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Circular No. 178/10/2022-GST

A. Decoding of What Constitutes Liquidated Damages:

Liquidated damages are mere a flow of money from the party who causes breach of the contract to the party who suffers loss or damage due to such breach. Such payments do not constitute consideration for a supply and are not taxable.

A perusal of the entry at serial 5(e) of Schedule II would reveal that it comprises the aforementioned three different sets of activities viz. (a) the obligation to refrain from an act, (b) obligation to tolerate an act or a situation and (c) obligation to do an act. All the three activities must be under an “agreement” or a “contract” (whether express or implied) to fall within the ambit of the said entry. In other words, one of the parties to such agreement/contract (the first party) must be under a contractual obligation to either (a) refrain from an act, or (b) to tolerate an act or a situation or (c) to do an act. Further some “consideration” must flow in return from the other party to this contract/agreement (the second party) to the first party for such (a) refraining or (b) tolerating or (c) doing.

B. Payment/ Consideration on damages

Payment of liquidated damages is stipulated in a contract to ensure performance and to deter non-performance, unsatisfactory performance or delayed performance. Liquidated damages are a measure of loss and damage that the parties agree would arise due to breach of contract. They do not act as a remedy for the breach of contract. They do not restitute the aggrieved person. It is further argued that a contract is entered into for execution and not for its breach. The liquidated damages or penalty are not the desired outcome of the contract.

The essence is that no one enters into any contract with the intention that the contract would get breached and the second party keeps an eye on the consideration which would flow once the contract is terminated.

In simple words, the second party enters the contract so that the necessary outcome and the desired results are delivered by the first party within the time frame and the costs associated which the second party is ready to pay on delivery. Liquidated damages are the outcomes of the non delivery/ short delivery of the desired results within the time and costs as entered into an agreement.

C. Gst Not Leviable On Such Damages

For example:

1. damages resulting from damage to property,

2. negligence,

3. piracy,

4. unauthorized use of trade name, copyright,

5. penalty stipulated in a contract for delayed construction of houses. It is a penalty paid by the builder to the buyers to compensate them for the loss that they suffer due to such delayed construction and not for getting anything in return from the buyers.

6. Similarly, forfeiture of earnest money by a seller in case of breach of ‘an agreement to sell’ an immovable property by the buyer or by Government or local authority in the event of a successful bidder failing to act after winning the bid, for allotment of natural resources, is a mere flow of money,

7. forfeiture of salary or payment of amount as per the employment bond for leaving the employment before the minimum agreed period. This circular has put to rest various divergent Gst AAR rulings on this matter. Bharat Oman Refineries Ltd, Madhya Pradesh AAR held that “relieving an employee without notice period or by accepting a shorter notice period” is a supply of service and hence GST is applicable on payment of notice pay by an employee to the employer.

AAAR reversed the ruling referring that there is no quid-pro-quo, for the transaction to qualify as a supply.

Syngenta India Limited Maharashtra authority for advance ruling (AAR) ordered that GST would not be leviable on these kinds of recoveries.

Gujarat AAR in July 2020 in the matter of M/s Amneal Pharmaceuticals Pvt Ltd, Ahmedabad, held gst leviable being services not classified elsewhere.

8. penalty for cheque dishonour since No supplier wants a cheque given to him to be dishonoured.

9. violation of laws such as traffic violations, or for violation of pollution norms or other laws are also not consideration for any supply received and are not taxable

Decoding GST on Liquidated Damages

There is no agreement between the Government and the violator specifying that violation would be allowed or permitted against payment of fine or penalty. The penal charges are imposed to deter and discourage the offender to repeat the violations again. Similar is the case in the case of liquidated damages in case of breach of contract. The first party is penalised to prevent repeating the same offence with any other party in future and penalty is a kind of remembrance to prevent its reoccurrence.

D. Option given to second party to breach the contract and the supplier retaining the advance or charging the amount

There are some instances where the supplier of services gives an option to breach the contract on forfeiture or retention on some amount. The service supplier is giving the option in the beginning or during the course of the contract period and is ready to take/ retain some part of money for tolerating the breach of contract. Here tolerating the breach of contract is pre-defined and the monetary penalties are already communicated and informed to the customer in advance. The customer knows that if he does not reach out at the set date and pre defined timelines, the advance money is liable to be forfeited or he has to pay an amount for breach of the contractual terms.

Here lies the difference and the essence of the contract is changed here.

E. Gst Applicablity on Breach of Contracts

For example

1. A contract for transport of passengers may stipulate that the ticket amount shall be partly or wholly forfeited if the passenger does not show up.

2. A contract for package tour may stipulate forfeiture of security deposit in the event of cancellation of tour by the customer.

3. Similarly, a contract for lease of movable or immovable property may stipulate that the lessee shall not terminate the lease before a certain period and if he does so he will have to pay certain amount as early termination fee or penalty.

4. Some banks similarly charge pre- payment penalty such payments, even though they may be referred to as fine or penalty, are actually payments that amount to consideration for supply, and are subject to GST, in cases where such supply is taxable. Since these supplies are ancillary to the principal supply for which the contract is signed, they shall be eligible to be assessed as the principal supply

5. booking of hotel accommodation

6. booking of an entertainment event

7. booking of an airline/ railway ticket

The key in such cases is to consider whether the impugned payments constitute consideration for another independent contract envisaging tolerating an act or situation or refraining from doing any act or situation or simply doing an act. If the answer is yes, then it constitutes a ‘supply’ within the meaning of the Act, otherwise it is not a “supply”.

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April 2024