Applicability of GST on ‘Pre-operative’ rent for immovable property

1. Nature of business of GGL Hotel and Resort Company Ltd.

1.1 Nature of Business – The GGL was in the hospitality and real estate business. It had embarked on a project of starting a hotel and banquet. For the purpose of this project the GGL had taken land on lease from West Bengal Housing Infrastructure Development Corporation Limited (WBHIDCL) for 32 years.

1.1-1 Financial understanding between both of the parties was finalised on a lease premium+annual lease rent at the rate of 10% of the lease premium for the first 2 years, which would be escalated at the rate of 5% per annum in the subsequent years from the start of the 3rd year over the last annual lease rent per annum. The project was proposed to be completed within a period of 2 years and the lease rent paid during the aforesaid pre-operative period was capitalized in the books of account by the GGL. The WBHIDCL charged GST at the rate of 18% on the lease rent.

Question

2.Whether ITC would be available on input tax paid on lease rent during pre-operative period for the leasehold land on which the resort was being constructed?

This article deals with the tax treatment of lease rent during pre-operative period only and not for the post–operative period.

3. Provision: Section 17(5)(d) of the CGST Act/WB GST Act deals with Blocked Credit concept

“(d) Notwithstanding anything contained in sub-section (1) of section 16 and sub-section (1) of section 18, input tax credit shall not be available in respect of the following, namely:—

goods or services or both received by a taxable person for construction of an immovable property (other than plant or machinery) on his own account including when such goods or services or both are used in the course or furtherance of business.”

The expression “construction” includes re-construction, renovation, additions or alterations or repairs, to the extent of capitalisation, to the said immovable property.

4. Case analysis

(1)	GGL Hotel and Resort Company Ltd., In re [2019] 101 taxmann.com 138/71 GST 577 (AAR – West Bengal)
(2)	GGL Hotel & Resort Company Ltd., In re [2019] 105 taxmann.com 248 (AAAR – West Bengal)

4.1 A few issues before going into the case analysis.

First Issue : Whether leasehold land is the immovable property?

Reply :  The word ‘immovable property’ is not defined in GST law. As per section 2(26) of the General Clauses Act, “immovable property” shall include land, benefits to arise out of land, and things attached to the earth, or permanently fastened to anything attached to the earth. Therefore, leasehold land is the immovable property.

Second Issue : Is there any difference between lease premium and lease rent?

Reply : Yes, Lease premium pretends for upfront premium and lease rent is the consideration to be paid on interval basis.

Third Issue : Whether 17(5)(d) is applicable for builder?

Reply : Section 17(5)(d) may be applied for person irrespective of the fact whether he is builder or otherwise. Section 17(5)(d) uses the word ‘taxable person’ and not just the ‘builder’. It says that ITC shall not be available for goods or services or both received by a taxable person for construction of an immovable property (other than plant or machinery) on his own account. So, if the taxable person himself is builder and he is receiving goods or services or both for the for construction of an immovable property (other than plant or machinery) on his own account then also ITC shall be blocked u/s 17(5)(d).

Fourth Issue : Why this ruling is focusing on the lease rent and not on the lease premium?

Reply : One time lease premium is exempted vide Notification No.12/2017 CT (R), Dated 28-6-2017. Entry is reproduced as below

“One time upfront amount (called as premium, salami, cost, price, development charges or by any other name) leviable in respect of the service, by way of granting long-term (thirty years, or more) lease of industrial plots, provided by the State Government Industrial Development Corporations or Undertakings to industrial units.”

Then an amendment came into the picture w.r.t. this entry vide Notification No. 32/2017-Central Tax (Rate), dated 13-10-2017, w.e.f. 13-10-2017.

Upfront amount (called as premium, salami, cost, price, development charges or by any other name) payable in respect of service by way of granting of long-term lease of thirty years, or more of industrial plots or plots for development of infrastructure for financial business, provided by the State Government Industrial Development Corporations or Undertakings or by any other entity having 50 per cent or more ownership of Central Government, State Government, Union territory to the industrial units or the developers in any industrial or financial business area.

Explanation.—For the purpose of this exemption, the Central Government, State Government or Union territory shall have 50 per cent or more ownership in the entity directly or through an entity which is wholly owned by the Central Government, State Government or Union territory.

It is clear that upfront premium amount is exempted supply and so, there cannot be the question of input tax and input tax credit on this transaction. Lease rent is not exempted and so the tax is levied and the same is bone of contention.

Fifth Issue : What is the significance of ‘capitalisation’ in section 17(5)(d)?

There are 2 interpretations w.r.t. construction (we are discussing on the construction activity only and not about re-construction, renovation, additions or alterations or repairs) :

1st : ITC is blocked only if construction is capitalized [Colour of construction is required to be tested]

2nd : ITC is blocked even if construction is not capitalized as the explanation is talking about those activities which are not construction activities but included in the definition of construction [Here in this approach colour of construction is required to be tested]. It is beyond doubt that capitalization test is always required to be performed in case of re-construction, renovation, additions or alterations or repairs to the said immovable property.

Ruling has adopted the first way of interpretation.

5. Analysis of Arguments by GGL

5.1 First Argument – The GST Act does not define the exact nature of the goods and services received that are deemed to relate to construction of immovable property. As a result, the meaning of construction cost is to be construed as is taken in the modern parlance. GGL is required to pay the lease rent to the lessor whether or not the construction has been carried out and shall be paying the lease amount even after the completion of the construction of the immovable property for the balance period of the lease period.

5.1-1 AAR countered – The GGL will admittedly capitalize the lease premium The property is, therefore, admittedly being constructed on the GGL’s own account and treated as fixed asset, including the lease rental paid.

5.1-2 Comment – Argument of GGL can not sustain in the law because of following reasons:

Section 17(5)(d) says ITC shall not be available in respect of goods or services or both received by a taxable person for construction of an immovable property (other than plant or machinery) on his own account.

Taking land on lease is nothing but a service as per section 2(102) of the CGST/WBGST Act.

Here law does not refer to the specific category of goods or services.

5.2 Second Argument – The lease rent for the pre-operative period is capitalized under the head ‘Leasehold Land’ and not under the head ‘Building Block’. It can, therefore, be inferred that the lease rent is not used for construction of the resort.

AAR stated  – Whether the lease rental paid for the pre-operative period is capitalized under the head ‘Leasehold Land’ or ‘Building Block’ is of little significance in this context.

AAR says that capitalization under the head ‘Leasehold Land’ or ‘Building Block’ is of little significance is creating apprehension. Does it not mean that there is a gap where ITC cannot be blocked by using this gap?

Comment  – AAR says that classification of lease rental is of little significance, whereas classification is of no significance (instead of ‘little significance’).

5.3 Third Argument – The renting services cannot be said to be received for the construction of immovable property as there is no nexus, direct or indirect, between the construction of the hotel and banquet and the rental service availed.

AAR stated – The GGL’s argument about absence of any nexus – direct or indirect – between the lease rental and construction of the buildings for hotel, etc., is incorrect. Construction of the hotel, etc., is impossible unless the GGL enjoys uninterrupted right to use the land. It is clear from the Agreement that the GGL cannot enjoy that right if he fails to pay the lease rental. Construction of the immovable property is, therefore, critically dependent on the supply of the leasing service. The nexus between them is, therefore, direct and the two are inseparable. The leasing service for right to use the land is, therefore, a supply for construction of the immovable property.

Arguments in continuity before AAAR – Construction of an immovable property is critically dependent on the supply of the leasing service. So there is an inseparable and direct nexus between lease rent of land and construction of the building. The lease rent if capitalized, will be capitalized under “Leasehold Land” and not under the “Building Block”. Thus, lease rent is not used for construction of the building. Further, the same cannot be used for construction of land since no development of land is taking place. There is no nexus between lease rent of land and construction of the building.

AAAR countered – Para A clause (i) of the Lease Agreement clearly stipulates that the Lessee shall use demised land exclusively for the purpose of constructing building at the cost of the Lessee. Further, the GGL is entitled to collect, inter-alia, all revenue from the project. So, the GGL’s argument on the absence of any nexus, direct or indirect between lease rental and construction of the Project is incorrect. The Lease Rent paid during preoperative period for the lease hold land, on which the construction activity had been taken for furtherance of business, has direct nexus with the Lease Rent and construction of resort. Had the GGL not paid the Lease Rent during pre-operative period they would not be able to take any construction activity thereon. Further, the asset will be capitalized in the books of account of the GGL. So it is clear that the GGL is building the Eco Resort on its own account for furtherance of business, and credit of Tax paid on input goods/services is debarred in terms of section l7(5)(d) of the GST Act.

Comment – In view of AAR, nexus between leasing services and construction of hotel is said to be a direct nexus and two are inseparable. GGL says both types of nexus, i.e., direct and indirect whereas AAR backed it’s view by referring to that both are having direct nexus (but not referring to the indirect nexus). An issue arises, whether ITC shall be blocked if the goods or services are having indirect nexus. In our opinion, even if there is indirect nexus, ITC is blocked.

Further, mere capitalization of the lease rental cannot make such services as received for the construction of immovable property.

5.4 Fourth Argument :

Arguments before AAAR  – The building will be constructed on a part of leased area (only 7,861.64 sq. m. out of 20,039.75 sq. m.) and the unconstructed area would be used for auxiliary services. Thus, the lease rent is partly used for construction of immovable properly and the GST on lease rental in respect of the area on which no immovable property is constructed would be eligible for input tax credit.

AARR countered – The Respondent submitted that the availability of input tax credit on goods and services used for construction of immovable property except plant and machinery comes under blocked credit as per the provisions of section 17(5)(d) of the CGST/WBGST Act. Further, the GGL’s prayer for allowing proportionate credit of lease rental on the unconstructed area of the project only strengthens the point that input tax credit on lease rental is not available in case of construction of an immovable property.

Comment – This was the fresh argument raised by GGL Hotel and Resort Company Ltd. It is like spider’s web where GGL itself is entrapped in it’s own net. AAAR smartly countered this one !!

5.5 Fifth Argument :

Arguments before AAAR – GGL said that it was providing construction service to the WBHIDCL and it was not the construction of an immovable property on his own account. Hence, the input on supply of construction should not be blocked. In support of this argument the GGL emphasized on the insertion of clauses in Para A (v) and (vi) of the Agreement, whereby the GGL is barred from excavation of land and removal of sub-soil except in the normal course of construction or alter the location of sewer/water connection.

AAAR countered – GGL acquired the land on lease for the sole purpose of building an Eco-Resort on DBO (Design, Built and Operate) Model in conformity with the development guidelines set by the West Bengal Housing Infrastructure Development Corporation Limited (WBHIDCL), who has been entrusted with the development of the entire area of ECO Park, New Town. WBHIDCL not only holds the title of the leased land but also is the town planner. Development/construction guidelines and restrictions are an integral part of town planning with an objective to conserve environment and ecosystem and is not a unique feature of this particular Lease agreement between the GGL and the WBHIDCL.

The project is building and operating a Hotel and Banquet with all added features in totality on the entire area of land measuring 20,039.75 sq. m. on lease. GGL’s submission that it is providing two types of services to the WBHIDCL, namely, construction service and operating service is incorrect. As per the Lease Agreement the scope of the project is to Design, Built and Operate the Eco-Resort. Now construction service is classified under SAC 9954 and the recipient of the service at the end of the construction also comes in possession of an asset in the manner of an immovable property. Para A clause (x) of the Lease Agreement stipulates that the GGL “shall restore the land to its original condition before expiry of lease period, and again Para A clause (xx) stipulates that at the end of lease period the GGL “shall make over peaceful vacant Khas possession of the demised land in as good a condition as the same is now ” to the WBHIDCL. So it is clear that the WBHIDCL holds the ownership title of the land only and holding no proprietary interest in the immovable property constructed or being constructed on it. The GGL is not providing any construction service to the WBHIDCL and also will not be operating the hotel on behalf of the latter. Further, the Eco-Resort comes not only with hotel building but also with swimming pool, cafeteria, outdoor barbeque, landscape gardens. The construction of Resort is not limited to the hotel building only as a significant amount of construction is involved for creating swimming pools and landscaping. The area for auxiliary services as presented by the GGL cannot be truncated from the area of the hotel building; the Resort and its facilities come under a single project. So the GGL’s argument of ownership of the project lies with the WBHIDCL is incorrect. Further, the GGL at the same time cannot capitalize the constructed property and not have ownership rights.

Comments – AAAR seems to have wrongly drafted the treatment of capitalization of the constructed property.

At the bottom of para 12 of AAAR ruling, it has mentioned “Further the GGL at the same time cannot capitalize the constructed property and not have ownership rights.” Whereas para 14 of AAAR ruling said “Further, the asset will be capitalized in the books of account of the GGL. So it is clear that the GGL is building the Eco-Resort on its own account for furtherance of business, and credit of Tax paid on input goods/services is debarred in terms of Section l7(5) (d) of GST Act.”

In our view the building will be capitalized in the books of GGL and thereby ITC shall not be available as mentioned in para 14. Conclusion reached upon by AAAR was same but it seems that they have drafted it mistakenly in para 12.

One may kindly refer to AS-19 Leases (Ind AS 116 wherever applicable), AS-10 Property, Plant and Equipment (IND AS 116) to understand the capitalization principle and treatment of lease in hands of lessor and lessee.

6. Conclusion

It can be inferred that AAAR has rightly upheld the decision of the AAR in above case. One may recall the judgment of the HC of Orissa in case of Safari Retreats (P.) Ltd. v. Chief Commissioner of Central Goods & Services Tax [2019] 105 taxmann.com 324 (Orissa) based on the same provision. It is held that in case of Safari Retreats (P.) Ltd. (supra) that if assessee is required to pay GST on rental income arising out of investment made in construction of shopping mall on which he has paid GST, it is eligible to take benefit of input credit on GST, which he has paid for construction and restriction under section 17(5)(d) is not applicable. Though judgment is pro-assessee, still this judgment is not free from the doubts on ITC. Interpretation taken by the Hon’ble HC for the wordings ‘on own account’ and acceptability of arguments on ITC eligibility by referring Eicher Motors Case are highly questionable. Therefore, this judgment is not referred to used here in this article for analysis.