Recent Development in Service Tax and

VAT in Real Estate

By Kantilal Jain, FCA

In the budget for 2010 both Central and State Governments have made certain amendments to
levy tax on sale of immovable property under construction to enhance their revenue and to
overcome certain judicial pronouncements. An attempt is made to discuss the implications of
the above amendments on the real estate transactions as to how the general public will be
affected by way of additional cost on account of the above mentioned amendments.

SERVICE TAX

By the Finance Act, 2010 the Government has amended the definition of Commercial or
Industrial Construction Service [Section 65 (25b) read with Section 65 (105) (zzq)] and
construction of Residential Complex [Section 65 (30a) read with Section 65 (zzzh)].

The scope of these categories is expanded to cover sale of flats/units under construction.
Builders/developers are now liable to service tax if any payment towards sale
consideration is received before the grant of completion certificate by the competent
authorities for such flats/units. This amendment overrides the Gauhati High Court’s
decision in the case of Magus Construction Private Limited v/s UOI [2008 11 STR 225].

Therefore, if a builder/developer receives the entire sale consideration for flats/units

after issue of completion certificate, the same is not liable to service tax.

There is an abetement of 75% of the sale value. Thus, the tax will be levied on 25% of the
sale value of flat at the rate of 10.3%. For example if the agreement value of a flat sold
under construction is Rs. 50,00,000/- then service tax @ 10.3% is payable on Rs. 12,50,000/-
which works out to 1,28,750/-. Thus, there will be an additional burden of 2.6% on the
agreement value of flat. The amendment will be effective from the date to be notified by the
Central Government.

….Contd. 2.

:2:

VAT

The Maharashtra Government in the state budget has also introduced a new composition
scheme on sale of under construction property along with land or interest in land @ 1%
of the agreement value. The scheme is effective from 1st April, 2010 but the notification in
respect of the same about the manner in which the tax is to collected by the builder/developer
has not yet come. There is no set off for inputs.

It may be noted that already a composition scheme @ 5% is in operation which is

effective from 20th June, 2006 i.e. the date on which the transfer of property under
construction was brought within the ambit of VAT.
It may further be noted that the levy of tax on property under construction itself is challenged
by Maharashtra Chamber of Housing Industry (MCHI) an association of builders by a writ
petition in Bombay High Court (being Tax writ petition No. 2022 of 2007). The major issue
involved in the writ petition is the competency of the State Legislature to enact the definition
of Works Contract in the manner which suggests its applicability to the builders/ developers,
in addition to the contractors. The definition talks about transfer of property in goods in the
execution of works contract including the building, construction, ……. . The Government is
competent to levy tax on construction (sale of goods involved in construction). Article 366
read with Article 246 (2) of the Constitution has authorised it to do so. But power to levy tax
on building; i.e. Sale of flats is unimaginable. It appears that prima facie the Hon’ble High
Court is convinced about this position and ordered for an interim relief for the members of
the Association. The Hon’ble High Court has directed that the members of the MCHI should
not be treated as ‘dealers’ liable to tax under the MVAT Act, 2002 in respect of sale of flats
on ownership basis under the Maharashtra Ownership Flats Act, 1963 (MOFA Act), provided
such members of MCHI submit the data and documents as mentioned in the Court Order.
Thus, such members of MCHI have been absolved from registration and also from
assessments till the disposal of the petition. However, the developers who are not members of
the Association are not protected by the Court Order.

….Contd. 3.

:3:

It seems that to divert the attention of the public from the court matter, the Government has
introduced new composition scheme @ 1% on the agreement value of the transfer of flat/unit
under construction without providing any deduction for land etc.

There is an impression in the mind of people that this is a new amendment and only
under construction flats/units sold after 1st April, 2010 are chargeable to VAT @ 1%.
This is not so, the amendment regarding tax on flat/unit under construction is effective
from 20th June, 2006. In this budget the Government has come out with new composition
scheme of 1% of agreement value without any deduction for land against earlier composition
scheme of 5%.

Though the new composition scheme is effective for the flat/units registered on or after 1st
April, 2010 the notification in respect of the same regarding procedural aspect has not yet
come. In the absence of the notification the builders are in a dilemma as to how and in what
manner the tax is to be collected as the full sale price is not collected at the time of executing
agreement for flat/unit which is under construction.

Thus in the hands of purchaser the overall cost of the flat/unit is going to increase by
about 3.6% of the agreement value by way of Service Tax and VAT. In the given
example of Rs. 50,00,000/- value of flat, the additional cost by way of Service Tax will be
Rs. 1,28,750/- and by way of VAT will be Rs. 50,000/- making it a total of Rs. 1,78,750/-.

It is pertinent to note that the above cost can be avoided if a ready flat is purchased
after builder obtains completion certificate.
Construction: Revenue recognition methods
Share

The past few years have seen tremendous buoyancy in the Indian construction sector, with activity
being witnessed in housing, real estate, road, ADVERTISEMENT

airport and port construction. This has benefited

construction companies in terms of strong revenue growth and better visibility into the future (by way
of them building up large order backlogs).

However, considering that these companies follow different methods of recognising revenues,
comparison becomes a tough ask. In this article, we analyse the tow most popular ways that
construction companies follow to recognize revenues in the books – ‘Percentage Completion’ and
‘Completed Contract’.

Percentage completion method: This method is used for long-term projects when there is a contract
and there are reliable estimates of revenues, costs and completion time. This method recognises
revenues and corresponding costs in proportion to the work completed. There are two methods that
can be used to measure the proportion of work completed:

 An engineering estimate.
 The ratio of incurred costs to the total estimated costs.

Completed contract method: This method is used for long-term projects when there is no contract
or estimates of revenues and costs are unreliable. In this method, revenues and expenses are not
recognised until the entire project has been completed i.e., the company does not recognises profits
until the contract has been completed. This method must be used for short-term contracts as well.

Now, since the percentage completion method recognises revenues and income earlier then the
project completion method, it is viewed as a better indicator of trends in earnings.

Financial impact
Sr.
Impact on Percentage completion Completed contract
No.
Recognised based on percentage of project No income recognised till
1 Income recognition
completed completion
2 Cash flows Same Same
3 Amounts billed Same Same
No profits recognised until last
4 Net Income Percentage of profits is recognised
year
No profits recognised until last
5 Total Assets Percentage of profits is recognised
year
6 Shareholders fund Increase to the extent of profits booked No impact
Construction in
7 Adjusted to factor percentage non-completion No impact
progress
*Construction in progress represents the costs incurred plus cumulative pro rata share in gross
profits.

Let us understand, by way of the following example, how a company recognises revenues using the
percentage completion method.

Suppose ‘Company A’ has to construct a commercial complex for Rs 10 m and estimated total cost of
the project is Rs 8 m. Consider the following assumptions:

(Rs m) FY05 FY06 FY07 Total

Amount billed 6 2 2 10
Costs incurred 4 3 1 8

In FY05, since half of the total costs have been incurred (Rs 4 m out of Rs 8 m), half of the total
revenue (Rs 10m / 2 = Rs 5 m) is recognised under the percentage completion method. So, the
resulting net income is Rs 1 m (Rs 5 m – Rs 4 m). Under the completed contract method, the profit of
Rs 2 m (Rs 10m – Rs 8m) will be recognised entirely in FY07.

Profit and loss account under percentage completion method

(Rs m) FY05 FY06 FY07 Total
Revenues 5.00 3.75 1.25 10.00
Costs 4.00 3.00 1.00 8.00
Profit 1.00 0.75 0.25 2.00

In India, different companies follow different methods for recognising revenues. Some companies
follow a threshold level for profit booking (L&T follows 50% limit). In case the projects do not cross a
particular threshold limit, revenues are booked equal to the expenses, without booking any profits.
Profits will be booked only after the threshold limit is achieved. However, some companies do not
follow any threshold limits for booking profits. Instead, they start booking profits proportionately with
the completion of the project (IVRCL, Madhucon Projects). On the other hand, a company like HDIL
follows the ‘Completed contract’ method for booking revenues.

One of the main concerns with construction companies is that they have very poor disclosure policies.
As such, investors trying to compare two companies in the sector must ensure that both the
companies follow the same method of recognising revenues, or there might be differences in the way
these companies are valued.