Service tax liability on construction and sale of residential units

The recent advance ruling in the case of Harekrishna Developers has revived an issue which was settled by the Department about a year ago, after significant deliberations. The ruling holds that a real estate developer, who charges a booking amount from his customers, constructs on his own and then sells residential units to these customers is liable to service tax under the category of residential complex construction services. Before discussing the ruling, it is relevant to consider the background of the controversy regarding service taxability of builders under residential complex construction services.

These services were first brought in the service tax net with effect from June16, 2005. The issue of charging service tax on builders/developers selling residential units first cropped up when the Director General of Service Tax (DGST) issued a circular in this regard, based on the Supreme Court’s judgment in the K. Raheja Developers case. In this case, the Apex Court had held that where a builder/ developer sells a flat under construction for a consideration to be received in installments, such a transaction is a works contract and hence chargeable to VAT. The notable point is that this case was unrelated to service tax. However, based on the ratio of the above case, the DGST issued a circular stating that as sales of residential units amounted to works contracts and since works contracts also involved services, such contracts were chargeable to service tax under the heading of residential complex construction services.

The above DGST circular was challenged in a writ in the Bombay High Court. While the case was pending with the Court, the CBEC issued a clarification stating that where the builder, promoter or developer builds a residential complex, having more than 12 residential units, by engaging a contractor for construction of such a residential complex, the contractor would be liable to pay service tax on the gross amount charged for the construction services provided to the builder under ‘construction of complex’ service. The circular also stated that if no other person was engaged for the construction work and where the builder undertook construction work on his own, then in the absence of the service provider and service recipient situation, the question service taxation of such contracts did not arise.

Though the above circular was not very clear in its language, it was nevertheless interpreted in a positive sense by trade and industry and also by the Government insofar no demands were thereafter raised on builders of residential complexes and the litigation in the Bombay High Court also did not proceed. To wind up the controversy, the Government last year brought in a new category of taxable service namely ‘works contract services’ under the service tax net. This category included within its purview, works contracts relating to residential complex construction services as well. Further, in order to remove any doubts on the appropriate classification of the service, the Department clarified that if a contract was that of works in nature, it would be covered under the new category. There is thus no longer any doubt on service taxability of works contracts.

The advance ruling has however revived the controversy for the past periods. The ruling holds that since the words ‘in relation to’ are used in the definition of taxable service, construction and other incidental and allied activities are covered therein and hence the sale of a residential unit, for which the purchaser book the unit in advance, would be covered under this category. In this regard the Authority has observed that though in one sense, the developer can be said to be constructing the residential unit on his own account and not on behalf of the customer, yet the developer did everything to honour his commitment to the customer from whom he had received valuable consideration. Thus an agreement to sell a ‘to be built unit’ would attract service tax while an outright sale of an already built unit would not attract the tax.

Another point made by the Authority is that the clarification issued by the CBEC lacks clarity in terms of its intent and cannot be interpreted to mean that developers are not liable to pay service tax. Further, as to the issue of classification of a service with respect to two contending categories of residential complex services and works contract services, the Authority observed that as per Section 65A, the most appropriate category to classify the service in question is ‘residential complex construction service’, irrespective of the fact that the service could also be brought within ambit of ‘works contract services’.

The ruling is thus majorly based on the representations of the Department against its own circulars. This has created confusion and has also given rise to the issue of whether the Department could so represent against its own clarifications. While the ruling has limited force in terms of its applicability, the Department has apparently started issuing show cause notices based thereon. The matter therefore needs to be immediately addressed for the past periods through issuance of appropriate clarifications.

S Madhavan

The author is Leader, Indirect Tax Practices, Pricewater houseCoopers. Views expresses are his own.