Exclusion of works contracts from the ambit of the MSME Act, 2006

On July 26, 2021, during the question hour in Parliament, Union Finance Minister Nirmala Sitharaman assured that she is personally looking into the issue of payment to Micro, Small, Medium Enterprises (MSMEs) being made within 45 days, by the Centre and its public undertakings. The reason for such focus on MSMEs is because they are said to contribute nearly 30% of the nation's GDP.

The COVID-19 pandemic adversely impacted the sustenance and growth of MSMEs. In such precarious times, it becomes necessary that such enterprises are protected and made legally aware of their rights, before entering into contracts. One such aspect requiring vigilance is the exclusion of “Works Contract” from the ambit of the Micro, Small and Medium Enterprises Development Act, 2006.

This article is focused on identifying such characteristics of a works contract, the reasons for its exclusion from the Act, and the way ahead.

Understanding the MSME Act, 2006

The legislature, with an intention to streamline, promote and protect MSMEs, enacted the said Act, on June 16, 2006.

The said Act provides for a Facilitation Council, which is empowered to adjudicate disputes - firstly through means of conciliation, failing which, arbitral proceedings can be initiated. The Arbitration and Conciliation Act, 1996, would govern such proceedings.

Any enterprise, to fall under the said Act, is required to file a memorandum and register itself with the state government or the Central government, as the case may be.

An enterprise can be a supplier of either goods and/or services and provide the same to a buyer, as defined in the Act. In the event of non-payment/delayed payment, an enterprise can approach the Facilitation Council.

An element critical to determine delayed payment is identifying the “appointed day”, which is defined under the Act as:

“…the day following immediately after the expiry of the period of fifteen days from day of acceptance or from the day of deemed acceptance of any goods or any services by a buyer from a supplier.”

The “day of acceptance” is further explained as either a day of actual delivery of goods and/or services or in case of an objection in writing by the buyer, then within fifteen days from such delivery of goods or rendering of services.

Upon having checked all the above essentials, an enterprise can approach the Facilitation Council, in case of non-payment/delayed payment. The exception to this mechanism is when MSMEs enter into a works contract. It is therefore necessary to understand what exactly is a works contract and the reasons for its exclusion from the ambit of the MSME Act.

Concept of “Works Contract” and reasons for exclusion from MSME Act, 2006

Works contracts are distinct from usual commercial contracts. The Supreme Court, in the case of CCE Customs v. Larsen & Toubro Ltd observed that a works contract is separate species of contracts. It is distinct from the contact for service as is recognized by the world of commerce as such.

Performance of a works contract would typically involve supply of goods and/or services, installation and maintenance. In the case of M/s Kone Elevators India Pvt Ltd v. State of Tamil Nadu, the apex court observed that if a contractor was required to install a lift, the nature of works would be a works contract, as it would include not just purchasing of the component of the lift, but also installation.

The Supreme Court upon considering CCE Customs, laid down four distinctive characteristics of a works contract, namely:

(i) The performance is not divisible into an exclusive contract for supply of goods or services with a caveat that although a works contract is indivisible, yet by a legal fiction, it is divided into parts for sale of goods and for supply of labour and services.

(ii) The concept of a dominant nature test does not apply to works contract.

(iii) A works contract, as in Clause 29A of Article 336 of the Constitution of India, sweeps in all genres of works contracts and is not narrowly construed to cover one species of contract to provide for labour and service alone.

(iv) The “overwhelming component test”, “the degree of labour and service test” or “degree of intention test” will not apply to work of composite nature.

The apex court therefore concluded that the nature of a works contract is distinct, indivisible and composite and hence a works contract is not amenable to the MSME Act, 2006.

The High Court of Bombay also followed these observations in its order and judgment of Sterling Wilson Pvt Limited v. Union of India & Ors, wherein a dispute arose due to awarding of a tender for design, installation and service of firefighting and detection systems. Following M/s Kone Elevators and CCE Customs, it was observed that in case of disputes arising out of performance/non-performance of a works contract, the MSME Act cannot be invoked, due to its composite nature.

In PL Adke v. Wardha Municipal Council, in a contract for planning, designing, constructing, operating and maintaining water supply and sewerage scheme, the contractor claimed to be an MSME. The contractor invoked provisions of Section 9 of the Arbitration and Conciliation Act against deductions in RA bills. The High Court of Bombay held that the nature of the contract was composite, indivisible and continuous, and hence was a works contract. To such a contract, the provisions of MSME Act will not apply. In absence of an arbitration clause, it was observed that even the Arbitration Act will not apply.

The Allahabad High Court in M/s Rahul Singh v. Union of India & Ors also reiterated this view. It further held that the MSME Act does not require a court of ;aw to deconstruct the works contract into its elements of supplying goods and providing services.

Practical difficulty in the application of the Act to a works contract is determining the “appointed date” or the “date of acceptance”. This is imperative for Facilitation Council while adjudicating the dispute relating to payment and awarding of interest thereof. Since a works contract is composite, continuous and indivisible, ascertaining the appointed date or a date of acceptance is next to impossible.

The way forward

The MSME Act is a beneficial legislation. The exception to its applicability is a works contract. The issue is pending consideration before the apex court in SLP (C) No. 4970 of 2021 IX.

As a way ahead, it would be advisable for the legislature to consider the rulings of various courts and clarify in the MSME Act, that the same will not be applicable to works contracts. Such clarification would be ideal to protect the interests of all such enterprises.

Until such clarification, every MSME is required to be aware and prudent of the nature of contract it enters into. The key lies in understanding every contract with a legally vigilant eye and ensuring the following:

a. To understand and identify the nature of the contract based on its characteristics,

b. To negotiate the terms of the contract and devise a mutually agreeable dispute resolution mechanism. This will ensure that the enterprise is not left remediless.

c. To be conscious that unlike a regular contract, the “degree of intention test” will not be applicable.

Thus, understanding the construct of a contract, negotiation and providing for a dispute resolution mechanism are the ways to protect the interests of MSMEs.

The author is an advocate practicing at the High Court of Bombay and NCLT, Mumbai.