True construction of a contract: guiding principles
Contract manufacturing means a work sub-contracted to any manufacturer by the owner of an intellectual property rights or product design. Depending upon the agreement between the parties, the manufacturer may even take the responsibility of marketing the products using the sub-contractor‟s brand and provide after-sales support. However, contract of sale is one whose main object is the transfer of, and the delivery of, the possession of a property. There are many common characteristics in both the types of contracts, some neutral in a particular contract and yet certain clinching terms in others. All that depends upon the facts and circumstances of each case, the answer to which is, not easy and has perplexed the jurists all over.
Recently, India has emerged as a favoured destination for contract manufacturing as it has developed a ready-to-go infrastructure; quality certified manufacturing units, and a huge supply of trained manpower to cope up with the production demands. With increasing contract manufacturing activities, the thin line between contract of sale and contract manufacturing needed a clear demarcation. This bulletin will explore the situations to see when a contract manufacturing will become a contract of sale and how that demarcation has been made by the courts with specific reference to deduction of tax at source (“TDS”).
1.0 Contract construction: essential elements
The contract of sale has been defined by courts in very clear terms as – “…a contract of sale is one whose main object is the transfer of property in, and the delivery of the possession of, a chattel as a chattel to the buyer. Where the principal object of work undertaken by the payee of the price is not the transfer of a chattel qua chattel, the contract is one of work and labour. The test is whether or not the work and labour bestowed end in anything that can properly become the subject of sale; neither the ownership of materials, nor the value of the skill and labour as compared with the value of the materials, is conclusive, although such matters may be taken into consideration in determining, in the circumstances of a particular case, whether the contract is in substance one for work and labour or one for the sale of a chattel”.1
Certain guidelines have been laid down by the Supreme Court in P.S. Company v. State of Andhra Pradesh2 to determine the true construction of a contract so as to determine, in turn, as to whether transaction covered by that contract is one of sale or of work and labour. Though these guidelines cannot be termed as infallible tests yet they provide valuable help and insights to arrive at correct decision. These guidelines are as under:
- The essence of the contract or the reality of the transaction as a whole has to be taken into consideration in judging whether the contract is for a sale or for work and labour.
- If the thing to be delivered has any individual existence before the delivery, as the sole property of the party who is to deliver it, then it is a sale.
- If the main object of the contract is the transfer from A to B, for a price, of the property in a thing in which B had no previous property, then the contract is a contract of sale.
- Where the main object of work undertaken by the payee of the price is not the transfer of a chattel qua chattel, the contract is one for work and labour.
- If the bulk of the material used in the construction belongs to the manufacturer who sells the end-product for a price that will be a strong pointer to a conclusion that the contract is in substance one for the sale of goods and not one for work and labour.
- A contract where not only work is to be done but the execution of such work requires goods to be used, may take one of three forms:
- The contract may be for work to be done for remuneration and for supply of materials used in the execution of the work for a price;
- It may be a contract for work in which the use of materials is accessory or incidental to the execution of work; or
- It may be a contract for supply of goods where some work is required to be done as incidental to the sale;
Essentially, where a contract is of the first type, it is a composite contract consisting essentially of two contracts, one for the sale of goods and the other for work and labour. The second type of work is clearly a contract for work and labour not involving sale of goods. While the third type is contract for sale where the goods are sold as chattels and some work is undoubtedly done, but it is done merely as incidental to the sale.
2.0 Contract manufacturing vs. contract of sale
The question whether contract manufacturing agreements are contract of sale has been decided by the Bombay High Court in Glenmark Pharmaceuticals Ltd.3 In this case, the assessee entered into an agreement with a third party for the manufacture of certain pharmaceutical products. Pursuant to the contract between them which was on a principal to principal basis, the assessee provided the formulations and specifications to the manufacturer and and the manufacturer affixed the trade mark of the assessee on the articles produced before sale. For the manufacture of the said products, the raw materials were purchased by the manufacturer and property in the goods passed to the assessee only upon delivery. Upon assessment the Assessing Officer from the income tax department took the view that the contract between Glen and the manufacturer was a contract of „work‟ and it amounts to tax deductible at source u/s 194C. Upon appeal, the Income Tax Appellate Tribunal upheld the contention of the assessee that the contract involved a sale and did not
represent a „contract for work‟ u/s 194C. Finally, on appeal the court dismissed the appeal and laid down the following principles –
“A contract for sale has hence to be distinguished from a contract of work. Whether a particular agreement falls within one or the other category depends upon the object and intent of the parties, as evidenced by the terms of the contract, the circumstances in which it was entered into and the custom of the trade. The substance of the matter and not the form is what is of importance. If a contract involves the sale of movable property as movable property, it would constitute a contract for sale. On the other hand, if the contract primarily involves carrying on of work involving labour and service and the use of materials is incidental to the execution of the work, the contract would constitute a contract of work and labour. One of the circumstances which is of relevance is whether the article which has to be delivered has an identifiable existence prior to its delivery to the purchaser upon the payment of a price. If the article has an identifiable existence prior to its delivery to the purchaser, and when the title to the property vests with the purchaser only upon delivery, that is an important indicator to suggest that the contract is a contract for sale and not a contract for work.”
Accordingly, to explain the above in clear terms, the following pointers can be noted
- Primarily, a contract for sale has to be distinguished from a contract of work. In case the real essence in a contract is the sale of movable property as movable property, it would constitute a contract for sale. Alternatively, contract of work and labour would include contracts involving carrying on of work of labour and service and the use of materials as incidental to the execution of the work.
- The contract in the instant case is not one of sale in the instant case based on the restrictions imposed on the manufacturer to utilise the formula provided by the assessee, affix the trade-mark of the assessee, and manufacture as per specifications provided by the assessee and to deal exclusively with the assessee show that.
- The agreement would constitute a contract for sale, if
- the property in the article passes to the customer upon delivery and
- the material that was required was not sourced from the customer/purchaser, but was independently obtained by the manufacturer from a third party;
- The current statutory position regarding the instant case is contained in the explanation (e) to section 194C inserted by the Finance Act 2009 to provide that the expression „work‟ shall not include manufacture or supply of a product according to the requirement or specification of a customer by using material which is purchased from a person other than such customer.
- The assessee imposed restrictions on the manufacturer as to quality of the goods, user of trade marks etc are merely matters of business expediency as clear from the facts below:
• The agreement was on a principal to principal basis,
• The manufacturer had his own establishment where the product was manufactured,
• The materials required in the manufacture of the article or thing was obtained by the manufacturer from a person other than the assessee and
• The property in the articles passes only upon the delivery of the product manufactured, the contract was one of “sale” and there was no obligation to deduct tax u/s 194C.
The court gave two simple illustrations to demonstrate applicability of the above-said principles – “A customer goes to a tailoring shop accompanied by a suit length in his hands and entrusts the same to the tailor for stitching a suit for him as per his measurements. The tailor by devoting his skill and labour stitches the suit and delivers the same to the customer. In this process the tailor utilises lining, buttons and threads of his own. The transaction would remain a contract for work and labour. The stitched suit delivered by the tailor to the customer is not a sale. It would not make any difference if the customer would have selected a piece of cloth of his own choice for a price to be paid or paid and having purchased the suit length left it with the tailor for being stitched into a suit. The property in the suit length had passed to the customer and physical possession over the suit length by the tailor thereafter was merely that of a bailee entrusted with the suit length.
However, if the tailor promises to stitch and deliver the suit for a price agreed upon, investing his own cloth and stitching materials such as lining, buttons and threads, and utilising his own skill and labour then though the customer might have chosen the piece of cloth as per his own liking as to the texture, colour and quality and given his own instructions in the matter of style, the transaction would remain a contract for sale of goods, that is, a stitched suit piece in as much as the object of the contract was to transfer property in the stitched suit piece along with delivery of the suit by the tailor to the customer, all investments, whether of material or of skill and labour having been made by the tailor incidental to the fulfillment of the contract.”
Finally, the court agreed and upheld the arguments of the pharmaceutical companies that contract manufacturing agreements entered into by them with other manufacturers amounted to a sales contract. Accordingly, this was held to be not liable to TDS under section 194C. This judgement brought certain clarity on the issue of deduction of TDS on sale contracts. Clearly, in sale of contract, what is paid as the price is not a deemed income, and hence not liable for TDS. Pursuant to this judgement, now the companies that outsource their manufacturing business to sub-contractors will not be liable to deduct TDS on payments to them and, in turn, will be allowed to treat these payments as deductible expenses.
1 Halsbury‟s Laws of England, 3rd edition, vol. 34, 6-7 as discussed in the State of Himachal Pradesh v. Associated Hotels of India Ltd. (AIR 1972 SC 1131) and Andhra Pradesh State Road Transport Corporation v. DCIT (2002) 74 TTJ 531 (Hyd.-ITAT).
2 56 STC 283.
3 ITA No. 2256 of 2009.