Andhra Pradesh High Court recently ruled that turnkey EPC contracts for the purpose of taxation are to be treated as indivisible contracts. This ruling will have far reaching ramifications.
One of the major costs in an infrastructure project is the tax cost that a project has to bear on account of various indirect taxes, viz., the value added tax, works contract tax, service tax and many other similar taxes. Typically, in most of the infrastructure projects, the owner awards a turnkey contract to one party known as the engineering, procurement and construction (EPC) contractor. The EPC contractor is responsible for the all material procurements, engineering, drawing and construction of the project and is required to deliver the project, ready for use, to the owner, i.e., the owner is only required to turn on the key to run the project.
The EPC contractor further enters into various subcontracts for supply of material or equipment (onshore and offshore) and for engineering and technical services (onshore and offshore), with various suppliers of material or equipment and provider of engineering and technical services. Accordingly, there are two legs of supplies taking in the above transaction:
A)Supply of goods and services from the sub-contractor to the EPC contractor; and
B)Supply of goods and services (in the form of completed project) from the EPC contractor to the owner.
In the first leg, i.e., leg A, supplies of individual goods or equipment, when purchased domestically would attract VAT, if purchased within the state, which is typically at the rate of 12.5 per cent. Alternately, it would attract central sales tax (CST), which is typically 2 per cent, subject to submission of prescribed statutory form. Further, the services would also attract service tax at the rate of 14 per cent.
In the second leg, i.e., leg B, since it´s a composite supply of both goods and services, the entire value of the project is subject to works contract tax, both under the VAT laws as well as the service tax laws. Further, since it is difficult to bifurcate the value of goods and services in a composite contract, the EPC contract becomes liable to pay VAT and service on the composite value of the contract at the prescribed rates.
Additionally, since the tax paid on leg B is on composition basis, the tax paid by the subcontractors in leg A and borne by the EPC contractor is not available as a credit or set off to the EPC contractor. This results in huge cascading tax impact on the entire contract cost. Also, most of the infrastructure projects are granted through an elaborate bidding process, wherein both the technical and financial bids are evaluated before awarding a contract. Tax, being one of the major costs, the EPC contractors undertake tax planning methods to mitigate this cost and factor the tax saved while bidding for the project.
Typically in any infrastructure project, the cost of supplies (material and equipment) is as high as 70 per cent as compared to the cost of services like installation. In order to avoid the cascading tax cost, the EPC contractors split the composite contract awarded by the owner into supplies contract and services contract. Typically both the supplies and services contract have a ´cross fall breach´ clause, i.e., breach committed in the supplies contract would enable the owner to rescind the services contract and vice versa.
Another method of securing performance of both the contracts is to enter into a ´wrap around agreement´ requiring the EPC contractor to fulfill both the supply as well as services contract and further make a provision that breach of any one of the contracts would result in breach of the other contract. In case of the split method, the goods are sold by the EPC contractor to the owner by transfer of documents, also known as in-transit sales.
Under this, while the goods are in motion from the supplier, the EPC contractor sells the goods to the owner by transferring the documents pertaining to title of goods in favour of the owner. Accordingly, these goods are directly supplied to the project site, which are issued by the owner to the EPC contractor on a ´free of cost basis´ for incorporation into the project.
By undertaking the split method, the EPC contractors achieve the following tax mitigations:
a)with respect to supplies (raw material and equipment) from outside the state, the second sale between the EPC contractors and the owner is claimed as exempted sale under Section 6 of the CST Act; the above exemption is subject to issuance of prescribed statutory documents between the owner, the EPC contractor and the supplier;
b)pay only service tax for the service portion of contract with the owner, without considering the same as works contract;
c)since the second sale, i.e., between the EPC contractor and the owner is an inter-state sale, the EPC contractor claims that the tax authority in the state of the project has no jurisdiction to charge VAT on the transaction and that it is the state tax authority, wherefrom the movement of goods commences, that has the jurisdiction to levy and collect CST.
High Court Ruling
In a recent case before the Andhra Pradesh High Court (HC), the petitioner, being an EPC contractor, entered into such separate contracts for supply of goods and provision of services with the owners. The EPC contractor purchased the goods required for the project from third party supplier situated outside the State of Andhra Pradesh (AP).
Further, when the goods commenced movement, the EPC contractor transferred the documents pertaining to the title of the goods in favour of the owner. Accordingly, the EPC contractor made the following claims before the tax authorities:
a)The first sale of goods from the supplier to the EPC contractor was an inter-state sale since the sale occasioned movement of goods from one state to another. This supply would be subject to CST at 2 per cent subject to the EPC contractor issuing the supplier prescribed form;
b)The second sale, i.e., from the EPC contractor to the project owner by transfer of documents, was also an inter-state sale and took place while the goods were in movement from one state to the other. Accordingly, the EPC contractor claimed exemption on this leg of the supply to the owner under Section 6(1) of the CST Act, 1956 (typically known as the E-1 sales);
c)No works contract between the EPC contractor and the owner since the contract has been split into supplies and services rendering it a divisible contract.
However, the AP Tax department did not agree with such an arrangement and alleged that the EPC contractor had intentionally styled the contract as two separate divisible contracts- one for supply and other for services- even though it should have qualified as a single indivisible contract eligible for VAT as works contract.
Further, the tax department also contended that an EPC contract cannot be an inter-state sale since the goods have been incorporated in the project in AP and it is, thus, an intra-state sale liable for payment of VAT in the State of AP. The AP High Court, after going through the supply contracts and service contracts between the EPC contractor and the owner, held that the contract between them is a single indivisible contract.
The HC reasoned that the existence of the cross fall breach clause in both supply and service contract would show that these were not independent contracts but were interdependent, i.e., the intention of the parties is to undertake the entire project and not execute individual contract. Another reason stated by the Hon´ble Court was that the payment terms of the contract were such that balance payment in both supply contract and services contract was payable by the owner to the EPC contractor only upon the successful commissioning of the entire project. Accordingly, the HC held that the contract between the owner and the EPC contractor is a works contract and is accordingly liable to VAT.
On the second issue regarding the in-transit sale, the HC held that the exemption under Section 6 of the CST Act would not be available on the second sale between the EPC contractor and the owner, since the supply contract between the owner and EPC contractor was already in place. Thus, no contract came into existence while the goods were moving from the supplier´s end. Further, as per the supplies contract, the transfer of title in goods from the contractor to the owner took place only upon incorporation of the goods in the project.
The HC, however, did not agree with the argument of the state that in case of works contract there can be no inter-state sale. The state had argued that since the goods are incorporated within the state where the project is taking place, the entire contract is liable to VAT under the Andhra Pradesh VAT laws. The HC held that as long as the contract between the owner and the contractor results in movement of goods from one state to the other, the sale should be treated as inter-state sale, and an inter-state sale is possible even in a works contract. Accordingly, in the present case, the sale under works contract was held to be an inter-state sale and therefore the state, wherefrom the goods originated, alone could impose CST.
This verdict of the HC is likely to have a huge service tax exposure on infra projects since works contract service tax would become payable on composite basis, i.e., including value of supplies. Also, the second sale between the EPC contractor and the owner would be subject to levy of CST, which till now was being claimed as an exemption by the EPC contractor.
On the upside, this decision clarifies that inter-state sale is possible even in case of a works contract arrangement and that in such cases, the state of goods or supplies´ origin alone would have the jurisdiction to levy and collect CST. In other words, the state where the project is being executed or erected would have no jurisdiction to levy or collect CST. This has been a constant dispute between the EPC contractor and the VAT department of the state wherein the project is being executed, which has been put to rest by the HC.
It is expected that both the EPC contractor and the State of AP are likely to challenge the above decision before the Hon´ble Supreme Court, whose verdict would alone settle this dispute between the industry and the tax department.
Author: Nand Kishore, Partner at HSA Advocates. Ramanath Prabhu has also contributed to this article.