The unlikely panacea of indirect tax woes of Real Estate Industry

Works contracts and real estate sector have always been characterised by unsettled Indirect tax positions and complexities. Adoption of different models for contract execution, increasing prevalence of joint development and redevelopment arrangements, composite nature of transactions involving goods, services as well as immovable property have always resulted into a plethora of Indirect tax issues unique to this industry.

While a lot in the Indirect tax scenario is expected to change with introduction of GST and some of the peculiar issues applicable to deemed sale transactions may no longer persist, the road ahead is not entirely simple for the real estate sector. In this article, we are analysing some of the uncertainties and challenges for the real estate sector that are likely to persist even under the forthcoming GST regime.

Deduction for land and development rights

In terms of Entry 49 of the List II to the Seventh Schedule of the Constitution, taxation of land and building continues to fall under the exclusive taxing jurisdiction of the States. Considering the same, introduction of some valuation mechanism to exclude value of land for taxation of construction services liable to GST is likely. The manner of deriving land value or slab for such deduction would play a crucial role in determining GST cost for the real estate sector.

It is well recognised that the value of land and proportion of land cost in overall construction cost differs sharply in various parts of the country. For instance, the component of land cost in overall construction cost in Mumbai would be way higher than the same in some non-metro place. In fact, the component of land cost varies sharply across the metro cities or different areas of the same metro city. Therefore, it would be pertinent that the slabs of land deduction under the GST regime are dynamic and take into consideration the difference in land cost across different geographic regions.

Further, if such deduction is provided on actual value basis, linking of such deduction to reckoner value may turn out to be detrimental to the industry, since in a lot of cases the actual price to be paid for the land tends to be higher than the reckoner value.
Further, it would also be important to have deduction for purchase of Transferrable Development Rights (‘TDR’) which have been held to be akin to immovable property in various judicial precedents.

Allocation of units against TDR and valuation thereof

Allocation of units against receipt of consideration in the form of TDR has been a regular feature of various redevelopment and joint development arrangements. Under the current regime, while such arrangements are charged to Service tax, VAT is not discharged on the same by most developers relying on various judicial precedents supporting that barter does not constitute sale[2]. However, such transactions would very well fall within ambit of the term ‘Supply’ and hence would be liable to GST. Since the tax charged on such transactions is usually borne by the developer, the cost of redevelopment and joint development arrangements is now poised for an upward shift.

While the applicability of GST on such transaction is apparent, the manner of determining value of such transactions for discharging the tax liability may continue to be a pain point for the industry. Under the current Service tax regime, divergent views exist as regards valuation of such services. While developers in most cases may prefer valuation of such services based on value of TDR less cost of goods involved, an alternative view suggests valuing such services based on consideration charged from independent service recipients.

Unless specific valuation provisions are notified for such transactions, the controversy as regards valuation of such construction services would continue.

The applicability of ‘Open Market Value’ concept to determine value of such services may lead to a huge increase in tax cost of such transactions, especially if values of third party sales are used for valuation.

Rate of tax

Under the current regime, the effective rate of Service tax on construction services works out to be 4.50% (15*0.30) and the composition rate for such works contracts under various State VAT laws are in the range of approx. 0.50 to 3%. In addition to the above, stamp duty in range of approx. 5 to 7% applies in most States; which would continue to be applicable even under the GST regime.

Considering the applicable rates of Service tax and VAT, classification of the construction services in the rate bracket higher than 5% would significantly increase the tax burden on the industry (forming cost in hands of customers / businesses buying units). Applicability of even lower standard rate of 12% would result into a steep increase of around 4 to 7% on the value of properties, which may significantly inflate the property prices.

Impact on lease model

The distinction between developers adopting sale model and lease model for commercial properties is continued even under the GST regime, with credit of works contract services being restricted to developers engaged in sale model (i.e. providing works contract / construction services). While the seamless credit chain was one of the fundamental tenets for introduction of GST in India, various credit restrictions including the one in respect of developers engaged in lease model have been continued in the GST Bills. The impact of such restriction under the GST regime will only widen the tax costs for a lease model vis-à-vis a sale model.

Under the existing Service tax regime, CENVAT credit of Capital goods was at least available to such developers operating under lease model. However, due to blanket credit restriction on goods and services used for construction (as per Section 17(5)(d) of the CGST Bill), the hitherto eligible credits in respect of Capital goods may cease to be eligible to such developers. This would effectively amount to further shrinking of the credit base for the developers operating under the lease model.

In light of the above, it is evident that introduction of GST is not likely to be the panacea for all the Indirect tax issues faced by the real estate industry. While some of the issues such as dual levy of taxes would get resolved with introduction of GST, a sizable set of issues (some of which are highlighted above) faced by the industry are not likely to rest even after introduction of GST.

While the dust of demonetisation is now more or less settled, the forthcoming legislative reforms, with introduction of Real Estate (Regulation and Development) Act, 2016 and GST around the corner, may once again blow the winds of uncertainty for the industry. For the moment, it seems that the tax and regulatory aspects may drive the business in this industry, rather than the other way round.

The journey is long, and the secret destinations on the way unknown!