Liquidated damages – Liable to GST?

As the world fights the COVID-19 pandemic, businesses struggle to overcome the economic slowdown post lifting lockdown. Businesses find it difficult to meet the contractual obligations which results in non-performance or delay in performance of obligations. As a result of such defaults, businesses incur huge liability towards compensation or damages based on the terms of various agreements entered into by it.

Damages are pre-determined compensation imposed by the injured party or party at loss upon a specific breach of contract or late performance. The said damages do not form part of consideration agreed upon for the activity to be carried out. The said value is a mere compensation in case of default.

This article is aimed to analyse the taxability of such damages under the prevailing GST law.

Firstly, whether the transaction amounts to supply? For this, analysis of Section 7 of CGST Act (along with the Schedules) is necessary.

Section 7(1) of CGST Act, 2017 provides the scope of supply in an inclusive manner. It includes all forms of goods or services or both such as sale, transfer, barter, exchange, licence, rental etc., made or agreed to be made for a consideration in the course of furtherance of business.

Here, it is interesting to note that Clause (d) of Section 7(1) being “the activities to be treated as supply of goods or supply of services as referred to in Schedule II” was omitted w.e.f. February 1, 2019 vide CGST Amendment Act, 2018. Further, Sub-Section (1A) was inserted through the aforementioned Amendment Act which specifies the following:

“(1A) where certain activities or transactions constitute a supply in accordance with the provisions of sub-section (1), they shall be treated either as supply of goods or supply of services as referred to in Schedule II.”

This amendment would imply that activities & transactions mentioned in Schedule II will no longer form part of scope of supply under Section 7(1). Schedule II would be only for the purpose of classification of a supply as supply of goods or as supply of services. Therefore, an activity / transaction should first amount to supply as per Section 7(1), post which Schedule II is to be referred for classification of the supply.

In this regard, Entry 5(e) of Schedule II is relevant for discussion which specifically provides that agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act amounts to a supply of service.

Possible interpretations

GST is applicable on damages:

This interpretation is based on entry 5(e) of Schedule II. The damages incurred on non-performance or delayed performance of obligations would amount to “tolerating an act” and hence, qualifies as supply of service and is liable to GST.

However, the question arising in the light of above discussion is that, what would be the quantum of loss of tax to be borne by businesses arising on damages, currently when the economy has hit the mud due to COVID-19.

GST is not applicable on damages:

It may be noted that for an activity to be taxable under GST, the said activity has to fall under the scope of Supply as per Section 7. In the current scenario, it could be said that the purpose of agreeing for payment of liquidated damages is to ensure performance and there is no activity involved such as sale, transfer, barter, exchange, licence, rental, lease or disposal for goods or services for a consideration.

Further, it may also be argued that the amount of damages received is not a consideration for any of the abovementioned activities. It may be considered as a mere compensation paid and may not qualify as consideration. Thus, excluding it from the scope of supply under Section 7(1).

Taking it further, although reference to Schedule II will not be of any relevance in cases where activity does not qualify to be supply, damages received may not be a consideration for tolerating non-performance. By imposing damages, the customer does not tolerate any loss incurred due to non-performance or delayed performance of contract. The penalties merely aim to compensate the customer in a manner as if the default did not occur.

Analysis of Case laws and Advance Rulings:

With heated debate on the taxability of damages, there have been various judgments and rulings pronounced in this regard with diverse judgements. Some of the rulings pronounced are listed below.

Liquidated damages are liable for GST:

The Authority for Advance Ruling (‘AAR’), Maharashtra, in the case of Maharashtra State Power Generation Company Ltd. (2018-VIL-33-AAR) held that liquidated damages are to be viewed as consideration for an act of tolerance of non-performance, and thus are subject to GST at 18%. The said ruling has been was further affirmed by the Maharashtra AAAR.

Further, there are plethora of advance rulings confirming the aforesaid position adopted by the Revenue. Some of the said rulings are listed below:

1. North American Coal Corporation India Pvt. Ltd. (GST – AAR Maharashtra);
2. Rashtriya Ispat Nigam Ltd. (GST – AAR Andhra Pradesh)
3. Dholera Industrial City Development Project Ltd. (GST – AAR Gujarat); and
4. Bajaj Finance Limited (GST – AAAR Maharashtra);

Liquidated damages are not liable for GST

A look at international statutes and rulings can be taken as guidance.

In the United Kingdom, Her Majesty’s Revenue and Customs in VAT Notice 708, clearly specify that damages are not be treated as payment for a supply and no VAT leviable on the said amount. Such amounts, collected as liquidated damages, cannot be considered as consideration for an act of tolerance and hence cannot be treated as a supply.

Similarly, the Australian Tax Office in its rulings has also clarified that damage or loss or injury does not constitute a supply under the provision of Australian GST and payments in respect of damages will not constitute consideration for a supply eligible to tax.

Further, the Bombay High Court, in the case of Bai Mamubai Trust, vs. Suchitra (Citation) has held that GST is not payable on damages/compensation paid for a legal injury. The principle laid down by the Court is that such payment does not have the necessary quality of reciprocity to make it a ‘supply’ and, therefore, GST is not payable on such amount.

Relief measures by Government

There are thousands of contracts being executed by private contracts with the  Central and State Governments. In highway sectors alone, there are more than 1,500 contractors employed for  services. Keeping these sectors in view, in light of COVID-19, the Government has given up to six months extension for completing the assigned projects.

Conclusion

Although the country awaits a positive ruling on damages, the currents rulings and judgments passed stand the other way. In view of the same, we believe its time Government clears the air on this issue as the country is suffering from COVID-19 and also its effect on the economy.