CCE Kerala v. Larsen & Toubro: no service tax on works contracts before 1 June 2007

The facts in brief

The lead matter was Civil Appeal 6770 of 2004, filed by the Commissioner of Central Excise and Customs, Kerala against Larsen & Toubro Ltd. A tagged Civil Appeal 4468 of 2006 by CCE Vadodara-II and Civil Appeal 6434 of 2015 came up with it. The dispute had been pending for more than a decade, and the Department's repeated attempts to recharacterise composite construction contracts under generic Finance Act 1994 service heads had generated parallel CESTAT and High Court litigation across the country.

L&T's composite contracts in issue were turnkey civil-engineering projects, commercial-complex construction and residential housing construction. The Department's case was that a service component lay embedded in each contract and was taxable under one or more of five heads in s.65(105) of the Finance Act 1994: commercial or industrial construction service (s.65(105)(zzq)), construction of residential complex (s.65(105)(zzzh)), erection, commissioning or installation (s.65(105)(zzd)), turnkey project under engineering consultancy (s.65(105)(g)) and the general engineering-consultancy entry.

The Department's preferred administrative practice was either to treat the entire contract value as a taxable service (which the trade resisted on the obvious ground that goods constituted a large share) or, more commonly, to tax a notional 33 per cent of contract value as the "service component" — a figure drawn from abatement notifications rather than from any statutory bifurcation rule. The 33 per cent device was applied without reference to the actual goods-versus-services share of any particular contract.

L&T's defence rested on a constitutional reading of the post-46th-Amendment architecture and on the structure of the Finance Act 1994 itself. The Court was asked to decide whether the Finance Act 1994, as it stood before the 1 June 2007 amendment which introduced s.65(105)(zzzza) "Works Contract Service", could carry the Department's pre-2007 levies on composite construction contracts.

The constitutional question

The case sat at the intersection of two constitutional regimes. On the States' side, Article 366(29A)(b) — inserted by the 46th Constitutional Amendment 1982 — deemed the transfer of property in goods involved in the execution of a works contract to be a sale of goods, allowing State VAT to capture the goods-element. The Supreme Court's 1993 decision in Gannon Dunkerley v. State of Rajasthan had mapped how far that deeming fiction could carry the States: only the value of goods at the time of incorporation, not labour, not service margin, not overheads.

On the Union's side, no parallel constitutional mechanism existed before 2017. Service tax derived from Parliament's residuary entry. To tax the service-element of a composite works contract, the Union had to identify, by statute, both a taxable event (the charge) and a method to value the service-element separately from the goods-element (the machinery). The constitutional question crystallised: in the absence of both, could the Department use generic Finance Act 1994 heads to capture the service-element of a composite construction contract?

What the Court held

The five generic heads catch only service contracts simpliciter

Nariman J., writing for himself and Sikri J., held that each of the five Finance Act 1994 heads relied on by the Department referred — as a matter of statutory interpretation — to service contracts simpliciter. None reached a composite contract that combined service with the transfer of goods.

A "commercial or industrial construction service" provider who supplies labour and supervision against payment was taxable. A turnkey contractor who supplies labour together with cement, steel, sand, fixtures and plumbing — and transfers property in those goods to the owner as the structure rises — was not within the same head, because the head was not drafted to absorb that combination.

Charge plus machinery — the architectural rule

The judgment articulated a discipline applicable to every indirect-tax statute, not only to the Finance Act 1994. A service-tax charge requires two distinct legislative components: a charging section that identifies the taxable event and a rate; and a machinery provision that identifies the value on which the rate operates. For a composite contract, the second limb additionally requires a bifurcation rule — a statutory method to separate the service-value from the goods-value.

The pre-2007 Finance Act carried neither the charge nor the machinery for the composite category. The Department's 33 per cent rule of thumb — drawn from abatement notifications and applied administratively — was a "judicial creation" without legislative foundation. It could not survive scrutiny because it was not a Parliament-authored bifurcation rule but an administrative shortcut filling a statutory void.

The 2007 amendment is the inflection point

Parliament's introduction of s.65(105)(zzzza) "Works Contract Service" with effect from 1 June 2007, together with the Works Contract (Composition Scheme for Payment of Service Tax) Rules 2007, supplied both the missing charge and the missing machinery. The composition rules offered a percentage-of-contract-value alternative — but only because Parliament now expressly authorised that bifurcation. The choice of commencement date, the Court observed, was itself significant: Parliament had implicitly acknowledged that the prior architecture had been deficient.

The constitutional split

The judgment crystallised the post-46th-Amendment distribution of competence in a single sentence that has since been quoted in every dual-tax dispute under the Finance Act 1994 and the State VAT regimes.

The Court rejected the Department's appeals. CESTAT's pro-assessee orders were affirmed. A decade of pre-2007 service-tax disputes on composite construction contracts was closed in a single ruling.

What the judgment did not decide

The bench did not address the post-1 June 2007 valuation question: what percentage of a composite contract represents the service component under s.65(105)(zzzza). That surface was left to the 2007 Composition Rules and to subsequent CESTAT jurisprudence. It did not pronounce on whether the abatement notifications — particularly Notification 1/2006-ST — which had provided a 33 per cent abatement for construction services, could survive as a stand-in machinery provision. Their doctrinal status remained uncertain.

The refund consequences for assessees who had paid service tax under protest on pre-2007 composite contracts were not adjudicated. Limitation and unjust-enrichment issues were left to refund-claim courts under s.11B of the Central Excise Act. The interaction with State VAT — whether a contractor who had paid State VAT on the deemed goods-element and Union service-tax on the deemed service-element had any double-taxation remedy — was also untouched.

Finally, the bench did not address the GST-era treatment of works contracts. Under CGST Act 2017 Schedule II paragraph 6(a), works contracts are deemed services with no goods-element split. The Article 366(29A)(b) deeming fiction is, for GST purposes, statutorily reversed. The 2015 judgment's relevance survives chiefly for the pre-2017 refund corridor.

The doctrinal architecture

The judgment is the Union-side companion to L&T v. State of Karnataka (2014), which had addressed the States' side of the same composite-contract puzzle. Read together, the two decisions map the constitutional split. The States may tax the goods-element of works contracts under Article 366(29A)(b), constrained by the Gannon Dunkerley value-at-incorporation discipline and the eight-deductions template. The Union may tax the service-element only with both a charge and a machinery provision — both of which existed only from 1 June 2007.

The charge-and-machinery architecture has travelled well beyond works contracts. In Northern Operating Systems v. Commissioner of Customs and Service Tax (2022), the same discipline governed the service-tax treatment of employee secondment from foreign parent to Indian subsidiary. In Mohit Minerals v. Union of India (2022), the absence of a clear charging-event for ocean freight on CIF imports under the IGST Act helped sink the impugned notifications. The discipline is now a settled rule of indirect-tax interpretation.

The 2017 GST architecture collapses the works-contract split: under CGST Schedule II paragraph 6(a), works contracts are deemed supplies of services, with no Article 366(29A) split required. Article 246A's concurrent legislative power over GST replaces the 46th-Amendment deeming fiction as the constitutional foundation. The result is administratively cleaner; the doctrinal grammar built between 1992 and 2015, however, continues to discipline how courts read the new statute when fresh composite-supply disputes arise under CGST s.8.

After the judgment

For the pre-2007 refund window, the 2015 decision generated thousands of refund claims that travelled through CESTAT into 2018 and beyond. Most were resolved in the assessee's favour subject to limitation and unjust-enrichment defences. The Department made one further attempt to unsettle the position: in Total Environment Building Systems Pvt Ltd v. Deputy Commissioner of Commercial Taxes, decided 16 August 2023, the Supreme Court was asked to reconsider the Larsen & Toubro holding. The plea was rejected, the 2015 ratio reaffirmed.

The GST-era statutory treatment of works contracts as services means that the Union-States competence split which animated the 2015 judgment has lost most of its practical bite. What survives — and what makes CCE Kerala v. L&T a permanent fixture in tax-law teaching — is the charge-and-machinery architecture. Every Department attempt to retrofit a tax on a composite or hybrid transaction without a Parliament-authored bifurcation rule encounters the same line: a charge without machinery is no charge at all.

Related on Valkya

• State of Madras v. Gannon Dunkerley (1958): the original works-contract decision
• Gannon Dunkerley v. Rajasthan (1993): eight permissible deductions
• BSNL v. Union of India: composite transactions and the aspect doctrine
• Larsen & Toubro v. Karnataka: builder-developer apartment sales as works contracts

Sources

1. LiveLaw — "Supreme Court: Service Tax Not Leviable on Composite Work Contracts Prior to Finance Act 2007": https://www.livelaw.in/top-stories/supreme-court-service-tax-not-leviable-composite-work-contracts-finance-act-2007-205536
2. SCC OnLine Blog — "No service tax can be levied on indivisible works contracts prior to June 1, 2007": https://www.scconline.com/blog/post/2015/08/27/no-service-tax-can-be-levied-on-indivisible-works-contracts-prior-to-june-1-2007/
3. SCC OnLine Blog — "Works contracts leviable to service tax: legal update" (2023 reaffirmation): https://www.scconline.com/blog/post/2023/08/24/works-contracts-leviable-to-service-tax-legal-update/
4. Bar and Bench — Arvind Datar column on the Gannon Dunkerley test: https://www.barandbench.com/columns/legal-notes-by-arvind-datar-the-gannon-dunkerley-test-incorrect-and-unnecessary-dilution
5. Supreme Court of India — official judgment archive: https://api.sci.gov.in/jonew/judis/42870.pdf