In the COVID-19 pandemic, businesses find it increasingly difficult to meet their contractual obligations, which results in non-performance/delays of agreed obligations. These defaults are the primal reason for surge in claims for liquidated damages, especially in cases where the plea of force majeure (unforeseeable circumstances that prevent someone from fulfilling a contract) is untenable.
With an increase in claims for damages, levying of taxes on ‘liquidated damages’ remains one of the most debated issues under the Goods and Services (GST) laws.
This article is an attempt to understand applicability of GST on liquidated damages.
Understanding the terminology ‘liquidated damages’
Liquidated Damages is not defined in GST Acts but is a common concept in business. Section 73 and 74 of Indian Contract Act, 1872 deals with ‘liquidated damages’.
Liquidated damages are the common terminology used by the parties under a contract, generally it is a compensation agreed upon by the parties entering a contract and is payable by the failure of either party to ‘perform’ its obligations completely or as per the agreed terms.
The amount of the liquidated damages are generally ascertained where loss is intangible and is supposed to be the parties’ best estimate of the damages that would be caused by a breach at the time of signing the contract. If a breach occurs and the liquidated damages clause is enforceable, the parties do not calculate the actual damages (i.e., how much money a party actually lost as a result of the breach), instead, the breaching party pays the predetermined sum provided by the liquidated damages provision.
GST on ‘liquidated damages’
Section 7(a) of the CGST Act provides that supply includes all forms of supply of goods or services or both such as sale, transfer, barter, exchange, licence, rental, lease or disposal made or agreed to be made for a consideration by a person in the course or furtherance of business.
Schedule II provides as to be what shall be treated as supply of goods and what shall be treated as supply of services. Entry no.5, Clause (e) in the said schedule reads as follows ‘agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act’.
Tax authorities are interpreting this clause to apply to payments for liquidated damages as “consideration” towards supply of service for “tolerating an act” of non-performance, and hence, seek to levy GST on the same. The concern is amplified due to certain Advance Rulings that affirm this analogy and deem that payment of such damages would be subject to GST.
The Authority for Advance Ruling (‘AAR’), Maharashtra, in the case ofMaharashtra State Power Generation Company Ltd. [Order No. GST-ARA- 15/2017-18/B-30, decided on May 8, 2018] has held that liquidated damages are to be viewed as consideration for an act of tolerance of non-performance, and thus are subject to GST at 18% (Heading 9997). The said ruling has been further affirmed by the Maharashtra Appellate AAR also [2018 (70 GST 411)].
Further, some of the similar rulings pronounced in the following cases:
The core is to understand whether clause 5(e) can be invoked as there must be a consensus to tolerate. In this regard, one may appreciate that the claim for damages does not arise out of an obligation of the breached party to tolerate a non-performance but is more in the nature of financial compensation for the loss suffered on account of such non-performance. An interpretation to the contrary is uncalled for, as the contracts are not entered into for tolerating an act of non-performance by the contractor and the damages ought to be considered as penal or compensatory for the respective default or breach of contract. It is also possible to argue, by way of invoking such damages, that the customer in no way tolerates or accepts non-performance of contractual commitments. In fact, the breach is not tolerated, which is why the breached party imposes the penalty or damages. The penalties merely aim to compensate the party in a manner as if the default not occurred. Further, a contract must be read in its entirety, to ensure specific clauses are not read independently to distort the essence. In other words, clauses pertaining to damages must not be read in isolation to infer that the contract is entered to render a service of tolerating or accepting a breach of a contract.
In recent times, the Bombay High Court, in the case of Bai Mamubai Trust, Vithaldas Laxmidas Bhatia, Smt. Indu Vithaldas Bhatia vs. Suchitra, has held that GST is not payable on damages/compensation paid for a legal injury. The principle laid down by the Court is that such payment does not have the necessary quality of reciprocity to make it a ‘supply’ and, therefore, GST is not payable on such amount.
In this case, there was a dispute between the landlord and an occupant of premises, and a court receiver was appointed by the High Court for maintenance of the property and to collect rent from the defendant. The plaintiff claimed that in case his right over the property is proved in Court and the royalty amount is paid to him, then the same will be an income earned by him for letting out the premises and will be a taxable income under GST. The plaintiff moved an application to the Court to direct the defendant to pay royalty along with GST. Although in the ruling, the Court did not discuss at length on the issue of whether the damages paid would fall under clause 5(e) of Schedule II of the CGST Act. However, it is to be noted that according to the amendment in the scope of ‘supply’ under Section 7 of the CGST Act, all activities which are specified in Schedule II would have to first qualify as a supply in terms of Section 7(1A) of CGST Act. Therefore, the reference to clause 5(e) of Schedule II will not be relevant in cases where supply is absent. Thus, the principles laid down by the Bombay High Court will go a long way to determine the taxability of payments where an underlying ‘supply’ is unclear.
Also, Courts have analysed the taxability of such payments in the pre-GST regime, and held that such penalties/ damages should not be subject to tax, as they do not form a consideration towards rendering service (M/s. South Eastern Coalfields Ltd. v. Commissioner of Central Excise and Service Tax [Service Tax Appeal No. 50567 of 2019, decided on December 22, 2020]). Globally too liquidated damages are not chargeable to GST/VAT, the view being that such damages are meant to compensate the breached party for losses suffered on account of the default and have no connection with the supplies agreed between the parties.
Earlier (before the Central Goods and Services (Amendment) Act, 2018) the same was dealt under Section 7(1)(d) of the Central Goods and Services Act, 2017 (“CGST Act”), which included activities referred to in Schedule II to CGST Act, in the scope of supply. Paragraph 5 of Schedule II to the CGST Act provides a list of activities to be treated as either as ‘supply of goods’ or ‘supply of services’ wherein inter alia comprised Para 5(e) “agreeing to the obligation to refrain from an act, or to tolerate an act or situation, or to do an act”.
Thereafter, vide Central Goods and Services (Amendment) Act, 2018, Section 7(1)(d) of the CGST Act was retrospectively omitted and a new sub-section i.e., Section 7(1A) of the CGST Act was inserted w.e.f. July 1, 2017. Consequently, all activities which were specified in Schedule II to the CGST Act would be only for determination of classification of transactions either as ‘supply of goods’ or supply of services’ but, it would be chargeable to GST only if such transaction qualify as a supply in terms of Section 7(1) of CGST Act.
Schedule II of the CGST Act is confined to define as to what constitute supply of goods or supply of services and does not defines supply per se. Schedule II of the CGST Act has to be read along with Section 7 of the CGST Act, which means if an activity does not constitute a “supply” in itself as per Section 7(1) of the CGST Act, mere coverage of the same under the entry Schedule II cannot make it liable to GST. Further, there is no positive act of supply of services between the parties and there is no agreement between the parties to cause loss or damage by breaching terms and conditions of an agreement 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. The payment of damages is a condition of contract and not a consideration for any service in nature of tolerating an act.
Therefore, there is merit in the position that GST should not be levied on liquidated damages.
To avoid potential litigations the government should bring in more clarity in matters related to liquidated damages.