A commonly used term during the negotiation of contracts is ‘Liquidated Damages’. A significant conundrum has always existed regarding the taxability of liquidated damages in relation to indirect taxes, under the previous law and even under the current Goods and Services Tax (GST) law, with no measures undertaken by the Government to resolve this dilemma.
Damages refer to the compensation paid by the defaulting party in the event of non-performance of its obligations under the contract, causing loss or injury to the non-defaulting party of the contract. When the quantum of such compensation is agreed upon by the parties in advance, it is referred to as Liquidated Damages.
According to Section 7(1A) of the Central Goods and Services Tax Act, 2017 (CGST Act), the scope of supply includes activities or transactions which constitute a supply in accordance with Section 7(1) of the CGST Act, as listed in Schedule II. Liquidated damages are considered to be classified as services under Schedule II with GST applicable at the rate of 18%. However, there is no precise tax or exemption Schedule provided for the same. This paper shall elaborate upon the issue of applicability of GST on liquidated damages.
LIQUIDATED DAMAGES UNDER CONTRACT LAW
Liquidated Damages refer to the amount of compensation pre-determined in a contract, in estimation of the actual loss or injury to be suffered by one party for the breach of obligations under the contract by the other party. Such compensation is stipulated under a ‘Liquidated Damages’ clause in the contract, which specifies the amount of compensation to be paid in case of specific types of breaches of the contract by the defaulting party. Liquidated Damages are often stipulated where such loss is of intangible nature, such as loss of revenue, loss of business, etc.
The terms ‘Damages’ and ‘Liquidated Damages’ have not been defined under the Indian Contract Act, 1872 (the Contract Act). However, Section 73 of the Contract Act provides for compensation for loss or damage caused by breach of contract, and Section 74 of the Contract Act stipulates compensation for breach of contract where penalty is stipulated, i.e., in the case of Liquidated Damages.
Sections 73 and 74 of the Contract Act provide for Damages and Liquidated Damages. Section 73 of the Contract Act provides for compensation for loss or damage caused by breach of contract. It states that a party who suffers by the breach of contract is entitled to receive compensation for any loss or damage naturally arising in the usual course of things from such breach, from the party who breaches the contract.
Section 74 of the Contract Act deals with compensation for breach of contract where penalty is stipulated. It states that in case of breach of a contract, if the contract stipulates the amount to be paid in case of such breach or stipulates any penalty, the aggrieved party is entitled to receive from the defaulting party reasonable compensation to the extent stipulated in the contract, without proving actual damage or loss caused to him.
The term ‘Liquidated Damages’ is defined in Black’s Law Dictionary as “an amount contractually stipulated as a reasonable estimation of actual damages to be recovered by one party if the other party breaches. If the parties to a contract have properly agreed on liquidated damages, the sum fixed is the measure of damages for a breach, whether it exceeds or falls short of the actual damages.”
APPLICABILITY OF GST ON LIQUIDATED DAMAGES
As per Section 7(1A) of the CGST Act, scope of supply includes activities or transactions which constitute a supply under Section 7(1) of the CGST Act, as referred to in Schedule II of the CGST Act.
Paragraph 5 of Schedule II of the CGST Act stipulates the activities to be treated as supply of services, which includes in sub-clause (e) the activity of “agreeing to the obligation to refrain from an act, or to tolerate an act or situation, or to do an act.”
On the basis of Paragraph 5 (e) of Schedule II of the CGST Act, the activity of the defaulting party ‘tolerating’ the non-defaulting party’s non-performance under the contract on receipt of Liquidated Damages is considered as supply of service.
Section 9 of the CGST Act envisages the applicability of GST on supply of goods or services or both, as defined under Section 7 of the CGST Act. Such tax is levied on the value of taxable supply, as defined under Section 15 of the CGST Act to refer to the “transactional value, which is the price actually paid or payable for the said supply of goods or services or both where the supplier and the recipient of the supply are not related and the price is the sole consideration for the supply.”
In light of Section 7 read with Paragraph 5 (e) of Schedule II and Section 9 of the CGST Act, GST is applicable on the value of Liquidated Damages paid by the defaulting party to the non-defaulting party for tolerating the act of non-performance or breach of the contract.
RATE OF GST ON LIQUIDATED DAMAGES
The rate of GST applicable on Liquidated Damages is prescribed by GST Circular No. 12 dated 04.10.2018 issued by Prasar Bharati, Taxation Section (GST Circular).
The GST Circular prescribes the Service Accounting Code (SAC) for Liquidated Damages under the Heading 9997, as so specific SAC was prescribed for Liquidated Damages earlier. Accordingly, the relevant GST rate applicable on liquidated damages is 18 percent.
However, Notification No. 12/2017-Central Tax (Rate) dated 28th June, 2017 (Notification) provides for exemption from the levy of GST on Liquidated Damages received by the Government or Local Authority. Serial No. 62 of the Notification prescribes Nil rate of GST to be applicable on “Services provided by Central Government, State Government, Union territory or local authority by way of tolerating non-performance of a contract for which consideration in the form of fines or liquidated damages is payable to the Central Government, State Government, Union territory or local authority under such contract.”
JUDICIAL PRECEDENTS ON APPLICABILITY OF GST ON LIQUIDATED DAMAGES
- Decisions under the Pre-GST Era:
Prior to the introduction of GST Regime, the Central Board of Excise and Customs (CBEC) granted exemption on the levy of service tax for the services rendered by the Government or local authority through tolerating non-performance of a contract, for which the Government or the local authority is entitled for compensation in the form of penalty or Liquidated Damages in the case of Central Board of Excise and Customs v. Larsen & Toubro Ltd. (2015) 39 S.T.R. 913 (SC).
- Decisions under the GST Regime:
A significant decision of the GST era is the case of Maharashtra State Power Generation Company Ltd. (2018-VIL-33-AAR), wherein the Maharashtra Authority for Advance Ruling (AAR) held that Liquidated Damages are to be treated as consideration for an act of tolerance of non-performance, and thus the value of Liquidated Damages is subject to GST at the rate of 18% under the Heading 9997”. The Maharashtra Appellate AAR has further affirmed the ruling of the Maharashtra AAR in [2018 (70 GST 411)].
Similar rulings have also been pronounced in the below mentioned matters:
- Fastrack Deal Comm (P.) Ltd. (GUJ/GAAR/R/58/2020 dated 30.07.2020) – Gujarat AAR held that GST is applicable on advance forfeited for breach of terms of contract.
- Amneal Pharmaceuticals (P.) Ltd. (GUJ/GAAR/R/51/2020 dated 30.07.2020) – Gujarat AAR held that GST is applicable on compensation paid by an employee to the employer for not serving the stipulated notice period.
- M/S TP Ajmer Distribution Limited [(2019) 103 taxmann.com 227 (AAAR-RAJASTHAN)] – Rajasthan Appellate AAR held that GST is applicable on fees paid in lieu of dishonoured cheque.
- M/S Bajaj Finance Limited (MAH/AAAR/SS-RJ/24/2018-19) – Maharashtra AAR held that GST is applicable on compensation paid by the owner to tenant for temporary relocation.
However, in the case of Bai Mamubai Trust, Vithaldas Laxmidas Bhatia, Smt. Indu Vithaldas Bhatia v. Suchitra (Commercial Suit (L) No. 236 of 2017), the Bombay High Court held that GST is not applicable on Damages or compensation paid to the aggrieved party for a legal injury. The Bombay High Court relied on the principle that such payment lacks the requisite quality of reciprocity to be considered a “supply,” and hence, GST shall not be levied on such amount.
The Bombay High Court did not decide on the issue of whether such damages come under the purview of Paragraph 5(e) of Schedule II of the CGST Act. The Bombay High Court’s decision is in line with the amendment to the definition of supply of services to include those activities enlisted in Schedule II, only when such activities first qualify as a supply under Section 7(1) of the CGST Act.
Consequently, in the absence of supply, the reference to Paragraph 5(e) of Schedule II of the CGST Act to include Liquidated Damages within the scope of supply of services is unfounded. The decision of the Bombay High Court paves the way for determination of the applicability of GST on Liquidated Damages which must first satisfy the pre-requisite of being a ‘supply’ under Section 7 (1) of the CGST Act.
The conundrum on applicability of GST on Liquidated Damages has been answered by various AARs as affirmative. Based on the conjoint reading of Section 7 and Paragraph 5 (e) of Schedule II of the CGST Act, the AARs have held that supply of services includes the activity of tolerating the non-performance of contract on payment of Liquidated Damages.
However, the recent decision of the Bombay High Court in the case of Bai Mamubai Trust, Vithaldas Laxmidas Bhatia, Smt. Indu Vithaldas Bhatia vs. Suchitra (supra) has been a ray of light to unearth the puzzle regarding the applicability of GST on the service of ‘tolerating non-performance’, when such an act does not satisfy the essentials of supply of service under Section 7 (1) of the CGST Act.
At present, the need of the hour is for the legislation to expressly declare the applicability/exemption of GST on Liquidated Damages. That being said, any provision made for the same should be in consonance with the existing provisions of the CGST Act and the CGST Rules made thereunder and with various international rulings, which have also held that Liquidated Damages cannot be viewed as consideration for tolerance of an act.
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