It is stated that performance is the essence of any contract and hence each party to the contract, generally, incorporate their expectation in contract. Failure of expectation of one party i.e. failure of performance by other party as per the agreed terms, may prescribe damages for deficiency in the performance of contract known as ‘liquidated damages. Please note that such damages are said to be liquidated once agreed and fixed by the parties in a contract. In another way, it is the sum agreed by the parties by contract as payable on the default of one of them.

The term “damages” is not defined under the Indian Contract Act, 1872 (“Contract Act”). However, in common parlance, it means an award of money to be paid by a defaulting party (for their non-performance) to a non-defaulting party (for their expectation) as compensation for loss or injury caused on account of the defaulting Party’s breach of the terms and conditions of the contract.

Section 74 of Contract Act applies to such types of damages as amount/penalty is already stipulated in the contract. In all other cases, the court quantifies or assesses the damage or loss and such types of damages are unliquidated. The parties may only fix an amount as liquidated damages for specific types of a breach, then the party suffering from another type breach may sue for unliquidated damages resulting from such breach.

74. Compensation for breach of contract where penalty stipulated for-

“When a contract has been broken, if a sum is named in the contract as the amount to be paid in case of such breach, or if the contract contains any other stipulation by way of penalty, the party complaining of the breach is entitled, whether or not actual damages or loss is proved to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so names or, as the case may be, the penalty stipulated for.”

For instance, when time is the essence of contract, then delay, if any, may invites penalty say, 1% of the value of the contract for every week delay and the like. Similarly, it is common to forfeit earnest money deposit (EMD) from a bidder in case he wins the bid but fails to act thereafter. This forfeiture clause is a deterrent for non-serious bidders entering the fray.

Section 74 of Contract Act, provides that if an amount is mentioned in a contract as the sum to be paid in case of a breach, then the suffering party is entitled to reasonable compensation, not exceeding the amount specified. For example: A contracts with B to pay B Rs. 1,000 if he fails to pay B Rs. 500 on a given day. A fail to pay B Rs. 500 on that day, B is entitled to recover from A such compensation, not exceeding Rs. 1,000, as the Court considers reasonable.

GST on Liquidated Damages

There is a view that liquidated damages and forfeiture are consideration for the non-performance/delayed performance. To tax the same, the related provisions have been incorporated in Central Goods and Services Tax Act, 2017 (“CGST Act, 2017”) with Schedule II. Section 7(1) (d) of the CGST Act, 2017 includes activities referred to in Schedule II in the Scope of Supply. Para 5 of Schedule II to CGST Act, 2017 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“.

Under GST law, taxable event is supply which includes all forms of supply for a consideration which is made in course of or in furtherance of business. As per above provisions there should be an agreement between the parties to either refrain from doing an act, or to tolerate an act/situation or to do an act.

The act of tolerance or agreeing to refrain from an act is treated as course as supply of service under the CGST Act, 2017 as mentioned by Maharashtra Authority for Advance Ruling in M/s. Maharashtra State Power Generation Co. Ltd (AAR Maharashtra) No. GST-ARA- 15/2017-18/B-30; dt. 08/05/2018. Similar rulings were also made in others matters.

Further, one point of view is that liquidated damages does not satisfy the essentials of supply or service. As mentioned above the purpose of agreeing to payment of liquidated damages between the parties is only to ensure performance and not for tolerating of an act. The provisions of law as mentioned above cannot be applied to consideration to situations where the contract does not want delay in performance whereas time is the essence of the contract. Many International Rulings are also in support that liquidated damages cannot be consideration for tolerance of an act. Therefore, Government should clarify what includes in tolerance of an act.

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Disclaimer: Nothing contained in this document is to be construed as a legal opinion or view of either of the authors whatsoever and the content is to be used strictly for educative purposes only.           

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