The VAT bulldozer on builders

The recent Supreme Court (SC) judgment in the case of Larsen & Toubro & Anr. V.State of Karnataka & Anr (L&T judgment) has shattered the hopes of various developers across the country. As per the recent ruling, the much wanted VAT relief for developers on under-construction flats has come crashing down. 

In 2008, pursuant to multiple appeals filed by various developers from Maharashtra and Karnataka, the division bench of Supreme Court had casted doubts on the legality of judgment delivered in K Raheja Development Corporation v. State of Karnataka case (Raheja case). As per the Raheja case, the court held that VAT is applicable on the sale of under-construction flats by developers. Consequently, the issue was referred to a three-judge SC bench. 

However, much to the developers’ anguish and disappointment, the higher bench of the Supreme Court has now emphatically affirmed the legal position taken in Raheja case, thereby settling the controversy. This landmark L&T judgment is likely to affect developers and buyers. This note tries to analyse the impact of this ruling. 

Real estate deals usually involve joint development agreements, which are essentially tripartite arrangements between the landowner, developer and purchaser. Accordingly, the landowner chips in land; the developer constructs the complex and sells it to the intended purchasers. Usually, these development agreements provide for the handing over the apartments to the prospective purchasers on completion of the construction, with an undivided interest in the land. However, this battle of tax was fought in the court, mainly on two grounds. Firstly, whether state governments have the jurisdiction to levy VAT on such joint development agreements? And if they do so, do these form of joint development agreements actually qualify as ‘works contracts’, to fall within the ambit of Article 366 (29A)(b) of Constitution of India? 

Addressing the first question in affirmative, the court held that the states have every right to impose VAT on such contracts. Article 366 of the Constitution, inserted by 46th Constitutional Amendment, bestows the power on the state government to impose tax on sale or purchase of the goods. Clause 29-A was added to the said constitutional provision, so that the state legislatures may levy sales tax on certain specific transactions. By virtue of sub section (b) of Article 366 (29A), transfer of property (as in a joint development contract) would be deemed as sale of goods in the execution of a works contract. The term ‘or in some other form’ in Article 366 (29A)(b) has certainly proved to be a game changer, expanding its applicability. Accordingly, states can levy such taxes not only on transfer of just conventional goods (movables), but also on those goods that have become part of an immovable property. In other words, transfer of immovable property in a works contract is termed as a ‘sale’ for levying sales tax, even if the said ‘sale’ does not come within the purview of definition provided under Sale of Goods Act, 1930. 

Further, the L&T judgment has explicated in no unclear terms, that development agreements qualify as ‘works contracts’. It may be noteworthy to mention here that state governments can impose sales tax/VAT, only in the instances where transactions are considered as ‘works contracts’. Simply put, works contract is an agreement where one of the parties is required to effectuate work in lieu of consideration provided by another party. The agreements executed to sell flats inevitably involve construction of these units by developers. In other words, it is obvious that these flats cannot be sold until they are constructed. This execution of work, that is, construction activity before selling apartments constitutes ‘works contract’. Consequently, the court upheld the constitutionality of VAT on properties sold prior to completion. 

Pursuant to L&T judgment, it is reasonably expected that the state governments would actively formulate policies to collect VAT from the developers, especially those who have avoided paying the tax in the course of construction. Interestingly, the court in L&T judgment has held that VAT would be imposed on value of goods transferred pursuant to the agreement between developers and purchaser. But developers in some states, regardless of stage of construction, had forced buyers to pay VAT calculated on total value of the apartments. What remains to be seen is whether such buyers can demand refund from the developers in these cases, where they were forced to pay a relatively greater VAT. 

Nonetheless, it is almost certain that the prices of under construction apartments would increase proportionally to the quantum of VAT in a particular State. But the question remains: who should bear this liability? VAT, being an indirect tax, can be passed to the buyers. However, should they do so, since the liability has been fixed directly onto the builders? Maybe, another round of litigation is in the waiting. 

(Sidharrth Shankar is a partner at law firm J Sagar Associates. The views of the author are personal.)

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