The GST law was with also the objective of reducing multiple litigations pertaining to erstwhile regime like VAT, Service Tax, and Excise etc. being put to rest. However, there are still aspects like compensatory damages, employee notice period recovery which needs clarity. In many private organizations, employees would be legally bound to serve for specified period which could vary from 1 month to 3 months depending on termination. If employee fails, then the security amount collected during appointment or amount which could be part of salary would be withheld by the organization as ‘Notice period pay’. The question of levy of tax on such income started after introduction of negative list in service tax. The lack of clarity on taxation of such notice period pay continues. Before, going into the detailed legal implication of this transaction, let us understand the various relevant provisions under the GST law.

Section 7 of the CGST ACT, 2017 which defines the “Scope of supply” was amended retrospectively and the amendment was made effective since the inception of GST law in India i.e. 1st July 2017.

 acronym on sticky notes. Office desk background

Extracts of section 7 prior to CGST (Amend.) Act, 2018.

7. (1) For the purposes of this Act, the expression “supply” includes––

(a)………..;

(b)…………….;

(c)………………; and

(d) The activities to be treated as supply of goods or supply of services as referred to in Schedule II.

Accordingly, certain transactions were coming within ambit of supply merely by virtue of reference of Schedule II in the definition of “supply”.

Extracts of section 7 post to CGST (Amend.) Act, 2018.

7. (1) For the purposes of this Act, the expression “supply” includes––

 (a)………..;                                                                         

(b)…………….; [and]

(c)………………; and

(d) The activities to be treated as supply of goods or supply of services as referred to in Schedule II.

[(1A) where certain activities or transactions constitute a supply in accordance with the provisions of sub-section (1), they shall be treated either as supply of goods or supply of services as referred to in Schedule II.];

The amendment has rectified the anomaly by providing that merely coverage of a transaction in Schedule II will not make it supply. First, it has to satisfy the test of ‘supply’ within clause (a) to (c) of section 7 (1). Having done so, reference would be made to Schedule II to determine as to whether it ‘supply of goods’ or ‘supply of services.

This amendment has led to reconsideration of views on the activities which have been considered as taxable under the entry “agreeing to obligation to refrain from an act or to tolerate an act or a situation or to do an act”.

Notice pay is nothing, but the amount stipulated in the employment contract for breach in serving (not serving) the stipulated notice period. In other words, notice pay is a sum mutually agreed between the employer and the employee for breach of contract, it can be regarded as a consideration flowing from the employment contract itself.

The impact of the above amendments in respect of notice period recovery can be understood by going back in the era of Service Tax where the term service was defined as:

“Service” means any activity carried out by a person for another for consideration, and includes a declared service

The declared service entry had specifically included the below entry:

Agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act.

In view of the inclusion of declared service within the definition of service, there was a view that notice pay recovery is liable to service tax in the erstwhile regime.

With introduction of GST and before recent amendment in the definition of supply, there was similar interpretation to the levy of GST on the Notice Pay recovery as entries of Schedule II were covered within ambit of supply.

Post amendments stated supra, the levy of GST on notice pay recovery depends upon the “test of supply” i.e. one has to satisfy that notice pay in itself is a supply then only GST could be levied on it as the amendments has clarified that Schedule II is confined to define as to what constitute supply of goods or supply of services and does not defines supply per se.

There is view that there is no positive act of supply of service by company to employee leaving the organization. It is merely recovery of compensation from the employees on account of their failure to fulfil the terms of contract/appointment and tantamount to be liquidated damages.

It must be noted, the damages or liquidated damages means a compensation payable by the seller/supplier for the loss or injury suffered by the recipient on account of non-performance or delay in performance or deficiency. The payment of damages is a condition of contract.

In case of notice pay recoveries, there is no agreement by the employer to causing loss or damage by leaving early for a consideration. The expression ‘to tolerate an act’ relates to situations where a person commissions another person to do or commit a particular act for a consideration.

There is a clear distinction between the damages or compensation payable for breach of contract or delay in performance as compared to payment of a consideration for forbearance or tolerating an act or not performing an act. The payment of damages is a condition of contract and not a consideration for any service in the nature of forbearance or tolerating an act.

Here, it is important to appreciate that there is a difference between a transaction which is a “condition to a supply” and a transaction which is a “consideration for a supply”. For example, mobilization advance given against a bank guarantee as collateral is like an Earnest money deposit and is a condition for supply and not a consideration for supply.

The Hon. Supreme Court in the case of Ghaziabad Development Authority Vs Union of India and another (2000) 6 SCC 113 has observed that in case of breach of contract damages may be claimed by one party from the other who has broken its contractual obligation in some way or the other.

Thus, the notice pay recoveries are paid by the employee in default to compensate the employer who has suffered because of non-fulfillment of the conditions stipulated in the employment contract/agreement. They cannot be termed as a consideration for any service.

Reference may be made to Section 2(d) of the Indian Contract Act, 1872 which defines the consideration as under;

When, at the desire of the promisor, the promisee or any other person has done or abstained from doing, or does or abstains from doing, or promises to do or to abstain from doing, something, such act or abstinence or promise is called a consideration for the promise”.

From the above, it is clear that committing an act or abstaining from the act or doing something must be at the desire of the recipient for a consideration. In a contract for supply of goods or services, the recipient does not desire that the vendor should abstain from such supply. There is no agreement for abstinence between the parties.

In this regard attention must also be drawn towards Section 74 of the Indian Contract Act, 1872 which lays down the consequences of a contract when, the contract is breached by the parties to it. Relevant part reproduced below.

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 damage 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 named or, as the case may be, the penalty stipulated for.

That, in terms of Section 74 ibid, it is explicitly clear that, the amount a party (‘receiver’) is eligible to receive upon the breaking of a contract is in the nature of compensation for breach. The term breach implies an act on part of the one breaching the contract (‘the defaulter’), the breach doesn’t therefore implies that the receiver is doing an act or tolerating an act. There is no supply element when the receiver is getting compensated owing to an act of the defaulter.

It is pertinent to note that the concept of ‘liquidated damages’ is brought in Section 74 of the Indian Contract Act, 1872 which deals with cases of “compensation of breach of contract where penalty stipulated for”. And meaning of the term consideration is discussed in section 2(d) of the said act which does not cover liquidated damages within its ambit. This further strengthens the fact that as per Indian contract act which is the parent act for law relating contracts also does not treats liquidated damages as a consideration and therefore liquidated damages are neither paid for any promise to do an act nor for abstaining from a promise.

In the case of Punjab Communications Ltd vs. State of Punjab and others (2002) 128 STC 306, The court relied upon the above-mentioned clause and held that the liquidated damages were in the nature of an expenditure which the dealer had to incur for its default. This was not a discount as contemplated under section 2(h). The court noted that the damages in the very nature of things are meant to compensate the party for the loss it suffers on account of the default of the supplier. It has no connection with the sale price agreed upon between the parties.

The Larger Bench of the Hon. Tribunal in the case of Victory Electricals 2013 (298) ELT 534 (Tri.) has held that wherever the assessee, as per the terms of the contract and on account of delay in delivery of manufactured goods is liable to pay a lesser amount than the generically agreed price as a result of a clause (in the agreement) stipulating variation in the price, on account of the liability to “liquidated damages”, irrespective of whether the clause is titled “penalty” or “liquidated damages”.

Further, it must be noted that as per the notice pay recovery clause, the employer can only sue the employee for the amount stipulated in the contract, the employer in any case cannot mandate the employee to serve the balance period.

This gives strength to the argument that the receipt of compensation was a consideration against agreeing to the obligation to refrain from an act of suing the employee for mandatory serving ?

Reference could also be made to UK VAT law where tax is not levied on termination of contract subject to condition that the contract originally contains a clause allowing the parties to terminate early in lieu of compensation for losses arising from termination. This view is not directly applicable in India.

Further, the scope of the entry “agreeing to obligation to refrain from an act or to tolerate an act or a situation or to do an act” was examined and clarified by the department through its Circular 212/2/2019 dated 21st May 2019, Service tax.

The issue in circular stated supra pertains to the period of demonetization were the Ministry of Road Transport and Highways (MoRTH) and National Highway Authority of India (NHAI) issued directions to concessionaries operating tolls that they would allow free access to users form 08th November 2016 to 1st December 2016 and the consideration for this period would be paid by NHAI.

Certain authorities commenced investigations on the view that forgoing of toll by toll operator would come under “declared service”.

Service by way of access to a road or bridge on payment of toll charges” is included in the Negative list. Considering that the following was clarified through Circular 212/2/2019 dated 21st May 2019, Service tax that:

  • When the service remained the same throughout and it continued to be in the negative list, there can be no legal reason to treat it differently for the demonetization period.
  • Section 66E of the Finance Act, 1994 has to be read along with other provisions of that Act. A declared service cannot therefore, be assumed to have an overriding or omnibus character over other provisions.
  • Thus, one cannot apply the concept of “declared service” to remove a service from the Negative list and make it a taxable service.

Analogy could be drawn from the above Circular that, Schedule II has to be read along with other provisions of GST law which means if an activity does not constitute a “supply” in itself, mere coverage under the entry Schedule II cannot make it liable to GST as Schedule II does not have overriding effect over other provisions.

Recently the Allahabad CESTAT in the matter of M/S HCL Learning Limited (dated 25/11/2019) held that “notice pay recovery is out of the salary already paid and we also note that salary is not covered by the provisions of service tax. Therefore, we set aside the impugned order and allow the appeal”. Under GST law the services by an employee to the employer in the course of or in relation to his employment are covered under Schedule III and thus salary does not have any implications under GST law also. Therefore, the cited case law could squarely be applied in the notice pay recoveries in GST regime.

Conclusion:

In view of the above, it can be stated that the supply element seems to be missing in case of notice period recovery as the employer is only getting compensation on account of breach by the employee. In the absence of any supply element, the paper writer is of the view that there may not be any GST liability on the notice pay recoveries even after amendment in the definition of supply. The above view could be challenged by the department in the course of audit, scrutiny, assessments laying emphasis on the pre-GST accepted principles which would be settled by the Courts.

CA Madhukar Hiregange and CA Bhavesh Mittal

CA Madhukar Hiregange & CA Bhavesh Mittal

I am thankful to CA Ashish Chaudhary for his valuable inputs in this article.

(For any feedback or clarifications you can write us at madhukar@hiregange.com or bhaveshmittal@hiregange.com)

Author Bio

Qualification: CA in Practice
Company: Hiregange & Associates
Location: Gurgaon, Haryana, IN
Member Since: 12 Dec 2019 | Total Posts: 1

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