Hike In Home Prices

The Supreme Court held that state governments can levy a value added tax (VAT) on the cost of building a flat when property developers sell it to buyers. The decision has rocked developers, given enough reasons for tax firms to hold con calls like the way they did for the Vodafone retrospective tax judgement case and made the price of a flat just that much more costly for buyers. The issue is again retrospective impact but this time it is the courts that have held that past purchases can be re-opened too.

The Court went by a clear logic. When developers construct a flat and eventually sell it with a fraction of land, such transaction involves construction activity too. In other words only if a flat is constructed can it be sold. Construction means there is a works contract being executed and that is taxable under the VAT rules. So even if the ultimate transaction between the parties may be sale of flat, it cannot be said that the characteristics of works contract are not involved in the transaction.

Currently, very few states have VAT in place for property. In 2006, Maharashtra government decided to charge a 5 per cent VAT on properties under construction. This had led to much confusion and the decision was contested in the Bombay High Court, which upheld the decision in a judgement delivered in July 2012. A petition was filed in the Supreme Court, which while ruling in the Larsen & Toubro case has upheld the Maharashtra decision.

"This judgment should act as a sign of relief for the developers and for the buyers. In many states there is an ambiguity with respect to determination of measure of tax. This judgement amply makes it clear that the value that would be taxed would be the sum that can be ascribed to the goods that are incorporated in the works," said Aditya Tiwari, Partner, Prudentius Legal Advocates.

The judgement has also made it clear that although the flat or the building would be transferred on a date after the incorporation of goods in the works, it would not impact the tax levied. For the purpose of levy of VAT, the date of incorporation is crucial. "In other words, it would either depend upon the builder to provide date of incorporation of goods into the works or in case states take initiative they would have to come out with appropriate rules to incorporate these principles into their rules," said Tiwari.

According to BMR Advisors, state governments would now aggressively pursue developers to recover VAT. "Many states may not even be required to make retrospective amendments to levy VAT since the definition of works contract in state legislations typically include any agreement for carrying out for cash, deferred payment or other valuable consideration, the building / construction of any immovable property" the note from BMR said.

For completed projects developers may not, however, be able to recover VAT from purchasers. So the ability to avail past VAT credits or deductions made by sub-contractors should be examined. But Harishanker Subramaniam, Partner & National Leader Indirect Tax, was convinced that since the judgement is merely an interpretation of an already existing law, "It is likely to have a retrospective effect. It will be interesting to see how the developers will commercially recover the additional burden of tax from the flat buyer."

"Needless to say, being an indirect tax, the VAT payable may be passed on to the buyers resulting in a net increase ranging between 2-6 per cent in the net price payable for flats under construction, depending on the applicable rate of state VAT and stage at which buyer enters into an agreement to buy an apartment," said Mahesh Jaising, partner, BMR Advisors.

The confusion over how taxes are calculated is due to the two methods that states follow. In the first method, the developer could provide details of materials separately that are used as raw materials into a building and get itself assessed on that basis. This process led to complications as different goods may have different rates of taxation and for some goods it would be difficult to determine exactly how much of it was used and when.

"Say for example there are nails, bolts, cement, electrical wires etc. This would mean that not only developer has to keep detailed record in respect of the material used to erect the building but also has to correctly state the date of transfer of material into the works," said Tiwari. Buyers too have suspicions on whether the tax amount the developer asks them to cough up is indeed the right one. Buyers are in no position to evaluate the developer's expenses and there is every possibility that higher amounts may be collected from them.

The second method is that the developer at the commencement of the year chooses to opt for a compositions scheme. Every state has a compositions scheme, in most cases, a value to the contract is ascribed to a building, and certain permissible deductions are made towards, value of the immovable property, amount towards services and labour etc. The balance amount is taxable as amount of goods involved in transfer of works contract.

"Therefore, now with the judgment in the L&T case, in case the right title and interest in the immovable property is transferred along with a works contract, the value ascribed towards the immovable property shall also be deducted. The Supreme Court has categorically made it clear that the state does not have right to deduct value added tax on the immovable property. However, the state does have right to collect stamp duty on its transfer," said Tiwari.

A key issue was whether VAT that was charged on under-construction property was applicable to completed apartments and those on the resale market. The Maharashtra order, for example, did not clarify this aspect. "Conversely, the position that no VAT is payable if flats are sold after construction is complete has also been upheld," said Jaising.

In a conference call with media, Prashanth Bhat, Director-Indirect Tax, BMR Advisors said that while most developers in the southern states have been paying VAT on sale of flats under construction and may not be impacted much, the impact will be most in the northern and eastern states (Rajasthan, Delhi, Uttar Pradesh West Bengal, etc), where the developers were still taking a "no VAT" position.

Developers in Maharashtra are likely to be impacted for the period prior to April 2010, as most of them were not paying tax until then and only started paying VAT under the 1 per cent composition scheme since April 2010. Buyers, who are liable to be charged additional sum towards this tax, should now be prepared to ask some critical questions to their developer.

Developers apex body CREDAI Chairman Lalit Kumar Jain said "The judgment clearly lays down that an agreement entered into by a Developer/Builder with the purchaser is a composite contract involving a contact for work and labour and contract for sale and the same comes within the meaning of "works contract" and the provisions of Article 366(29-A)(b) are applicable. The Supreme Court has consequently dismissed the challenge to the Constitutional Validity of section 2(24) of the MVAT Act. However, in paragraph 115 of the judgment, the Supreme Court has clarified that activity of construction undertaken by a developer would be deemed as works contract only from the stage the Developer enters into a contract with the flat purchaser."

According to Dilip Shah, Senior Counselor and Analyst for Redevelopment of Housing Societies, the terms of agreement between the flat owner and the builder plays a key role to decide who ultimately has to bear the tax burden. "If the developer has clearly stated in the agreement that any future tax implemented by the government has to be paid by the buyer, the flat owner is liable to this entire tax. However, if the agreement does not contain the clause, the onus is solely on the builder." He also said that more often than not, builders have to explain the various rebate, discounts etc available to the buyer if he is liable to pay the tax. "Very few builders do that which means the builder himself has to pay the tax liability," he added.

According to a Consumer group, Flat Owners' Rights Protection Action Committee of Maharashtra (FORAM), "VAT on sale of flats amounts to double taxation, as taxes are already paid for when buying material for construction. And even though the tax department has made it clear that the burden of the tax dues lies squarely on the realtors, they have argued that they have very clear provisions which state additional costs will have to be borne by the buyers," says Anirudh Wahal, Director at property consulting firm DTZ, "In real estate, like any other products, all taxes are costs to seller's business and eventually will be borne by the consumer. If the builder has not already charged the customer for VAT, he can do so now but such retrospective proposals will only lead to more litigation."

"The taxes imposed by the government have always been passed on to the buyer. We will not pay from our pocket," said Sunil Mantri, vice-president NAREDCO, CMD Mantri Realty, adding that the SC verdict is likely to lead to more litigation between builders and buyers. Housing societies too had urged the court to take a humanitarian view. "It is not the builders but the consumer who has to bear the burden of taxes. The best solution is to start an amnesty scheme to give relief to flat owners," Ramesh Prabhu, chairman, Maharashtra Societies Welfare Association (MSWA) had said last year.

The sales tax department had in 2006 imposed 5 percent value added tax, which was challenged by builders in the Bombay HC. Following the dismissal of builders' petition by the Bombay High Court, developers across Maharashtra had approached the Supreme Court.

Adding an additional cost burden on developers and contractors will have a cascading effect on the overall project costs. In the current situation, developers are struggling with decreased project sales, and matters are not helped along by high interest costs and high project prices. In other words, this will further slow down the sales momentum in Housing sector. There is, of course, a potential opportunity for developers, as they may be in a position to bear this additional tax burden while keeping their price constant. This would improve the competitiveness of their projects. However, it is far more likely that these added costs will be passed on buyers, who are already struggling with high residential prices.