Covid-19 Pandemic has brought uncertainty and raised doubts on the future course of action to be adopted by entities. Amongst others, one cause of concern is the impact of the wide-scale defaults of the contractual obligations to be fulfilled during this pandemic. Parties will need to resort to contractual provisions such as an invocation of the Force Majeure clause written into the contract or where that is nonexistent; then, the doctrine of frustration of contract enshrined in Section 56 of the Indian Contract Act, 1872.
Considering the loss that businesses are facing, in light of serious commercial consequences arising out of Government restrictions, delays in supplies and payments, countrywide lockdown, labour shortage, shut-down of industries, cancellation of contracts etc. amidst Covid-19 pandemic, non-performance of the contractual liabilities is an evitable result. Various businesses may go into arbitration and be dragged to Courts for compensation/liquidated damages of the losses incurred on account of the non-performance of the contract. While this would result in an additional loss for businesses, the implication of Goods and Service Tax (the GST) on ‘liquidated damages’ in contractual disputes would add fuel to the fire.
(2) Implication of GST on ‘Liquidated Damages’ in Contractual Disputes:
Section 7 of the Central Goods and Services Tax Act, 2017 (the CGST Act) states that ‘supply’ includes “all forms of supply.” This prima facie implies that ‘supply’ can be considered to encompass everything in its sweep without any limitations whatsoever. However, in order to qualify within the ‘scope of supply,’ there should be a presence of an activity performed by the supplier, which is wanted or desired by the recipient. Such a presence can be established by way of a contractual relationship pursuant to which there is a reciprocal obligation between the parties. Hence, an element of ‘quid pro quo’ is essential for any activity to qualify as a ‘supply’ and be liable to tax. Accordingly, the liquidated damages receivable in contractual disputes need to be tested on the nexus of reciprocity/ quid pro quo depending upon the contract. For this purpose, it is necessary to distinguish between supplies and the taxable activity in the course of which they are made. In this regard, Clause 5 of Schedule II of the CGST Act provides for the list of activities that shall be treated as a supply of services. Inter alia, Clause 5(e) of the CGST Act which provides “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act” is treated as supply of services.
Most of the commercial contracts contain terms and conditions, which are expected to be complied with by the parties to the contract and obviously, the contracts also contain some clauses, providing for certain compensatory consequences in case of non-compliance. In such contracts, the compensatory consequences could be payment of an amount by way of damages (either liquidated or unliquidated), fine or even royalty. Such payment of amount can be said to be a consideration for “agreeing to the obligation to tolerate an act or a situation,” which is considered as a supply of service in GST under Entry 5(e) in Schedule II of the CGST Act.
The view supporting the levy of tax on liquidated damages is based on the premise that the party has ‘tolerated’ the non-performance. ‘Toleration’ is defined in Black’s Law Dictionary (Tenth Edition) as “The act or practice of permitting or enduring something not wholly approved of.” And “Obligation” means the imposition of a duty to perform an agreed act or a covenant, which is enforceable under law. The occurrence of the term ‘obligation’ under Clause 5(e) of Schedule II of the CGST Act, 2017 mandates that tolerance must be of an act or a situation and such tolerance must be enforceable.
Tolerating non-performance of a contract for which consideration in the form of fines or liquidated damages is payable to any other entity would be considered as a supply of services and liable to GST @ 18% under Heading 9997, i.e. ‘Other services’ of GST Tariff on the amount of liquidated damages. As per the FAQ 18 of sectoral FAQs released by CBIC, it has been clarified that “non-performance of a contract or breach of contract is one of the conditions normally stipulated in the Government contracts for the supply of goods or services. The agreement entered into between the parties stipulates that both the service provider and service recipient abide by the terms and conditions of the contract. In case any of the parties breach the contract for any reason including non-performance of the contract, then such a person is liable to pay damages in the form of fines or penalty to the other party. Non-performance of a contract is an activity or transaction which is treated as a supply of service and the person is deemed to have received the consideration in the form of fines or penalty and is, accordingly, required to pay tax on such amount.”
According to CTR Notification No. 12 of 2017 sr. 62, Services provided by the Government (“Central, State, 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 these “governments or local authorities” under such contract, are ‘exempt supply’ rated and GST is not applicable on such supplies.
(3) Judicial Pronouncements:
In the case of Maharashtra State Power Generation Company Ltd., In re. Maharashtra State Power Generating Company entered into a contract with BHEL for erection and commissioning of power plant. The contract also provided that liquidated damages will be payable by the contractor in case the project is delayed. Mah-AAR held that act of Maharashtra State Power Generating Co. against the receipt of liquidated damages amounts to “tolerating an act” and hence is a “supply” liable to GST under Heading 9997 , i.e. ‘Other services‘ at rate of 18 percent. In the appeal before Mah. Appellate Authority for Advance Ruling, Mah-AAAR has upheld this view of Mah-AAR.
Similarly, In Dholera Industrial City Development Project Ltd, In re, the Gujarat Advance Ruling Authority (Guj-AAR) discussing the Mah-AAR ruling in Maharashtra State Power Generation Company Ltd., In re., also held that GST would be payable on the amount of liquidated damages, being a consideration for the supply of services. Further, the Guj-AAR Authority also held that GST would also be payable on the interest payable on the deferred payment of the liquidated damages. Moreover, in the case of In re Rashtriya Ispat Nigam Ltd, Andhra Pradesh-AAR held that GST would be applicable on the Liquidated Damages and is covered under Schedule II entry No. 5(2)(e) vide HSN code 9997 – Other services, for which the rate at 18% is relevant, or any other entry is applicable.
In the case of North American Coal Corpn India (P.) Ltd., In re, Mah-AAR took the similar position while dealing with liquidated damages received in Arbitral Awards. In this case, North American Coal Corpn had entered into an Association Agreement with Sasan Power Limited (SPL), a subsidiary of Reliance Power Limited, in order to provide technical know-how to SPL in relation to mine development and operations. After sometime, SPL curtailed activities of applicant and, accordingly, agreement between them was terminated. Arbitration proceedings were filed by North American Coal, before International Chamber of Commerce (ICC), London seeking liquidated damages for termination of agreement. Mah-AAR held that liquidated damages that may be awarded to applicant by ICC, London pursuant to arbitration proceedings would qualify as ‘supply‘ as per Sr. No. 5(e) of Schedule II of the CGST Act, being a ‘toleration of an act.’
Court also observed that the provisions of section 13 of CGST Act would determine the time of supply in cases of supply of services. In the subject case, the liability of tax would arise on the applicant as per Sr. No. 5(e) of Schedule II of section 7(1) of the CGST Act and the time of supply would be determined as per the provisions of section 13 after the award of arbitration proceedings is given by the Arbitration Tribunal. Moreover, the value of supply of services will be actual liquidated damages-cum-consideration as decided and pronounced in the award administered by ICC.
One may argue that for levying tax on liquidated damage, transaction will have first to pass the test of supply, which appears to be a difficult proposition. Since the amount awarded under the Contract does not relate to provision of any activity between the parties, it is not a ‘supply’ and is merely a Compensatory damage arising out of a Court order or termination of the contract. In such a situation, it may be possible to contend that the liquidated damages, being awarded with no obligation of a quid pro quo, ought not to be seen as a ‘supply’ under Section 7 of the CGST Act including Entry 5(e) of Schedule II thereof. However, the position described above is highly litigious.
In the light of the above discussion, liquidated damages are treated as ‘supply of services,’ and GST is applicable in terms of clause 5(e) of Schedule-II of the CGST Act. HSN code 9997, i.e. “miscellaneous services including services nowhere else classified” of the GST Tariff is relevant and applicable rate of GST on liquidated damages shall be 18 percent (9 percent as CGST + 9 percent as SGST). It is time that the Government clarifies the issue with an illustrative list of what constitutes ‘tolerance of an act.’