Washout Charges or Liquidated Damages in GST

What is Washout charge or Liquidated Damages?

“A sum equivalent to difference between the settlement rate (market rate) and the rate as agreed in contract”.

It’s discretionary upon the both parties of the contract to settle / close / washout the unexecuted contract at the rate fixed by it. In this regard, on mutual agreement, the rates which contracts settles is usually the market rate. In case of ‘Closure’ or ‘washout’ of aforesaid contracts, the party to the contract which opts for such closure is required to pay the other party a sum of equivalent to difference  between the settlement rate (market rate) and the rate as agreed in contract.

Section 7 Schedule II Para 5( e ) reproduced here under.

Schedule II, Section 7:- Activities to be treated as supply of goods or supply of services.

As per the provisions laid down under Section 7 of the CGST Act, the expression “supply” includes all forms of supply of goods / services for a consideration by a person in the course and furtherance of business.

Para 5 (e):- Agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act; and

Perusal of the aforesaid Schedule II entry makes it amply clear that in order to invoke the above taxable activity, there needs to be an agreement to tolerate a situation. This is not the case of washout such as contractual penalties, liquidated damages / cancellation fee etc.

> The understanding of the learned adjudicating authority seems contradictory to the commercial understanding because –

> These washout charges arise on mutual acceptance of both parties on account of an ‘unintentional occurrence’ which both parties actually intend to avoid.

> Damages / cancellation charges/ washout charges are provided for with an intent to ensure due performance of an agreement or to further obedience of the law.

> It is an expression of dissatisfaction or a form of penalty resulting from unsatisfactory performance or breach of the contract.

> Such washouts are not the desired result or intended to be a source of revenue for the receiving party but are incurred to compensate for loss suffered by one party upon the occurrence of an unintended event.

> Washout charges / damages are measures of compensation for breach / non-execution of contract due to conditions not under one’s control, but not a fee for agreeing to tolerate an act or situation.

> Washout charges result from failure to perform as per agreed terms.

The very purpose of agreeing to payment of washout Charges is to ensure performance and not for tolerating non-performance.

A contract is never entered into with an intent of non-performance or to tolerate non-performance.

Washout Charges are not the desired income or Expense or result of contract but are compensation for the loss suffered by receiving party.

A contract can never be read as agreeing to breach of the contract.

Before, determining any person as supplier, the activity or transaction of goods or services carried out by such person should be covered within the scope of “supply”. The scope of “supply” is denoted in section 7 of the CGST Act which is reproduced as under:

Section 7. Scope of supply.—

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

 (a) 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;

 (b) import of services for a consideration whether or not in the course or furtherance of business; and (c) the activities specified in Schedule I, made or agreed to be made without a consideration;

(d) *****.

(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.

(2) Notwithstanding anything contained in sub-section (1),––

(a) activities or transactions specified in Schedule III; or

(b) such activities or transactions undertaken by the Central Government, a State Government or any local authority in which they are engaged as public authorities, as may be notified by the Government on the recommendations of the Council, shall be treated neither as a supply of goods nor a supply of services

Thus, as per section 7 of the CGST Act, any transaction should pass through the following tests as in order to be qualified as a “supply”,

 (a) agreement for transaction or activity i.e. the transaction or activity should be made or agreed to be made;

(b) transaction or activity should be relating to goods / services;

(c) an element of consideration should be present in transaction or activity.

(d) transaction or activity should be carried out in the course and furtherance of business;

(e) activities specified in Schedule I, made or agreed to be made even though without a consideration; (f) the transaction should not be specified in Schedule III.

Absence of consideration: The term consideration is defined in clause (31) in section 2 of the CGST Act, which is reproduced as under:

(31) “consideration” in relation to the supply of goods or services or both includes–

(a) ………………;

(b) ………………:

In the above definition of “consideration”, the words “in relation to” are used. In the case of ‘Doypack Systems Pvt. Ltd. v. Union India & Ors.1988 AIR 782, 1988 SCR (2) 962,the Apex Court has categorically held that the phrase “in relation to” is equivalent to the phrases “concerning with” and “pertaining to”. Therefore, the phrase “In relation to” used in the definition of the term “consideration” suggests a connection with the act of supply. Therefore, it can be deduced that any consideration should have a direct nexus to the voluntary act of supply.

In order to understand a clear intention of the legislature reliance is drawn towards Schedule II 5 (e) of the GST Act 2017. It will be convenient if the above entry is split into its components for a clear and easy understanding:

Agreeing to the obligation –

• to refrain from an act, or
• to tolerate an act or a situation, or
• to do an act

In order to invoke the above clause, there needs to be consensus or a clear agreement to tolerate or to enter into a contract agreeing to tolerate a situation.

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

In recent times, the Bombay High Court, in the case of Bai Mamubai Trust, Vithaldas Laxmidas Bhatia, Smt.Indu Vithaldas Bhatia vs. Suchitra, Commercial Suit No 236 of 2017 judgment pronounced on 13th September 2019 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 in the above case will squarely applicable to our present issue “ Washout Charges” where the supply or service is not qualify hence GST is not attracted.

Provision in clause 5(e) of the Schedule II of the CGST Act is similar to the earlier Service Tax law i.e. Section 66E(e) of the Finance Act, 1994. With reference to the said earlier Act.

Very Recent judgements of CESTAT held that Penalty / Liquidated Damages/ Compensation Charges are not treated as services. Hence it is not  liable for service tax. Rulings are as under.

The very essence of the contract is tolerating of act or situation and not to recover any damages where as in performance based contracts, performance is the very essence of contract and not non-performance or tolerating non-performance, therefore the amount of damages so received cannot be said to be the consideration for tolerating non-performance. Per say, the liquidated damages will not fall under the ambit of ‘SUPPLY/SERVICES’ and hence will not be subject to GST.

1. The view of not considering Washout Charges / Liquidated Damages as supply/services for tolerating an act has also been supported by various International Jurisprudence.

Ruling GSTR 2001/4 (GSTR 2003/11 issued by the Australian Tax Office, where it has been clarified that damage or loss or injury does not constitute a supply under the provisions of Australian GST.

2. The European Court of Justicein the case of Societe Thermale v. Ministere de l’Economie [2007] S.T.I 1866, Celex No. 650J0277 has held that where the client exercises the cancellation option available to him as compensation for the loss suffered and which has no direct connection with the supply of any service for consideration, it is not subject to tax.

3. The Court of Appeal (UK)in case of Vehicle Control Services Limited (2013) EWCA Civ 186, has said that payment in the form of damages/penalty for parking wrong places/ wrong manner is not a consideration for services as the same arises out of breach of contract with the parking manager.

Hence we conclude that washout charges are not covered under the definition of “supply” or “service”. Hence GST is not attracted on this issue.

Further, there is no obligation under the subject contracts for refraining from an act or to tolerate an act or a situation or to do any specific act. Thus, the present transaction does not qualify as a service as provided in para 5(e) of Schedule II.

The CBIC has issued circular to provide clarifications on several contentious issues such as GST applicability on liquidated damages, notice pay recovery, compensation for non-collecting roll charges etc vide Circular No 178/10/2022-GST dated 03rd August 2022 (Copy enclosed)

In respect to taxability of liquidated damages, the CBIC has clarified that where the amount paid as ‘liquidated damages’ is an amount paid only to compensate for injury, loss or damage suffered by the aggrieved party due to breach of the contract and there is no agreement, express or implied, by the aggrieved party receiving the liquidated damages, to refrain from or tolerate an act or to do anything for the party paying the liquidated damages, in such cases liquidated damages are mere a flow of money due to such breach. Such payments do not constitute consideration for a supply and are not taxable.

Para number 7.1 to 7.1.6  of the above said circular is reproduced here under for your ready reference.

7.1 Breach or non-performance of contract by one party results in loss and damages to the other party. Therefore, the law provides in Section 73 of the Contract Act, 1972 that when a contract has been broken, the party which suffers by such breach is entitled to receive from the other party compensation for any loss or damage caused to him by such breach. The compensation is not by way of consideration for any other independent activity; it is just an event in the course of performance of that contract.

7.1.1 It is common for the parties entering into a contract, to specify in the contract itself, the compensation that would be payable in the event of the breach of the contract. Such compensation specified in a written contract for breach of non-performance of the contract or parties of the contract is referred to as liquidated damages. Black’s Law Dictionary defines ‘Liquidated Damages’ as cash compensation agreed to by a signed, written contract for breach of contract, payable to the aggrieved party.

7.1.2 Section 74 of the Contract Act, 1972 provides that when a contract is broken, if a sum has been named or a penalty stipulated in the contract as the amount or penalty to be paid in case of breach, the aggrieved party shall be entitled to receive reasonable compensation not exceeding the amount so named or the penalty so stipulated.

7.1.3 It is argued that performance is the essence of a contract. Liquidated damages cannot be said to be a consideration received for tolerating the breach or non-performance of contract. They are rather payments for not tolerating the breach of contract. Payment of liquidated damages is stipulated in a contract to ensure performance and to deter non-performance, unsatisfactory performance or delayed performance. Liquidated damages are a measure of loss and damage that the parties agree would arise due to breach of contract. They do not act as a remedy for the breach of contract. They do not restitute the aggrieved person. It is further argued that a contract is entered into for execution and not for its breach. The liquidated damages or penalty are not the desired outcome of the contract. By accepting the liquidated damages, the party aggrieved by breach of contract cannot be said to have permitted or tolerated the deviation or non-fulfilment of the promise by the other party.

7.1.4 In this background a reasonable view that can be taken with regard to taxability of liquidated damages is that where the amount paid as ‘liquidated damages’ is an amount paid only to compensate for injury, loss or damage suffered by the aggrieved party due to breach of the contract and there is no agreement, express or implied, by the aggrieved party receiving the liquidated damages, to refrain from or tolerate an act or to do anything for the party paying the liquidated damages, in such cases liquidated damages are mere a flow of money from the party who causes breach of the contract to the party who suffers loss or damage due to such breach. Such payments do not constitute consideration for a supply and are not taxable.

7.1.5 Examples of such cases are damages resulting from damage to property, negligence, piracy, unauthorized use of trade name, copyright, etc. Other examples that may be covered here are the penalty stipulated in a contract for delayed construction of houses. It is a penalty paid by the builder to the buyers to compensate them for the loss that they suffer due to such delayed construction and not for getting anything in return from the buyers. Similarly, forfeiture of earnest money by a seller in case of breach of ‘an agreement to sell’ an immovable property by the buyer or by Government or local authority in the event of a successful bidder failing to act after winning the bid, for allotment of natural resources, is a mere flow of money, as the buyer or the successful bidder does not get anything in return for such forfeiture of earnest money. Forfeiture of Earnest money is stipulated in such cases not as a consideration for tolerating the breach of contract but as a compensation for the losses suffered and as a penalty for discouraging the non-serious buyers or bidders. Such payments being merely flow of money are not a consideration for any supply and are not taxable. The key in such cases is to consider whether the impugned payments constitute consideration for another independent contract envisaging tolerating an act or situation or refraining from doing any act or situation or simply doing an act. If the answer is yes, then it constitutes a ‘supply’ within the meaning of the Act, otherwise it is not a “supply”.

7.1.6 If a payment constitutes a consideration for a supply, then it is taxable irrespective of by what name it is called; it must be remembered that a “consideration” cannot be considered de hors an agreement/contract between two persons wherein one person does something for another and that other pays the first in return. If the payment is merely an event in the course of the performance of the agreement and it does not represent the ‘object’, as such, of the contract then it cannot be considered ‘consideration’. For example, a contract may provide that payment by the recipient of goods or services shall be made before a certain date and failure to make payment by the due date shall attract late fee or penalty. A contract for transport of passengers may stipulate that the ticket amount shall be partly or wholly forfeited if the passenger does not show up. A contract for package tour may stipulate forfeiture of security deposit in the event of cancellation of tour by the customer. Similarly, a contract for lease of movable or immovable property may stipulate that the lessee shall not terminate the lease before a certain period and if he does so he will have to pay certain amount as early termination fee or penalty. Some banks similarly charge pre- payment penalty if the borrower wishes to repay the loan before the maturity of the loan period. Such amounts paid for acceptance of late payment, early termination of lease or for pre-payment of loan or the amounts forfeited on cancellation of service by the customer as contemplated by the contract as part of commercial terms agreed to by the parties, constitute consideration for the supply of a facility, namely, of acceptance of late payment, early termination of a lease agreement, of pre-payment of loan and of making arrangements for the intended supply by the tour operator respectively. Therefore, such payments, even though they may be referred to as fine or penalty, are actually payments that amount to consideration for supply, and are subject to GST, in cases where such supply is taxable. Since these supplies are ancillary to the principal supply for which the contract is signed, they shall be eligible to be assessed as the principal supply, as discussed in detail in the later paragraphs. Naturally, such payments will not be taxable if the principal supply is exempt.

Further the circular clarified the below Points  where GST Will not be applicable in Below cases :

1. Liquidated Damages compensation for cancellation of coal Blocks.

2. Cheques Dishonour

3. Fines/ Penalties imposed for violation of law

4. Notice pay recovery

5. Compensation for not collecting toll charges

6. Late Payment surcharge fee ( Should Be assessed at the same rate as Principle Supply).

7. Fixed Capacity Charges for Power Cancellation Charges ( Depends up on Nature of Supply).

Hence with the above detailed explanation  and CBIC Circular No 178/10/2022-GST Dated 04.08.2022 the Washout charges / Liquidated Damages are not covered under para no 5( e ) of schedule II of section 7 of CGST Act and not chargeable to GST.