The use of sub-contracting or co-contracting is typically a part of the strategy of most complex projects, especially in the construction or works industry. Conventionally, sub-contractor arrangements include similar rights and obligations/ liabilities as subscribed to by the main contractor in the main contract with the Project Owner. Further, with or without use of special purpose vehicle (SPV) entities (for projects), it is common to identify sub-contractors upfront for large projects and the scope/ necessary approvals are also handed ab initio by the Project Owner. Several legal issues are sought to be addressed through such structures i.e. deploying SPVs or employing sub-contractors; however, taxation (more specifically indirect taxes) is usually not underscored properly in most of these instances. The said position is confirmed by the fact that sub-contractors are amongst the businesses that have filed most representations with the government ever since the advent of Goods and Services Tax or GST seeking reliefs & clarity in equal measure.
Taxation of the sub-contractor arrangements, in any case, has been an argumentative matter ever since. From exemptions under service tax to concessional rates of duty/ issuance of forms under VAT and determination of taxable turnovers, sub-contractor arrangements remained a permanent fixture in courts.
A theme that is witnessed throughout as a cause of disputes/ litigation/ difficult self-assessed positions is that either the rate of tax on main and sub-contractors is not the same or the tax paid by the sub-contractor may not be fully fungible in the hands of the main contractor. A similar dispute was also existent under the pre-GST regime where some exemptions were upheld to be available for sub-contractors as well, on the premise of supplies being directly made from sub-contractor to project owners with main contractors being a mere financial pass through. Legislators and judiciary, however, have been cognizant of these matters and admittedly some resolutions have been delivered. Illustratively, clarification on taxability of works contract services by subcontractors for construction of dams, tunnels, etc. for being eligible to service tax exemptions similar to those accorded to main contractors for such works was a welcome move. The Apex Court upholding the deduction of sub-contractor turnover (for VAT assessment), was a landmark verdict in the 2008 Larsen & Toubro matter. The sufficiency of these actions however, has always been a subjective issue. Also, with passage of time, even if some of these issues arguably attained certainty under the pre-GST regime, introduction of the new tax regime has revived this quandary.
The core of GST, is a tax regime without any cascading effects and maximum financial efficiency. The ground reality, for sub-contractors however remains that challenges still exist and suo moto interpretations are litigious. An irrational rate structure or half-baked scope of exemption, which does not take into account industry dynamics leads to an aggregation of avoidable costs for a given project in turn making general or public construction activity more expensive.
Consider a few examples. With an objective of withdrawing taxes/ optimizing tax costs in activities undertaken as a sovereign responsibility of the Government, various exemptions under the GST law were prescribed on supplies related to such functions. Unlike the service tax regime, the GST law envisages an exemption for pure services provided to the Government or their entities in relation to execution of their specified sovereign functions. The exemption has been prescribed under Entry 3 of Notification No 12/2017- Central Tax (Rate) and reads as “Pure services (excluding works contract service or other composite supplies involving supply of any goods) provided to the Central Government, State Government or Union territory or local authority or a Governmental authority or a Government Entity by way of any activity in relation to any function entrusted to a Panchayat under article 243G of the Constitution or in relation to any function entrusted to a Municipality under article 243W of the Constitution”.
The purview of the aforementioned entry is wide enough to include various services provided to the Government under different schemes including but not limited to Skill India, Pradhan Mantri Swasthya Suraksha Yojana, Saubhagya Scheme, Deen Dayal Upadhyaya Gram Jyoti Yojana, Beti Bachao Beti Padhao, etc. For most Government related contracts , the supply chain is designed to appoint a main contractor for ease of coordination and responsibility, with the main contractor then sub-contracting parts of the work to various sub-contractors. In relation to such sub-contractor services (to whom similar terms and conditions as are binding on the main contractor apply), there continues a debate on whether the exemption under entry 3 would be available. Further, to make matters worse, conflicting advance rulings have been pronounced on this very issue.
The principle that supports extension of exemption entry to even the sub-contractors is the doctrine of purposive interpretation; basis which denial of an exemption at lower levels of supply chain would defy the purposes behind a notified exemption. The alternative view is that, the exemption should be read & interpreted strictly with no scope there in to read legislative intent, if at all.
Yet another example is whether the lower rate of GST, as available to the main contractor in several cases, extends to sub-contractors too? A careful reading of the Rate Notification 11/2017 – Central Tax (Rate) posts amendments approved by the GST Council in their 25th meeting, suggest that the benefit of lower rate is applicable only for main-contractors listed at entry (iii) to (vi) under Heading 9954, while the lower rate for sub-contractor is available only if the main contractor is covered at said entry (iii) or (vi) implying sub-contractors to main contractors covered at (iv) and (v) have been overlooked for concessional rate benefit. The advance rulings, from Uttarakhand and Maharashtra, in such cases are divided.
Given this, it is worth a mention that the divergent views on the matter have opened a Pandora’s box for various industry players including those engaged in the business of Government supplies. Where on the one hand, a position to discharge tax could trigger conflicts with both the main contractor for commercial reasons (who may exhort sub-contractors to explore a no tax/lower tax position, given the possible reduced costs) and Government officials, on the eligibility of input tax credit (as the Government officials may contend non-eligibility of ITC on exempt services), a no tax position, might be a advantageous to the main contractor but could entail substantial litigation and related costs for the sub-contractors where the position is disputed by the Government officials.
While some AARs have denied eligibility of sub-contractors for the above exemption, the doctrine of purposive interpretation has been upheld by higher forums and in specific, the Supreme Court in multiple instances. In interpreting a legislation in its true spirit, the right direction is always to give a full and literal meaning to the language with a view to understanding the absolute purpose of the statute and not to make it sterile by giving a strict literal interpretation. This principle merits consideration in interpreting the extension of the exemption under entry 3 to sub-contractors as well. As the mechanical interpretation of the exemption would defy the objective of the exemption, traveling beyond the literal construction of the entry undeniably deserves consideration.
The intention of the legislature to align rates for main contractors and sub-contractors is also evident from rate changes approved in the GST Council’s 25th meeting as well; where rates on sub-contractor works contract services were (in most cases) aligned to those applicable for services provided by the main contractor; so as to eliminate any unwarranted accumulation of taxes at any leg of the supply chain for services to the Project Owners. Hence, a view on exemption under entry 3 being applicable to subcontractor arrangements clearly deserves a reconsideration/ evaluation
Where the above exemption is upheld to cover sub-contracting arrangements as well, it could have larger implications on various other supplies where subcontracting arrangements are prevalent and differential rates are prescribed vis-à-vis a class of recipients. Given the possible optimization in tax costs/ financial exposures, businesses should consider evaluating these supplies even more comprehensively and evaluate avenues like financial checks in contractual clauses, advocacy, seeking a clarification for their own supply chain and similar options.
With inputs from Adarsh Somani, Partner, Economic Laws Practice
