Goods & Services Tax (GST) in IndiaApplicability of GST on Liquidated Damages, Compensation and Penalty arising out of Breach of Contract

Introduction

The Central Board for Indirect Taxes and Customs (CBIC), after the 47^th Goods and Services Tax (GST) Council Meeting held in Chandigarh; issued a Circular dated 03.08.2022 bearing No. 178/09/2022-TRU (the Circular), explaining the taxability of certain activities or transactions as the supply of service of agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act, in order to remove misunderstandings and mitigate legal issues.

The CBIC examined the extent of relevant entry of Schedule II of the Central Goods and Services Tax Act, 2017 (CGST Act) in terms of applicability of GST on payments made in the form of liquidated damages, compensation, penalty, cancellation charges, late payment surcharge, and so on arising from a breach of contract.

It has been stated that payment cannot be anticipated for doing an act, abstaining from performing an act, or tolerating an act in the absence of an expressed or implied promise by the receiver. Furthermore, payments such as liquidated damages, salary loss for early termination of employment, penalty for check dishonour, and so on are not a factor in tolerating a conduct or condition. Rather, such payments are made to avoid contract violation or non-performance and are thus only “events” in a contract.

Examining Para 5(e) of Schedule II of Central Goods and Services Tax Act, 2017

The CBIC has examined the extent of paragraph 5 (e) of Schedule II of the CGST Act, which has three parts as follows:

• Agreeing to the obligation to refrain from an act;
• Agreeing to the obligation to tolerate an act or a situation; and
• Agreeing to the obligation to do an act

“Agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act” is included in the definition of supply. The Circular has provided examples of practices that fall within this category:

1. Agreeing to the obligation to refrain from an act: This includes non-compete agreements, in which one person promises not to contend with the other in a product, service, or geographical region in exchange for a consideration from the other party. Another example of an activity would be a builder abstaining from erecting more than a specific number of stories, although being licenced to do so by municipal authorities, in exchange for compensation given by a neighbouring housing complex that wishes to safeguard its sunlight.
2. Agreeing to the obligation to tolerate an act or a situation: Allowing a shopkeeper to operate from the pavement in front of his shop in exchange for a monthly payment by the hawker or Residential Welfare Association accepting loud speakers being used for early morning prayers by a school in exchange for compensation are examples of these activities.
3. Agreeing to the obligation to do an act: This includes the case where an industrial unit commits to install equipment for zero emissions at the request of the Residential Welfare Association of a neighbouring residential complex in exchange for a fee paid by such Residential Welfare Association, despite the fact that the emissions from the industrial plant was within the permissible limits and the individual unit had no legal obligation to do so.

It is made clear that there must be a necessary and adequate link between the supply and the consideration. Furthermore, the following criteria are required to qualify any activity or transaction under the appropriate entry, as under:

• The actions must be governed by a “contract” or “agreement” (whether express or implied).
• The agreement entered into between the Parties must be a stand-alone agreement. It can exist as an independent stand-alone contract or as part of another contract.
• The contract must be for a ‘consideration’ in return from one party to another.
• A contract cannot arise simply because money is transferred from one party to another.

Non-Applicability of GST on Specified Transactions

The Circular underlined that GST will not be levied in certain circumstances. The CBIC has offered thorough clarifications on the following specific operations or transactions:

1. Liquidated Damages

Liquidated Damages are paid in order to compensate for a loss, injury or damage that is suffered by the aggrieved party due to breach of contract under Section 73 of the Contract Act, 1872. Liquidated damages are a representation of the loss and damage that the parties agree would occur as a result of contract violation.

A contract may include the payment of liquidated damages to ensure performance and prevent non-performance, unsatisfactory performance, or late performance. A party that has suffered a breach of contract cannot be deemed to have condoned or accepted the other party’s deviation or non-fulfilment of the commitment.

In such instances, liquidated damages are simply a transfer of funds from the aggrieved party to the party that suffers loss or harm as a result of the violation. A contract’s desired outcome is not liquidated damages. As a result, such payment would not be considered as consideration for supply and hence, would not be taxed.

However, if payment represents consideration for a supply, it is taxed regardless of what name it is labelled. As a result, if the payment does not reflect the “object” of the contract, it cannot be deemed to be “consideration.”

2. Compensation for Cancellation of Coal Blocks

The Hon’ble Supreme Court invalidated coal block/mine allocations in 2014 in a ruling in the case of Manohar Lal Sharma v. The Principal Secretary & Ors. [Writ Petition (Crl.) No. 120 of 2012] dated 24.09.2014. Following that, the Coal Mines (Special Provisions) Act, 2015 was passed, which provided for the allocation of coal mines and the vesting of title, rights, and interest in and over the land and mine infrastructure to the successful allottees and bidders.

Compensation was given to previous mine allottees in accordance with the said Supreme Court judgement. As a result, there was no agreement between such coal block allottees and the Government. Consequently, such former allottees cannot be deemed to have rendered a service to the Government by consenting to suffer the cancellation of the allocations.

Furthermore, it cannot be claimed that the cancellation compensation was a consideration for such service and thus, cannot be taxed.

3. Cheque Dishonour Fine/Penalty

No supplier wants a cheque written to him to be dishonoured. It adds to his administrative costs and disrupts his usual activities and cash flow. A fine or penalty for cheque dishonour is not a consideration for any service and is not taxed.

The provider makes no implicit offer or readiness to accept the deposit of an invalid, fraudulent, or worthless instrument. These transactions are equivalent to a fee or penalty levied by a supplier or bank for cheque dishonour.

The aforementioned fine/penalty is not levied in exchange for tolerating the conduct or event. Rather, it is imposed for not tolerating and to punish and discourage such an act.

Therefore, the Circular clarifies that the cheque dishonour fine or penalty does not constitute consideration for any service and therefore, is not taxable.

4. Penalty imposed for Violation of Laws

Penalties imposed for infractions of legislation, such as traffic or environmental offences, are not compensation for any supply received and are not taxable. There is no agreement between the Government and the offender stipulating that the violation would be tolerated or accepted in exchange for payment of a fee or penalty. The same holds true for GST also.

5. Forfeiture of salary or payment of the bond amount in the event of the employee leaving the employment before the minimum agreed period

The employment contract includes provisions for salary forfeiture or bond recovery in the event of an employee leaving the job before the minimum agreed-upon period. The aforementioned sums are recovered by the employer as fines for discouraging non-serious employees from seeking work and to deter and prevent such behaviour.

Furthermore, the employee receives nothing in exchange for such payment. As a result, such recoveries by the employer are not taxed as consideration.

6. Compensation for Not Collecting Toll Charges

The dispute arose as to whether the compensation provided to the concessionaire by project authorities, namely the National Highways Authority of India (NHAI), in lieu of toll suspension during the demonetisation period was taxable as a service.

It has been clarified in Circular No. 212/2/2019-ST dated 21.05.2019 that toll operators give access to a road or bridge, with toll rates being only a consideration for that service. NHAI continues to provide the service for which the consideration was received during the relevant time.

In this regard, it is now stated that the service cannot be regarded to have changed just because consideration was received from someone other than the real user of the service.

7. Late Payment Surcharge or Fee

Almost all service providers all over the world allow late payments with a late charge or penalty. Even though this service is represented as tolerating the act of late payment, it is an ancillary supply and should be treated and assessed at the same rate as the primary supply.

8. Fixed Capacity Charges for Power

The price of energy levied by power generating corporations from State Electricity Boards/Distribution Companies or by individual consumers consists of two components: a minimum fixed charge (or capacity charge) and a variable per unit charge.

The fact that the minimum fixed charges remain the same regardless of whether electricity is consumed or not, or whether it is scheduled/consumed below the contracted or available capacity or a minimum threshold, does not imply that a portion of it is a charge for tolerating the act of not scheduling or consuming the minimum.

As a result, it is clear that both price components are paid for the sale of energy, which is free from GST. Therefore, it is not taxed.

9. Cancellation Charges

A commodity contracted for, such as hotel accommodations, an entertainment event, or travel, may be cancelled by a consumer owing to his failure to appear at the scheduled location and time. The provider may enable the consumer to discontinue the supply within a defined time period upon payment of a cancellation charge.

Cancellation costs for a class of railway ticket would be subject to GST at the same rate as the class (i.e., 5% on first class or air-conditioned coach tickets and zero for other classes). The seller’s forfeiture of earnest money in the event of the buyer’s breach of “an agreement to sell” an immovable property is a simple flow of money and is not taxable.

Furthermore, forfeiture of earnest money is negotiated as compensation for losses incurred and as a penalty for deterring non-serious buyers or bids. It cannot be used as a justification for allowing the violation of contract.

Therefore, such transaction is a mere flow of money and not consideration for any supply and therefore, is not taxable.

AMLEGALS Remarks

For a long time, the taxability of liquidated damages, notice pay recovery, and other issues have been the subject of substantial litigation.

The current CBIC clarifications have highlighted that for a taxable supply, there needs to be an expressed or an implied agreement, which might be oral or written, to do or refrain from doing anything in exchange for payment of value. Furthermore, it cannot be assumed that an agreement exists only because money is transferred from one party to another.

These explanations will be critical in establishing the taxability of the supply of service of consenting to the responsibility to refrain from any conduct, or to tolerate an act or a condition, to do an act, depending on the facts of the case. Furthermore, the Circular is expected to end the disputes and demands made on taxpayers on the topic.

–Team AMLEGALS, assisted by Ms. Devanshi Jain (Intern)

For any queries or feedback, please feel free to get in touch with chaitali.sadayet@amlegals.com or aditi.tiwari@amlegals.com.