Liquidated Damages are being levied for Non-Performance or Breach of Contract, Late Delivery of Supplies etc. In this article let’s discuss about applicability of GST on Liquidated Damages.
Black’s Law Dictionary (Tenth Edition) on page 473 defines Liquidated Damages thus:
“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.”
Liquidated damages are a means of compensation for the breach of a contract.
Example : If a contractor failed to complete a construction project on time and LD is charged daily until the project has been finished.
A liquidated damages clause generally specifies a predetermined amount of money that must be paid as damages for failure to perform under a contract.
Section 7(1) (d) of the GST Act, 2017 includes activities referred to in Schedule II in the Scope of Supply. Paragraph 5 of Schedule II to CGST Act provides a list of activities to be treated as ‘supply of services’ which inter alia comprises – “(e) agreeing to the obligation to refrain from an act, or to tolerate an act or situation, or to do an act“.
The view supporting levy of tax on liquidated damages and forfeiture of earnest money is based on premise that the party has ‘tolerated’ the non-performance which is Supply.
GST is applicable on ‘supply’ of goods or services or both and is charged on the ‘value of supply’.
Section 15(1) of the GST Act defines ‘value of taxable supply’ as the transaction value, which is the price actually paid or payable for the said supply where the supplier and the recipient of supply are unrelated and the price is the sole consideration.
In case of Liquidated Damages, there is an act of Non-Performance / Breach and the same has been tolerated by an additional levy in the nature of liquidated damage.
There are two events, the first event calls for the payment of a contract price to the Contractor and the second event calls for the payment of liquidated damage to the owner.
The income (though presented in the form of deduction) from payments to be made to the Party that Breached (Contractor) is the income of the Party that Suffered Damage (Principal / Owner) and would be a supply of ‘service’ in terms of schedule II para 5 clause (e) of the GST Act.
Therefore, GST is applicable on Liquidated Damages.
The Maharashtra Authority for Advance Ruling (“AAR”) in the case of Maharashtra State Power Generation Company Limited (“Applicant”) held that Goods and Services Tax (“GST”) at the rate of 18% would be payable on liquidated damages (“LD”) received by the Applicant for delayed supply under a contract.
The AAR has considered LD to be a consideration for agreeing to the obligation to tolerate an act or a situation, which is treated as a supply of service under para 5(e) of Schedule II of the Central Goods and Services Act, 2017 (“CGST Act”) / Maharashtra Goods and Services Act, 2017 (“MGST”)
Similar Ruling are made in the following AARs
The Rulings also impacts many other similar transactions.
For example, if a builder forfeits a buyer’s earnest money after the buyer fails to buy a flat in a contracted period, GST will be levied on that forfeited amount since the builder has ‘tolerated your act’ of not paying the full amount, therefore, it becomes a ‘deemed service’ and GST is due.
So, GST is Applicable on
> Liquidated Damages & other Penalties like milestone penalties,
> Penal / Default Interest in case of delay in repayment of EMI
> Advance Forfeited for Cancellation of Agreement,
> Forfeiture of Security for Damages Done,
> Compensation to Termination of Contract,
> Non-Compete Fee for Agreeing Not to Compete,
> Cancellation Charges for Cancelling Travel Ticket (Air, Train, Bus),
> Demurrage or Detention Charges,
The Party Collecting Liquidated Damages, Penalties, Compensation, Cancellation Charges, Demurrage or Detention Charges etc. shall raise the Invoice by Charging GST with SAC code 9997 (Other services) GST @ 18%.