Article discusses applicability of GST on various aspects such as liquidated damages, compensation, and penalties arising from breaches of contract or legal provisions. Understanding the scope of supply as defined by Schedule II Para 5(e) is crucial in determining the taxability of such transactions.
Applicability of GST on Liquidated damages, Compensation and penalty arising out of breach of contract or other provisions of law.
Schedule II Para 5( e) states that, agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act is a supply of service.
There are 3 limbs of this Para.
A. Agreeing to the obligation to refrain from an act-
Example of activities that would be covered by this part of the expression would include non-compete agreements, where one party agrees not to compete with the other party in a product, service or geographical area against a consideration paid by the other party, agreeing not to use others brand name etc.
Another example of such activities would be a builder refraining from constructing more than ascertain number of floors, even though permitted to do so by the municipal authorities, against a compensation paid by the neighbouring housing project, which wants to protect its sunlight or an industrial unit refraining from manufacturing activity during certain hours against an agreed compensation paid by neighbouring school, which wants to avoid noise during those hours.
B. Agreeing to the obligation to tolerate an act or a situation-
This would include activities such a shopkeeper allowing a hawker to operate from the common pavement in front of his shop against a monthly payment by the hawker, or an RWA tolerating the use of loud speakers for early morning prayers by a school located in the colony subject to the school paying an agreed sum to the RWA as compensation.
C. Agreeing to the obligation to do an act-
This would include the case where an industrial unit agrees to install equipment for zero emission/discharge at the behest of the RWA of a neighbouring Residential complex against a consideration paid by such RWA, even though the emission/discharge from the industrial unit was within permissible limits and there was no legal obligation upon the individual unit to do so.
Circular No.178/10/2022 GST, Dated 03.08.2022 explains the details of applicability of GST on above mentioned services. Before going into the merits of Circular we will again split the definition of supply.
As in last weekly series we have gone through the definitions of supplier, goods, services and actionable claim. Again to understand the concept of Schedule II para 5(e), we will just overlook Supply includes all forms of supply of goods or services or both such as sale, Transfer, Barter, Exchange, Licence, Rental, Lease or disposal made or agreed to be made for a consideration by a person in the course or furtherance of business.
That means, if the above para 5( e) of Schedule II is to be taxable, there must be supply of goods or services or both by supplier and consideration must be paid by the recipient or any other person on behalf of recipient except transactions enumerated in Schedule III (negative list) but para 5( e) of Schedule II is not a part of negative list, hence to constitute above service a taxable supply, there must be a supply by any mode mentioned above and also there must be a consideration paid or to be paid by the recipient or any other person on behalf of recipient.
Section 2(31) defines “Consideration” in relation to the supply of goods or services or both includes-
(a) any payment made or to be made, whether in money or otherwise, in respect of, in response to, or for the inducement of, the supply of goods or services or both, whether by the recipient or by any other person but shall not include any subsidy given by the Central Government or a State Government;
(b) the monetary value of any act or forbearance, in respect of, in response to, or for the inducement of, the supply of goods or services or both, whether by the recipient or by any other person but shall not include any subsidy given by the Central Government or a State Government.
Provided that a deposit given in respect of the supply of goods or services or both shall not be considered as payment made for such supply unless the supplier applies such deposit as consideration for the said supply.
para 5 (e) of Schedule II of CGST Act is strikingly similar to the definition of contract in the Contract Act, 1872. The Contract Act defines ‘Contract’ as a set of promises, forming consideration for each other. ‘Promise’ has been defined as willingness of the ‘promisor’ to do or to abstain from doing anything. ‘Consideration’ has been defined in the Contract Act as what the ‘promisee’ does or abstains from doing for the promises made to him.
That means there must be a necessary and sufficient nexus between the supply (i.e. agreement to do or to abstain from doing something) and the consideration.
Lets understand Para 5 ( e) of Schedule II with examples:
I. Liquidated damages paid for breach of contract.
II. Cheque dishonour fine/penalty charged by a power distribution company from the customers.
III. Bond amount recovered from an employee leaving the employment before the agreed period.
IV. Late payment charges collected by any service provider for late payment of bills.
All the above compensation , damages or loss are not by way of consideration for any other independent activity, it is just an event in the course of performance of that contract and also there is no supply of any service from one party to another as well as all the above acts are not for tolerating an act but for not to tolerate an act and hence, all the above transactions does not amount to supply and GST not applicable. Mere flow of money in terms of damages, compensation does not amount to taxability, same has been clarified in the above Circular No. 178/10/2022 dated 03.08.2022.
Another examples of taxability are-
I) a contract may provide that payment by the recipient of goods or services shall be made before a certain date and failure to make payment by the due date shall attract late fee or penalty.
II) 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.
III) A contract for package tour may stipulate forfeiture of security deposit in the event of cancellation of tour by the 0customer.
IV) 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.
V) Some banks similarly charge pre- payment penalty if the borrower wishes to repay the loan before the maturity of the loan period.
Analysis of above services taxability in circular with Writer’s opinion.
1. For serial number I and V
GST is liable to be paid as there is a flow of supply in both situations ,
I. supply of goods or services and
V. there is a flow of facility by bank for prepayment of loan due.
Same has been explained in the circular too.
2. For serial number II, III and IV
Circular says it is taxable and GST is liable to be paid, the question arises, if in these services there is no supply from supplier to buyer and it is again for not tolerating an act, GST must not to be collected.
Moreover in all the above 3 services, charges are deducted from security deposit amount and not adjusted against final consideration as the service provision is only cancelled then question of adjustment for consideration from security deposit does not arise. Mere intention of future provision of service does not amount to supply of service. Consideration is something for transportation or accommodation etc. and if that service is not availed then consideration does not exist and adjustment and adjustment of same from security deposit does not arise. Definition of Consideration clearly defines Security deposit is not a consideration unless and until it is adjusted against final consideration require to be paid. There must be nexus between supply and consideration , in the above 3 transactions nexus is absent.
Hence in my opinion, If any litigation faced in these matters once can take the shelter of above argument before judicial Authorities. In order to come out from this conflict, government needs to come with more clarity in respect of it or else will have to wait for Judicial Pronouncement.
Conclusion:The intricate interplay between supply, consideration, and the nature of transactions dictates the applicability of GST on liquidated damages, compensation, and penalties. As businesses navigate these complexities, clarity from authorities or judicial pronouncements becomes essential to ensure compliance and mitigate potential disputes.
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