Monday, 21 April 2014

TAXATION ISSUES IN REAL ESTATE DEVELOPMENT TRANSACTIONS


3900TH POST 
                                                

Taxation of real estate development transactions is a very complex subject. Income tax and Service tax issues concerning both the landowner and developer are discussed here.

INCOME TAX ISSUES CONCERNING THE LANDOWNER

The issues can be categorized under the following heads

1        To be taxed as capital gain or business income
2        Point of accrual of income
3        Amount of income
4        Whether any exemptions are available



1  To be taxed as capital gain or business income

The answer to this question depends upon the nature of transaction undertaken. In most of the cases the resulting gain would be treated as Long Term Capital Gain. However, if the activity undertaken is in the nature of a trade, even if it is a solitary transaction, the same would be treated as a business transaction and accordingly the resulting gain would be business income.


2  Point of accrual of income

The question to be decided is at what point of time the transfer is complete as far as the landowner is concerned. The various points of time which can be considered are:

a.      The date of execution of the Development Agreement
b.      The date of handing over of possession of land to the developer
c.      The date of handing over of possession of land to the developer together with a GPA authorizing the developer to transfer his share of the property.
d.      The date on which the first sale deed is executed for undivided share in land for the developer’s  share.
e.      The date on which the first sale deed is executed for undivided share in land for the landowner’s share.
f.       The date on which the building is completed and share of the landowner is handed over.

The questions are not easy to answer. Let us discuss these situations in brief :


The date of execution of the Development Agreement

Does a mere execution of development agreement satisfy all the conditions as are given in Section 2 (47) of the Income Tax Act. The answer is no. The transfer would not be complete unless the contents of the agreement give an indication that conditions laid down U/s 2 (47) together with provisions of Section 53A of the Transfer of Property Act have been fulfilled.

Section 2 (47) (v) of the IT Act reads as under:

Any transaction involving the allowing of the possession of any immovable property  to be taken or retained in part performance of a contract of the nature referred to in S 53A of the Transfer of Property Act, 1882.


The date of handing over of possession of land to the developer


If the development agreement contains a clause which says that possession has been handed over to the Developer and he is free to deal with the land as he desires, it  leads to a situation where the AO can say that transfer is complete. The drafting of development agreements is very important here and they should be drafted in such a way that the transfer is not complete at the time of handing over of property for construction purposes.

Let us assume the following clause appears in the Development Agreement

‘It is hereby expressly agreed that till the time the building is not complete in all respects and the Landowner’s share of the builtup area is not handed over to him, the Developer shall only be a licensee on the Scheduled Property and it shall not get any ownership rights over the scheduled property. It is also clearly understood that permitting the Second Party to enter upon the scheduled property and construct the building shall not be construed as delivery of possession in part performance of the contract as understood under the provisions of Section 53A of the Transfer of Property Act or under the provisions of The Income Tax Act.’

The above clause will go a long way in defending the stand of the assessee that there is no transfer on the date of development agreement or on the date of handing over of possession.

The date of handing over of possession of land to the developer together with a GPA authorizing the developer to transfer his share of the property.

This is a very interesting situation wherein the developer is given a GPA to register sale deeds for his portion of the undivided share and builtup area. Even if a clause as stated in the earlier point exists, it would lead to a contradictory situation wherein on one hand the Landowner says that till the time he gets his share of builtup area there is no transfer and on the other hand the developer is given possession as well as a right to execute sale deeds. In such a case the transfer would be complete as far as the Landowner is concerned and capital gain would be attracted.

The Bombay Hight Court has taken a view in favour of the department in Chaturbhuj Dwarkadas Kapadia Vs CIT ( 2003 ) 260 ITR 491

The AAR, in the case of  Jasbir Singh Sarkaria ( 2007) 294 ITR 196,  examined the various clauses  in the development agreement and came to the conclusion that capital gains for the landlord accrued when irrevocable GPA was given in favour of the developer. This decision really puts the Landowners to great hardship as they will have to shell out capital gains tax even before any construction takes place on their land.


The date on which the first sale deed is executed for undivided share in land for the developer’s share.

In a situation where GPA is not given to the developer but sale deeds are executed for undivided share in land for the developer’s share  it would be safer to offer proportionate capital gains tax as and when sale deeds  are executed.


The date on which the first sale deed is executed for undivided share in land for the landowner’s share.

When the Landowner himself sells a portion of his share of land and transfers a right to a third party, will it not amount to transfer of property. Here there will be a transfer of a portion of undivided share in land and capital gain will have to be computed accordingly. It is worthwhile to remember that the transfer would not be of the portion which is being given to the developer.


The date on which the building is completed and share of the landowner is handed over.

With a protective clause stated in the development agreement as given above and with no GPA given to the builder  this is the date on which the transfer would be complete and the transaction would be subjected to capital gains tax.


The decision of the Delhi Bench A in the case of Smt Vasavi Pratap Chand Vs DCIT 89 ITD 73 is worth noting. It was held in this case that :

No conveyance deed had been executed by the assessees. From the nature of the agreement, it was clear that the assessees were bound to transfer the land after the possession of built-up flats was given by the builder to the assessees. The possession of flats was given in financial year 1991-92. There was simultaneous transfer of possession of 44 percent of land by the builder to the assessees in financial year 1991-92 in terms of section 2 (47) read with section 53A of the Transfer of Property Act. Hence, the contention of the assesses that land was transferred on the date of collaboration agreement was to be rejected.


Conversion of  Capital Asset into Stock-in-trade

In view of the Bombay High Court judgement in the case of Dwarkadas Kapadia and the AAR ruling in the case of Jasbir Singh Sarkaria an alternative to the ‘Development Agreement’ which comes to mind is that the Landowner converts his land into stock in trade and if he does this, the provisions of Section 45(2) would become applicable and the tax is postponed to the year in which the actual sale takes place. The fair market value of the land on the date of conversion shall be adopted for purposes of section 48.


3  Amount of income

In a development agreement what the Landowner is transferring is a portion of his land. And the consideration he is getting is in the form of builtup area on the portion of land retained by him.

The consideration in a development agreement can be computed in two ways. Firstly it is the market value of proportionate share in land which the landowner is transferring.  Looking at it from another angle, it is the value of builtup area he is getting.

As the registration value of land would be lower than the market value the AO would resort to the second method in arriving at the value of sale consideration. Here, the value of builtup area is the cost of construction of the builtup area which the builder has incurred. It would be advisable to obtain a letter from the builder stating the per sq ft cost of construction incurred by him. This cost obviously will not include any interest cost or other expenses debited in the profit or loss account which are not directly related to cost of construction.

If the landowner has sold his share of the builtup area even before the construction is completed the consideration received on such sale would form part of the consideration for the original transfer of land. If he has sold part of his share of builtup area this will give rise to some complications in arriving at the total sale consideration. Because, in such a case it would be the sum of consideration received on sale and the cost of construction of the unsold portion.

If the landowner sells his portion of the builtup area just after construction, this will give rise to one more capital gain transaction. The first capital gain transaction would be a long term gain and the second one would give rise to long term gain as far as undivided share in land is concerned and a short term gain as far as builtup portion is concerned. The decision of the Madras High Court in CIT Vs Dr Ramachandra Rao ( 236 ITR 51 ) is relevant in this regard.


4  Whether any exemptions are available


If the land or  property has been held for more than 3 years, the development agreement transaction will result in a long term gain and the landowner can claim benefits U/s 54, 54 EC and 54F.

Property purchased in joint names would also qualify for exemption.

Purchase or retention of more than 1 residential flat would also qualify for exemption provided the flats are adjacent to each other or they are used as a single dwelling unit. The decisions rendered in D Anand Basappa V ITO ( 2005) 92 TTJ 597 (Bang),  K G Vyas V ITO ( 1986) 26 TTJ (Bom) 491 and Smt Fulwanti C Rathod V ITO ( ITA No 1092/Mum/1995 dated May 3, 2002 ) are  relevant in this regard. However there is a contrary decision given in Gulshan Banoo Vs JCIT ( 87 ITD 649 ).

It is interesting to note that in Ratanlal Murarka’s case ( ITA No 4485/Mum/1999 reported in BCAJ, 2003, the assessee had purchased one house in Pune and the other one in Thane and exemption was allowed for both the purchases U/s 54 holding that the expression ‘a residential house’ in section 54(1) includes two houses.

Another interesting decision is in the case of Mrs Prema P Shah Vs ITO (2006) 282 ITR (AT) 211 ( Mum.) wherein it was held that the requirement of section 54 was satisfied even where the residential property was purchased abroad.


INCOME TAX ISSUES CONCERNING THE DEVELOPER


The following issues need to be discussed as far as the Developer is concerned.

a.      Year of taxability of income
b.      Computation of income
c.      Deductions available


A  Year of taxability of income

The question which arises is as to when income becomes taxable. Is it the year of completion of the project. Or should the income be offered on a year to year basis. If the income is to be offered on a year to year basis should it be computed on  percentage of completion method or should it be estimated.

For the purposes of income tax income has to be determined on a year to year basis. This was so decided by the Supreme Court in the case of P M Mohammed Meerkhan Vs CIT (1969) 73 ITR 735

However the department has been accepting the ‘completed contract method’ also and the   Bombay High Court, in the case of Shree Nirmal Commercial Ltd V CIT 193 ITR 694 has accepted the completed contract method.

It is also interesting to note that the scrutiny norms announced by the CBDT for picking up cases for scrutiny also state that all cases of builders following the completed contract method should be picked up for scrutiny.

Should Accounting Standard AS-7,  which applies to construction contracts, be followed while computing the income of a real estate developer. The answer is ‘No’.  AS 7 applies to accounting for construction contracts in the financial statements of contractors and not to enterprises that are constructing properties on their own account. Therefore revenue recognition and valuation of inventories should be in accordance with AS 9 and AS 2 respectively.  In other words AS – 7 would apply when contract is being executed on behalf of a third party.


B  Computation of Income

What income should be offered to tax by a developer ?  If the profits are to be offered to tax on a year to year basis profits have to be estimated till the project is not complete. Income can be estimated as a percentage of work completed or as a percentage of  advances received.

The department has been accepting an 8 % profit on gross receipts or work completed when the project is incomplete. Balance of profit has to be offered in the year of completion.  For partnership firms, out of the 8 % profits, interest and remuneration to partners can be deducted to arrive at taxable income of the firm.

Section 44AD is applicable only in the case of civil contractors ( executing civil work for third parties )  having less than Rs 40 Lakhs of receipts and hence this section cannot be made use of by developers who are selling residential flats or office spaces on their own.


C  Deductions available

The only deduction available to developers is for construction of housing projects U/s 80-IB (10).

100 % of the profit derived in any previous year is exempt from tax if the following conditions are satisfied.

a.      The project is approved by a local authority before March 31, 2007.
b.      The size of the plot of land is a minimum of one acre
c.      The project should be completed within 4 years from the end of the financial year in which the housing project is first approved or before 1/4/2008, whichever is earlier.
d.      The builtup area of  shops and other commercial establishments included in the project shall not exceed 5 % of the total area or 2,000 sq ft whichever is less.
e.      The builtup area of each residential unit should not exceed 1000 sq ft within local limits of Delhi & Mumbai or 1500 sq ft in other areas.


 ISSUES  IN  SERVICE  TAX


Before proceeding to the specific topic of applicability of service tax to developers and builders it would be worthwhile discussing some basic issues in service tax.


Threshold Exemption


From the financial year 2008-09 onwards,  threshold exemption on the aggregate value of taxable services provided during a financial year is available to a service provider upto a maximum of Rs 10 Lakhs. 


Exemption linked to preceding year’s turnover :

Exemption is available if the aggregate value of taxable services provided has not exceeded the taxable limit in the preceding financial year. 


Tax payable for turnover over Rs 10 lakhs in the first year :

Service tax is payable only on the turnover exceeding Rs 10 lakhs and not on the entire amount in the first year. Thus in the first year of exemption, if the turnover is Rs 10.40 Lakhs, service tax is payable only on Rs 40,000/-.  However, from the next year tax is payable on the entire turnover.  It would be worthwhile to note here that if any service tax is collected which is not required to be collected or if any excess service tax is collected, the same has to be immediately paid into the account of the Central Govt.

In arriving at the limit of Rs 10 Lakhs only taxable services are to be counted. Thus if a person has turnover of Rs 5 lakhs for non-taxable service and a turnover of Rs 6 lakhs for taxable service, he can still enjoy tax exemption.


New services brought into tax net during the year

If a service is made taxable from a date in the middle of the year ( say from July 1 ) the turnover of the service provider upto the date of introduction of service would not be counted as part of the Rs 10 lakhs threshold limit.


Construction Services


Service Tax @ 10 % plus education cess @ 3 % of service tax ( total 10.30 % of the value of taxable service ) is applicable to the following two categories of construction services :

1   Commercial or Industrial construction services

2   Construction of complex service

1   Commercial or Industrial construction services

Section 65 (25b) of the Finance Act, 2005 defines the service as follows :

(25b) ‘commercial or industrial construction service’ means –

(a)    construction of a new building or a civil structure or a part thereof; or
(b)    construction of pipeline or conduit; or
(c)    completion and finishing services such as glazing, plastering, painting, floor and wall tiling, wall covering and wall papering, wood and metal joinery and carpentry, fencing and railing, construction of swimming pools, acoustic applications or fittings and other similar services, in relation to building or civil structure; or
(d)    repair, alteration, renovation or restoration of, or similar services in relation to, building or civil structure, pipeline or conduit,

which is  -

(i)                used, or to be used, primarily for; or
(ii)             occupied, or to be occupied, primarily with; or
(iii)           engaged, or to be engaged, primarily in,

commerce or industry, or work intended for commerce or industry, but does not include such services provided in respect of roads, airports, railways, transport terminals, bridges, tunnels and dams’.

Who is covered under this head :

-         Persons engaged in constructing shopping malls, commercial complexes, multiplexes etc.

-         Persons engaged in repairing, altering or restoring of any building or civil structure.
-         Persons engaged in construction of hoardings, construction of pipelines or conduit.
-         Persons engaged in completion and finishing services such as glazing, plastering, painting, floor and wall tiling, wall covering and wall papering, wood and metal joinery and carpentry, fencing and railing etc.

Who is not  covered under this head :


-         Persons engaged in constructing the building or civil structure for self-use or for renting out, or for sale
-         Persons engaged in construction of roads, bridges, airports, railways, transport terminals, tunnels and dams.

As stated above, it is very interesting to note that developers, builders who are constructing commercial complexes for renting out or for sale are not covered for service tax purposes. Para No12 of Circular No 80/10/2004 ST dated 17/9/2004 clarifies that  ‘ …..  estate builders who construct buildings / civil structures for themselves ( for their own use, renting it out or for selling it subsequently ) are not taxable service providers. However, if such real estate owners hire contractor / contractors, the payment made to such contractor would be subjected to service tax under this head…..’

This means that if a builder makes a sale deed for the commercial spaces which he is building, there will be no service tax. However, if  sale deeds are made for undivided share in land or semi finished structures and then ‘ Agreement of construction’ is made for constructing or finishing the structure it will attract service tax.

Abatement of Tax

Any service provider liable under this head can opt for availing abatement to the extent of 67 % of the gross receipts and pay tax only on the balance 33 % of the gross receipts. Other conditions like not availing Cenvat credit on inputs or capital goods or on input services are applicable.


2   Construction of complex service


Section 65 (30a) of the Finance Act, 2005 defines the service as follows :

(30a) ‘construction of complex ’ means –

(a)    construction of a new residential complex or a part thereof; or
(b)    completion and finishing services in relation to residential complex such as glazing, plastering, painting, floor and wall tiling, wall covering and wall papering, wood and metal joinery and carpentry, fencing and railing, construction of swimming pools, acoustic applications or fittings and other similar services; or
(c)    repair, alteration, renovation or restoration of, or similar services in relation to, residential complex

(91a) ‘residential complex’  means any complex comprising of –

(i)                a building or buildings, having more than twelve residential units;
(ii)             a common area and
(iii)           any one or more of facilities or services such as park, lift, parking space, community ball, common water supply or effluent treatment system

located within a premises and the layout of such premises is approved by an authority under any law for the time being in force, but does not include a complex which is constructed by a person directly engaging any other person for designing or planning of the layout, and the  construction of such complex is intended for personal use as residence by such person.

Explanation – For the removal of doubts, it is hereby declared that for the purposes of this clause, -

(a)    ‘ personal use’ includes permitting the complex for use as residence by another person on rent or without consideration;
(b)    ‘residential unit’ means a single house or a single apartment intended for use as a place of residence;’


Are builders / developers of residential complexes covered ?

The CBEC has clarified that where a builder, promoter or developer engages a contractor for construction of residential complex, the contractor shall be liable to pay service tax on the gross amount charged for construction services provided to a builder, promoter or developer. However, if no contractor is engaged and the job of construction is undertaken by the builder, promoter or developer himself, then in such cases, in the absence of service provider and service receiver relationship, the question of providing taxable service to any person by any person does not arise.

In other words if a builder is making sale deeds for the completed residential flats, he will not be liable to service tax. If ‘construction agreements’ are made with the intending buyers service tax will be payable.

The Authority for advance ruling ( in the case of Harekrishna Developers – Ruling AAR 4 of 2008 in Application No 10 of 2007 decided on 7-4-2008 )  has observed that builders who are executing sale deeds for residential portions on completion of building are also liable to service tax if the sale deed is executed in pursuance of an agreement to sell between the builder and the buyer. The AAR also observed that the situation covered by the Board circular is one of outright sale of  a residential unit after the construction, the construction having been done without reference to any agreement between the builder and buyer and the developer and buyer come face to face after the entire process of construction is complete.  This judgement comes as a surprise and could cause lot of hardship to  builders.

However the Guwahati Hight Court in WP©No 2615 of 2006 in the case of Magus Construction Pvt Ltd Vs Union of India has held that there is no service tax on sale of flats.


Abatement of Tax

Any service provider liable under this head can opt for availing abatement to the extent of 67 % of the gross receipts and pay tax only on the balance 33 % of the gross receipts. Other conditions like not availing Cenvat credit on inputs or capital goods or on input services are applicable.


Service tax on works contracts under the composition scheme

Under the works contract ( composition scheme for payment of service tax) Rules, 2007 the builder has an option to pay service tax at 4 % on the gross amount.  

 (Introduced vide Notification No.32/2007-Service Tax, dated 22nd May, 2007) 






1 comment:

Rahul Dixit said...

Thanks Manish ji....for sharing such a Practical Aspect of Real Estate Transactions.... Really good efforts.........