Taxation in Commercial Contracts: Strategic Tax Clauses, Global Compliance & Risk Mitigation

I. Taxation on Services

 A. Goods and Services Tax (GST) in India

The introduction of GST in 2017 replaced India’s fragmented indirect tax regime with a comprehensive, destination-based system. It applies to the supply of goods and services, simplifying compliance but introducing new challenges for contract management.

1.Tax Rates and Classifications

Services under GST are taxed at rates of 5%, 12%, 18%, or 28%, depending on the category. Professional services, such as consultancy, legal advisory, and IT services, generally fall under the 18% bracket. For example, under Notification No. 11/2017-Central Tax (Rate)[1], consultancy services are classified under Chapter Heading 9983(Other professional, technical and business services), attracting 18% GST.

2. Compliance and Reverse Charge Mechanism (RCM)

• Businesses exceeding specified turnover thresholds (₹20 lakhs for services in most states, ₹10 lakhs for special category states), inserted by the S.11, Central Goods and Services Tax (Amendment) Act, 2018, registration are required to register under GST. This threshold is mandated under Section 22(1), Central Goods and Services Tax Act 2017 (w.e.f. 22 June 2017, by Notification No. 01/2017-Central Tax dated 19 June 2017).
• The RCM applies to specific transactions, such as the import of services, where the recipient, instead of the supplier, is liable to pay GST. This is governed by Sections 9(3) and 9(4) (as amended by the Central Goods and Services Tax (Amendment) Act, 2018, which introduces the Reverse Charge Mechanism) of the CGST Act. For instance, legal services provided by an individual advocate to a business entity are taxable under RCM.

3. Exemptions

Certain services, such as healthcare and education, are exempt from GST under Notification No. 12/2017-Central Tax (Rate)[2]. However, ancillary services like premium hospital rooms or non-essential educational services are taxable. For instance, Room rent (excluding ICU) exceeding Rs 5000 per day per patient charged by a hospital shall be taxed to the extent of the amount charged for the room at 5% without ITC, as clarified in the 47th GST Council meeting[3]. Contractual clarity is crucial in these bundled offerings to delineate taxable and exempt components.

B. Value Added Tax (VAT) in Other Jurisdictions

VAT, a prevalent tax in over 160 countries, is a multi-stage consumption tax levied at each point in the supply chain. Compliance with VAT laws across jurisdictions requires businesses to be well-versed in local tax regulations. Unlike GST, which is designed to be more uniform across countries, VAT compliance is often decentralized, especially in the EU, where each member state has autonomy over its VAT rules.

II. VAT in Key Jurisdictions

1.European Union (EU)

The European Union has a harmonized VAT system, but each member state sets its own VAT rate and applies specific exemptions. The EU allows for cross-border transactions, but local compliance rules must still be adhered to.

VAT on Services in the EU:

Standard VAT: EU law requires a standard VAT rate of at least 15% to apply to most goods and services. Member States may also apply up to two reduced rates as low as 5%, one super-reduced rate lower than 5%, and one zero rate to a limited set of goods and services taken from an agreed list[4]. Generally, applies to services provided by businesses, including consultancy, legal services, IT services, and management services.

Exemptions and Reduced Rates:

• Healthcare and education services: Exempt or zero-rated in most countries.
• Financial services: Generally, exempt from VAT.
• Cultural services: Museums, theatres, and cultural institutions often benefit from exemptions.
• One-Stop-Shop (OSS): Simplifies VAT filing for digital services, requiring businesses to register in the consumer’s country to comply with VAT on cross-border services.

2.United Kingdom (Post-Brexit)

After Brexit, the UK maintains its VAT system independently from the EU, although it closely follows EU rules.

VAT Rates:

Standard rate: 20% (Most goods and services)

Reduced rate: 5% for certain goods/services (e.g., domestic fuel, children’s car seats)[5]

VAT on Services in the UK:

• Legal services: VAT applies to legal services unless exempt (e.g., court fees).
• Education and healthcare: Generally exempt, though private tutoring may attract VAT.
• Real estate: Sale of commercial properties is subject to VAT, but residential sales are generally exempt.
• Hospitality services: Hotel accommodations and restaurants are subject to VAT at 20%.

3.Middle East: UAE and Saudi Arabia
Both the UAE and Saudi Arabia introduced VAT in 2018, with a simplified flat-rate structure. The VAT rate in these countries is low compared to the global average.

VAT Rates:

UAE and Saudi Arabia: 5%

VAT on Services in the UAE and Saudi Arabia:[6]

• Commercial Property Sales and Leases: Sales or leases of commercial properties are subject to VAT at the standard rate (5%).
• Hospitality and Restaurant Services: VAT is charged at 5% on these services.
• Taxi Services: Transport services like taxis are subject to VAT.
• *Healthcare Services: In specific cases, some healthcare services may be subject to VAT, depending on their classification. However, most basic medical services are generally exempt.
• Education Services: Certain educational services and goods supplied to institutions are subject to VAT.
• International Transportation and Related Services: Supplies related to international transport are subject to VAT.
• Sea, Air, and Land Transportation: VAT is applied to supplies of transportation means like aircraft and ships.
• Investment Grade Precious Metals: Supplies of certain precious metals like gold and silver with a purity of 99% are subject to VAT.

4.Australia
It operates under a GST system, which functions similarly to VAT.

GST Rate: 10%

GST on Services in Australia:

• Consultancy and professional services: GST applies.
• Healthcare and education: Exempt, unless the service is not related to the core educational or healthcare process.
• Financial services: Exempt from GST.
• Digital services: GST applies to digital services from overseas providers to Australian consumers (implemented as a “Netflix tax”).

5.South Africa[7]
South Africa levies VAT on a wide range of services and goods.

VAT Rate: 15%

VAT on Services in South Africa:

• Legal and accounting services: VAT applies.
• Healthcare and education: Exempt from VAT.
• Transportation: Public transport is exempt, while private transport services attract VAT.
• Real estate: Residential property transactions are exempt from VAT; commercial properties are subject to VAT.

III. Key Takeaways for Businesses: Services Subject to VAT

Businesses must carefully review local tax laws and their VAT obligations in each jurisdiction where they operate. Below is a list of common service categories and their VAT applicability:

VAT Application on Services Across Various Countries:

1.Professional Services

• UK, Germany, France: VAT is applied to legal, accounting, and consulting services at the standard rate (e.g., 20% in the UK, 19% in Germany, and 20% in France).
• Finland: A VAT rate of 24% applies to most services, including professional ones.

2. Telecommunication Services

• South Korea, Singapore, UAE: VAT is applied to mobile and internet services (e.g., 10% in South Korea, 9% in Singapore, and 5% in the UAE).
• Europe (e.g., France, Germany): VAT on digital and telecom services is charged based on the customer’s location.

3. Hospitality and Leisure

• Germany, Italy, Spain: Hotels, catering, and event services are subject to VAT (e.g., 10%-19% in Germany and Spain, and 22% in Italy).
• France: A reduced VAT rate of 10% applies to hotel accommodation.

4. Transport Services

• Germany, UK, South Africa: VAT is applied to passenger transport services such as buses, taxis, and trains, with exemptions for some public transport types.

5. Education and Health Services

• Australia: Educational services are generally exempt from VAT, but certain services, such as vocational training, may be taxable.
• South Africa: VAT applies to private healthcare services.

6. Digital Services

• EU: Digital services like streaming and online advertising are taxed in the consumer’s location (e.g., 20% in France and 25% in Sweden).
• New Zealand: Digital services are taxed at 15% under the Goods and Services Tax (GST).

7. Real Estate Services

• UK, Germany, Spain: VAT is typically applied to real estate transactions, especially for commercial properties and agent services.

8. Financial and Insurance Services

• UAE, Canada, EU countries: Certain financial services, such as insurance premiums, are either exempt or taxed at reduced rates depending on the jurisdiction.

VAT Exempt or Zero-Rated:

Certain services, such as healthcare, education, financial services, public transportation, cultural services, and those provided by non-profit organizations, are often exempt from VAT or taxed at reduced rates due to their social or public value. For example, many countries (e.g., EU, UK, Australia) exempt healthcare and education services to ensure accessibility, while public transportation is typically VAT-free to encourage use. Financial services and non-profit activities are also frequently VAT-exempt, aligning with broader social goals (OECD, EU, and local tax codes).

IV. Compliance Considerations

Compliance with VAT laws across jurisdictions requires businesses to be well-versed in local tax regulations. Unlike GST, which is designed to be more uniform across countries, VAT compliance is often decentralized, especially in the EU, where each member state has autonomy over its VAT rules.

• Cross-border VAT compliance: Businesses involved in international trade must ensure they correctly handle VAT registration, invoicing, and remittance in each country they operate in.
• Digital services: The One-Stop-Shop (OSS) in the EU and similar systems in other regions have simplified cross-border VAT filing for digital services, but registration and tax remittance are still required in the consumer’s jurisdiction.

 V. Implications for Specific Service Sectors

1.Professional Services

The taxation of consultancy, IT, and legal advisory services requires precise contract terms to address tax liabilities. In cross-border agreements, dual taxation risks necessitate clarity on place-of-supply rules.

2. Digital Services and E-Commerce

• India: GST at 18% applies to digital services provided by non-resident entities, supplemented by the Equalization Levy for certain transactions.
• EU: Digital services fall under VAT, with the OSS simplifying compliance for businesses offering services to multiple EU countries.

3. Healthcare and Education

•  Exemptions for core services in these sectors are common but inconsistent. Contracts for bundled offerings, such as premium healthcare services or educational software, must delineate taxable and non-taxable components to avoid disputes.

 4. Construction and Real Estate

• India: GST on construction services varies from 5% to 18%, depending on the project type.
• EU: Reduced VAT rates often apply to housing projects, with significant variation across member states.

VI. Practical Challenges in Contract Drafting: Tax Law Implications

Drafting commercial contracts that comply with complex and varying tax regulations can be challenging, particularly in cross-border agreements. Key tax issues must be addressed, as they differ by jurisdiction, transaction type, and evolving tax laws. Key considerations include:

1. Tax Allocation Clauses

Clear language is essential to define who bears the responsibility for taxes, including VAT, GST, or sales tax. Particularly in complex supply chains or cross-border transactions, these clauses must address potential disruptions or jurisdictional tax shifts. A well-crafted clause may read:

• “All taxes, including GST/VAT, levied under applicable law shall be borne by the service recipient unless otherwise agreed in writing.” This ensures transparency and minimizes future disputes regarding tax obligations.

2. Escalation Clauses

Contracts must contain provisions to adjust pricing if tax rates change during the contract term. This protects parties from unexpected increases in tax burdens that could affect profitability. A typical provision might state:

• “In the event of any change in applicable tax rates, the consideration payable shall be adjusted accordingly.” This clause helps maintain financial fairness and operational flexibility in fluctuating tax environments.

3. Indemnity Provisions

Incorporating indemnities for unexpected tax liabilities is crucial for protecting businesses, especially in cases of reverse charge mechanisms or withholding tax obligations. A robust indemnity provision might read:

• “The Seller agrees to indemnify and hold the Buyer harmless for any penalties, interest, or taxes incurred due to inaccurate tax filings or non-compliance with applicable tax laws.” This protects against unanticipated tax burdens that could arise from errors or shifting regulations.

4. Cross-Border Considerations

For international contracts, addressing place-of-supply rules and ensuring alignment with double taxation treaties is critical to mitigate tax exposure. Cross-border tax issues, such as the determination of VAT applicability or withholding taxes, must be carefully examined. For example:

• “The Parties agree to comply with all relevant international tax treaties, and any taxes arising from cross-border transactions shall be borne as per the prevailing laws of the jurisdiction of supply.” This ensures both parties are aware of their tax obligations and avoids double taxation or conflicting tax claims.

VII. Conclusion: Strategic Implications

The implications of tax laws on commercial contracts are significant, influencing pricing, risk allocation, and compliance. Failure to address key tax issues—such as VAT, GST, and withholding taxes—can lead to unexpected liabilities, disputes, and financial exposure, particularly in cross-border agreements where tax regulations vary across jurisdictions.

Key Risks:

1.Tax Allocation Issues: Unclear tax responsibilities can result in disputes and unexpected costs, particularly when tax laws change unexpectedly or differ by jurisdiction.

2. Impact of Tax Fluctuations: Without escalation clauses, businesses risk absorbing increased tax burdens, affecting profitability. These clauses ensure financial balance by adjusting contract prices in response to tax changes.

3. Indemnity Risks: The absence of indemnity clauses exposes businesses to penalties, interest, and tax liabilities arising from misinterpretation or non-compliance with complex tax regimes, especially in reverse charge or withholding tax scenarios.

4. Cross-Border Complexities: Failure to address place-of-supply rules and double taxation treaties in international contracts can result in double taxation and conflicting claims, leading to significant financial and reputational risks.

Meticulously drafted contracts with clear tax allocation clauses, escalation provisions, and indemnity clauses mitigate risks and ensure financial security. Addressing cross-border taxation challenges fosters compliance, reduces disputes, and supports long-term operational success. Ultimately, this proactive approach protects businesses, enabling smoother transactions in the global marketplace.

[1] Notification No. 11/2017-Central Tax (Rate), Central Board of Indirect Taxes and Customs, 28 June 2017, accessed 21 November 2024

[2] Notification No. 12/2017-Central Tax (Rate), Central Board of Indirect Taxes and Customs, 28 June 2017,  accessed 21 November 2024.

[3] Press Information Bureau, ‘GST Council Approves Key Recommendations’ (Press Release, 18 November 2024) https://pib.gov.in/Pressreleaseshare.aspx?PRID=1838020 accessed 21 November 2024.

[4] European Commission, ‘Value Added Tax (VAT)’ (European Commission, updated 9 August 2023) https://taxation-customs.ec.europa.eu/taxation/vat_en accessed 22 November 2024.

[5] HM Revenue & Customs, ‘VAT Rates’ (GOV.UK) https://www.gov.uk/vat-rates accessed 22 November 2024

[6] Ministry of Finance, VAT (Ministry of Finance UAE, 2024) https://mof.gov.ae/vat/ accessed 22 November 2024.

[7] South African Revenue Service, ‘Value Added Tax’ https://www.sars.gov.za/types-of-tax/value-added-tax/ accessed 22 November 2024.