013-TIOL-46-SC-CT-LB) wherein the definition of works contract under clause (29A)(b) of Article 366 was analysed and held that a single and indivisible contract for supply and labour was allowed to be split.

The 5-member bench has reaffirmed the decision in L&T case that the “dominant nature”, “prominent intention” or “overwhelming component” test are not relevant post the 46th amendment. Keeping in with this, the significance or as the case may be insignificance of incidental part as regards labour and service has been rendered irrelevant for the purpose of determining the nature of the contract.

This decision of the Apex court will have significant impact in the way such contracts are classified. It is not only limited to the contract for sale and installation of lifts, but for all similar contracts. One can expect significant actions from both the State VAT and Service tax authorities in terms of reopening of cases where the similar contracts were treated as sales contract because the labour and service elements were considered to be secondary in value compared to the supply of goods.

(Tajinder Singh also contributed to this article)


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