Contract for Supplying Smart card with embedded requisite information is contact for labour and service and not for sale

CA Bimal Jain

Facts:

Zylog Systems (P) Ltd. (the Appellant) is a service provider having expertise in providing information technology services. The Transport Department of Karnataka had awarded a contract to the consortium of members in which, the Appellant was a member for supply, installation and maintenance of computer systems, supply and printing of smart cards, provision of data entry services and to carry out other activities incidental thereto.

The Appellant purchased ID smart cards for a certain amount and prepared therefrom smart cards as desired by the Transport Department which were supplied after lamination. The Appellant claimed that the entire contract was a service contract and consumption of smart cards was only incidental to the contract. A major portion of the value/consideration of the contract was towards providing the information technology services and the value towards the smart cards was negligible. It was not indulging in any sale of ID smart cards as such.

The Vat Department had taken a view that the Appellant had supplied the goods to the Transport Department for consideration and it was liable for payment of VAT.

Held:

The Hon’ble High Court of Karnataka held that:

• Unless the transaction in truth represents two distinct and separate contracts and is discernible as such, the State does not have the power to separate the ‘agreement to sell’ from the ‘agreement to render service’, and impose tax on the sale;
• The job of preparation of smart card involves skill like entering requisite data in the computers. The data so entered is to be transferred and stored in magnetic media in a manner so that the data can be utilized at a subsequent date for preparation of smart card;
• The smart cards, which are produced by the Appellant, have no utility or value to any other person than the Transport Department who paid for the services rendered by the Appellant;
• The smart cards are not the commodities saleable in open market. It fetches no commercial value in the open market. Hence, supply of smart cards cannot be held as sale. It is a contract for labour and service.

Our Comments:

The Hon’ble Supreme Court in the case of Bharat Sanchar Nigam Ltd. Vs. Union Of India [2006 (2) S.T.R. 161 (S.C.)] (BSNL Case) has very clearly held that “Of the three types of the composite contracts i.e. a work contract, hire purchase contract and catering contract, splitting of service and supply has been constitutionally permitted in case of works contract and catering contract and no other composite contract has been permitted to split.”

Similarly in Larsen Toubro and another Vs. State of Karnataka and another [2013-TIOL-46-SC-CT-LB] (Larsen Toubro Case), it was held that by the 46^thamendment, States have been empowered to bifurcate the contract to levy Sales tax on the value of the material in the execution of the Works contract.

Relying upon the decisions in BSNL Case and Larsen Toubro Case, the five Judge Constitution Bench of the Hon’ble Supreme Court of India in its land mark judgment in the case of Kone Elevator India Private Limited Vs. State of Andhra Pradesh [2014-TIOL-57-SC-CT-CB] (Kone Elevator Case), held that the Works contract is an indivisible contract but, by legal fiction, is divided into two parts, one for sale of goods, and the other for supply of labour and services. Further, the concept of “Dominant nature test” or for that matter, the “Degree of intention test” or “Overwhelming component test” for treating a contract as a Works contract is not applicable.

Further, the recent judgment of the Hon’ble Supreme Court in the case of State of Karnataka Etc. Vs .Pro LAB and Ors [2015-TIOL-08-SC-CT-LB] has re-affirmed the position laid down in Larsen Toubro Case followed by landmark judgment of Five Judge Constitution Bench of the Hon’ble Supreme Court in Kone Elevator Case, regarding inapplicability of ‘Dominant Intention Test’ in case of Works contract.

The Hon’ble Supreme Court held that after insertion of clause 29A in Article 366 of the Constitution, the Works contract which was indivisible one by legal fiction, altered into a contract, is permitted to be bifurcated into two: one for ‘sale of goods’ and other for ‘services’, thereby making goods component of the contract exigible to Sales tax. ‘Dominant Intention Test’ for treating a contract as a Works contract is not applicable.

(Author can be reached at Email: bimaljain@hotmail.com)

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