NO GST on Royalty Deductions in Government Contracts

When Government Departments Withhold Royalty from Contractors: Understanding GST Implications

Government contractors executing infrastructure projects increasingly face GST demands that stem from a fundamental misunderstanding of commercial reality. When contractors submit bills to government departments for civil works, they often find deductions labeled “royalty” in their payment receipts. GST authorities are now raising demands under Reverse Charge Mechanism on these amounts, creating both confusion and financial strain. This article examines why such demands are legally flawed.

The Practical Reality

Consider a contractor executing canal construction for a State Water Resources Department. The work requires sand, aggregate, and other minor minerals, which the contractor purchases from registered dealers in the open market. These dealers hold valid mining leases, have extracted minerals after paying royalty to the Mining Department, and sell materials with proper GST invoices.

When purchasing materials, the contractor receives both tax invoices and pit passes (royalty slips) proving that royalty has already been paid by the mining lessee. However, the contract with the government department requires the contractor to produce a consolidated Royalty Clearance Certificate from the Mining Department within a specified timeframe, typically thirty days from the final bill.

If this certificate isn’t produced timely, the Executive Engineer deducts a specified sum from the contractor’s payment and parks it in a deposit account. Crucially, this amount is typically four to five times the actual royalty applicable on the materials used. If the certificate is eventually produced, the withheld amount gets released. If not, it gets transferred to the concerned department.

Why GST Departments are Raising Demands

During GST audits, officers notice ledger entries showing “royalty” expenses. They assume the contractor is paying royalty for mining rights and apply the following logic: Service Accounting Code 9973 covers licensing services for mineral rights. When State Governments provide such services to business entities, Entry 5 of Notification 13/2017-Central Tax (Rate) mandates GST payment under Reverse Charge Mechanism at 18%. Since contractors either haven’t paid this GST or paid only 12% treating it as works contract cost, demands are raised for differential tax with interest and penalty under Section 74.

This interpretation collapses upon examining the transaction’s actual nature.

Defense One: No Supply Exists – The Amount is Merely Withheld

For GST to apply, there must be a supply as defined under Section 7 of the CGST Act, requiring a supplier, a recipient, and consideration flowing for goods or services. In royalty withholding cases, this foundational element is absent.

The government has granted no mining lease to the contractor. No land has been provided for mineral exploration or extraction. The contractor hasn’t approached the Mining Department seeking any mining rights. His entire engagement with minerals is limited to purchasing finished materials from registered dealers who have already paid royalty.

The government department isn’t providing any service to the contractor. It’s merely holding back a portion of money that belongs to the contractor pending documentary verification. This creates a suspense account entry, not revenue for services rendered. The amount remains the contractor’s money throughout – when the certificate is produced, it flows back to him.

The possibility of full release upon certificate production proves this point. If withholding were truly payment for licensing services, such complete reversal would be impossible. A service once consumed cannot become unconsumed. The very structure of the arrangement demonstrates it’s a security mechanism, not payment for supply.

Therefore, where no supply exists, GST liability under RCM simply cannot arise. The foundational requirement is absent.

Defense Two: If Considered a Deduction, It’s an Exempt Contractual Penalty

Even assuming without admitting that some transaction could be constructed, the amount’s characterization as contractual penalty brings it within a specific GST exemption.

Why would a department withhold four to five times the actual royalty if merely recovering unpaid royalty? This excessive quantum reveals the provision’s true nature – it operates as liquidated damages to ensure compliance through financial deterrence. The contractor has breached a contractual obligation by failing to produce the certificate timely. The department tolerates this non-performance but retains an amount as penalty.

Serial Number 62 of Notification 12/2017-Central Tax (Rate) specifically exempts services provided by government authorities by way of tolerating non-performance of a contract for which consideration in the form of fines or liquidated damages is payable. Both elements exist here: the department tolerates the contractor’s failure, and retains a penal sum for such tolerance.

The recent CBIC Circular 178/10/2022-GST dated August 3, 2022 provides authoritative guidance on this exact issue. It clarifies that liquidated damages paid for breach of contract, where the amount compensates for loss without any agreement to tolerate an act, don’t constitute consideration for supply. More importantly, it recognizes that amounts stipulated as penalty to ensure performance and deter non-performance aren’t consideration for any independent supply.

The circular explicitly states: “Such amounts are paid not for tolerating breach but for not tolerating breach, for penalizing and thereby deterring such breach.” It further clarifies: “Laws are not framed for tolerating their violation. They stipulate penalty not for tolerating violation but for not tolerating, penalizing and deterring such violations.”

Applying these principles, the government department doesn’t desire non-performance. The withholding is designed to prevent it through financial deterrence. When withholding occurs, it falls directly within the exemption. Even if characterized as government providing a service of tolerating non-performance, that service is explicitly exempted.

Both defenses – absence of supply and exempt penalty – lead to the same conclusion: no GST is payable.

The Critical Distinction: Why Both Arguments Matter

These defenses operate on different legal planes and must be articulated distinctly in responses to show cause notices.

The first argument is fundamental – it contends the transaction falls entirely outside GST’s charging section because no supply occurred. The amount is withheld (the contractor’s own money temporarily retained), not paid for any service. It remains the contractor’s money in a suspense account, refundable upon producing the certificate.

The second argument accepts for argument’s sake that some transaction might exist, but characterizes it as government tolerating contractual non-performance. The consideration is the amount forfeited or retained as penalty. The quantum (4-5 times actual royalty) proves its penal character, and such penal collections by government authorities are specifically exempted.

Both must be pleaded “without prejudice” to each other, providing comprehensive coverage regardless of how an adjudicating authority characterizes the transaction.

Why Classification under SAC 9973 Fails

The GST audit classification under Service Accounting Code 9973 (licensing services for mineral rights) presupposes the contractor obtained some license or mining lease from government. This factual premise doesn’t exist.

The contractor hasn’t applied for any mining lease. No mining area has been allotted. No exploration or extraction rights granted. The contractor’s interaction with the Mining Department is limited to seeking a certificate confirming that royalty has been paid by the dealers from whom materials were purchased – purely a documentary verification exercise, not a licensing transaction.

Moreover, proper GST determination requires identifying: Who is the service provider? What service is being provided? When was it provided? What is the consideration? Show cause notices typically fail to answer these basic questions because no such service exists.

The Procurement Chain Proves Prior Royalty Payment

Mining lessees extract minerals and pay royalty to the State Government under the Mines and Minerals Act, 1957. They receive pit passes confirming royalty payment. These lessees sell minerals to traders with GST invoices. Traders further sell to contractors, passing along the pit passes.

The contractor thus purchases materials on which royalty has been fully discharged at the extraction stage. The Royalty Clearance Certificate requirement exists because government departments want documentary proof that materials in public projects came through legitimate channels with proper royalty payment – an anti-evasion measure, not a tax or service charge.

Section 74 Invocation is Procedurally Invalid

Many show cause notices invoke Section 74 (dealing with fraud or willful misstatement), which is legally untenable. Section 74 requires satisfaction that tax wasn’t paid by reason of fraud, willful misstatement, or suppression of facts to evade tax – serious allegations casting aspersions on taxpayer integrity.

In these cases, there’s no fraud. The contractor hasn’t concealed information – all material procurement is duly recorded, purchase invoices are available, withheld amounts are clearly shown in financial statements. There’s no willful misstatement – the contractor uses terminology from the government department’s own payment receipts. There’s no suppression of facts – all transactions are transparent and documented.

At best, there’s a bona fide difference of opinion on tax treatment. Interpretational disputes cannot be equated with fraud. The settled legal position is that Section 74 is reserved for deliberate wrongdoing, not honest mistakes or debatable interpretations. Invoking it for interpretational issues violates principles of natural justice.

Revenue Neutrality Consideration

Even assuming GST under RCM were applicable, contractors are registered taxpayers entitled to claim input tax credit. If they pay GST under RCM, they immediately claim equivalent credit and utilize it for output tax on works contracts. This creates a revenue-neutral situation – the government collects tax under RCM, the contractor claims credit and uses it for output tax. Net revenue impact is zero.

Revenue neutrality significantly impacts interest and penalty. Where no revenue loss occurred, imposing penal consequences seems neither just nor reasonable. Several judicial pronouncements under earlier tax regimes recognized that in revenue-neutral situations, extended limitation cannot be invoked and penalties cannot be imposed.

Practical Defense Strategy

Contractors receiving such show cause notices should:

1. Establish factual foundation: Compile purchase invoices from dealers, pit passes/royalty slips received with materials, work order copies showing the contractual clause requiring certificate production, payment receipts showing the withholding, and any Royalty Clearance Certificates subsequently obtained.

2. Structure the written reply systematically:

• First ground: Assert absence of taxable supply – no mining lease granted, all materials purchased from market, government provided no licensing service, withheld amount is suspense account entry not consideration for supply
• Second ground (without prejudice): Characterize as contractual penalty exempt under Notification 12/2017, cite CBIC Circular 178/10/2022, emphasize the 4-5x multiplier proving penal character
• Third ground: Challenge Section 74 invocation – demonstrate absence of fraud/suppression, characterize as interpretational dispute
• Fourth ground: Highlight revenue neutrality negating basis for interest/penalty

3. Request personal hearing: Present original documents, walk through the complete procurement chain from mining lessee to dealer to contractor, demonstrate how pit passes flow through the supply chain.

Conclusion

GST demands on royalty withholdings by government departments represent a fundamental confusion between accounting nomenclature and commercial reality. Two powerful defenses exist: first, no supply occurs because government grants no mining rights and merely withholds the contractor’s own money pending documentary compliance; second, even if characterized as a transaction, it’s an exempt contractual penalty under Notification 12/2017 as clarified by CBIC Circular 178/10/2022.

Both defenses must be pleaded distinctly. Section 74 invocation is invalid absent fraud or suppression. Revenue neutrality further negates interest and penalty.

The fundamental principle is that substance must prevail over form. Accounting entries shouldn’t determine tax liability. The actual nature of transactions must be examined – tax should be levied only where genuine supply for consideration exists. In royalty withholdings, no such supply exists. Therefore, no tax is payable. This conclusion preserves both legal accuracy and the GST system’s integrity.

Contractors facing such demands should respond comprehensively with proper documentation and systematic legal arguments. The law clearly supports their position, and with proper presentation, these misconceived demands can be successfully contested.