No Service Tax on liquidated damages recovered for not adhering to time limits mentioned in contract

Neyveli Lignite Corporation Ltd. Vs Commissioner of Customs, Central Excise & Service Tax (CESTAT Chennai)

The Hon’ble CESTAT, Chennai in the matter of Neyveli Lignite Corporation Ltd. v. Commissioner of Customs, Central Excise & Service Tax, Chennai [Final Order No. 41702-41706 of 2021 in ST Appeal Nos. 41666, 41747 of 2016 & Ors., dated July 26, 2021] has held that, no service tax is to be imposed on liquidated damages recovered for not adhering to time limits mentioned in the contract as the same would not be covered in ‘Declared Services’ mentioned under Section 66E(e) of the Finance Act, 1994 (Finance Act).

Facts:

Neyveli Lignite Corporation India Limited (“the Appellant”) is a Public Sector Undertaking engaged in excavation of lignite from captive mines. The Appellant executed a contract with Bharat Heavy Electricals Limited (“BHEL”) for design, engineering, manufacture, supply, erection, testing, commissioning, and supply etc. wherein, BHEL failed to adhere to the time limits as per the contract, for which the Appellant recovered liquidated damages in terms of the contract for non-adherence to the time schedule for supplies from other contractors/vendors.

Subsequently, a Show Cause Notice dated June 3, 2015 (“SCN”) was issued by the Revenue Department (“the Respondent”) to the Appellant for alleged non-submission of service tax on  liquidated damages received for not adhering to time limits, since the same is covered under Section 66E(e) of the Finance Act and imposing interest and penalty on the same under Section 75, Section 76 and Section 78 of the Finance Act respectively.

Accordingly, the Appellant submitted a detailed reply to the SCN requesting to drop the proceedings for the reason that no service tax was payable on liquidated damages and penalties recovered under the contract. The Respondent vide order (“the Impugned Order”) rejected the contentions raised by the Appellant and confirmed the proposed demand.

Being aggrieved, this appeal has been filed.

Issue:

Whether the Appellant is liable to pay service tax under Section 66E(e) of the Finance Act on liquidated damages recovered on account of non-adherence to the time limits mentioned in the contract?

Held:

The Hon’ble CESTAT, Chennai in Final Order No. 41702-41706 of 2021, dated July 26, 2021 held as under:

• Relied on the decision of the Hon’ble CESTAT, New Delhi in M/s. South Eastern Coalfields Ltd. v. CCE & ST Service Tax Appeal No. 50567 of 2019, dated December 22, 2020] wherein, the Tribunal set aside the order passed by the Revenue Department holding that the amount received towards penalty, earnest money deposit forfeiture and liquidated damages would be tantamount to a consideration, for which service tax would be levied.
• Observed that, there has to be a flow of consideration from one person to another when one person agrees to the obligation to refrain from an act, or to tolerate an act, or a situation, or to do an act.
• Further noted that, the activities mentioned under Section 66E of the Finance Act are where the agreement specifically refers to such an activity or activities which have an expectation of flow of consideration of such service.
• Stated that, in view of the decision in South Eastern Coalfields Ltd. (ibid), it is not possible to sustain the view taken by the Respondent that since BHEL did not complete the task within the time schedule, the Appellant agreed to tolerate the same for a consideration in the form of liquidated damages, which would be subjected to service tax under Section 66E(e) of the Finance Act.
• Held that, service tax could not be levied, and the imposition of interest and penalty also cannot be sustained.
• Set aside the Impugned Order.

Our Comments:

Issue under the GST regime:

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.

Jurisprudence evolving on this issue:

The Hon’ble Maharashtra AAR in the matter of Maharashtra State Power Generation Company Limited [Order No. GST-ARA- 15/2017-18/B-30, dated May 8, 2018] held that GST at the rate of 18% would be payable on liquidated damages received by the assessee for delayed supply under a contract and considered liquidated damages to be a consideration for agreeing to the obligation to tolerate an act or a situation, which is treated as a supply of service under Para 5(e) of Schedule II of the CGST Act.

Further, a similar view has been taken by the Hon’ble Gujarat AAR, in the matter of M/s. Dholera Industrial City Development Project Ltd. [Advance Ruling No. GUJ/GAAR/R/2019/06, dated March 4, 2019] wherein it was held that assessee is liable to collect GST on amount recovered from contractors on account of breach of conditions specified in the contract and the transaction shall be treated as supply of services. Moreover, as violation charges are payable by the contractors, the same are required to be treated as consideration. Therefore, the transaction is liable to GST.

The Hon’ble Gujarat AAR in the matter of M/s. Fastrack Deal Comm Pvt. Ltd. [Advance Ruling No. GUJ/GAAR/R/58/2020, dated July 30, 2020] has held that GST is leviable on the amount forfeited on the ground of breach of agreement of sale of land, in terms of clause 5(e) of Schedule II to CGST Act

In our considered view, the levy of GST on recovery of compensation/penalty/damages depends upon the “test of supply” i.e., one has to satisfy that recovery of compensation/penalty/damages in itself is a supply, then only GST could be levied on it in terms of the insertion of sub-clause (1A) in Section 7 of the CGST Act read with omission of sub-section (d) of Section 7(1) of the CGST Act (vide Central Goods and Services (Amendment) Act, 2018 w.e.f. July 1, 2017).

The 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 ibid 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 the nature of forbearance or tolerating an act.

Relevant Provisions

Section 65B(44)(a) of the Finance Act:

(44) “service” means any activity carried out by a person for another for consideration, and includes a declared service, but shall not include-

(a) an activity which constitutes merely,-

(i) a transfer of title in goods or immovable property, by way of sale, gift or in any other manner; or

(ii) such transfer, delivery or supply of any goods which is deemed to be a sale within the meaning of clause (29A) of Article 366 of the Constitution; or

(iii) a transaction in money or actionable claim;

Section 66E(e) of the Finance Act:

“66E. The following shall constitute declared services, namely:—

(e) agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act;”

FULL TEXT OF THE CESTAT JUDGEMENT

The dispute in all the five appeals relates to demand of service tax on liquidated damages recovered by the appellant for acts of default, like delayed or deficient supplies by various suppliers.

2. The period involved in all the appeals is after 01.07.2012 and the case set out by the Department is that the appellant had agreed to tolerate breach of timelines stipulated in the contract; the amount imposed as liquidated damages are consideration for the act of tolerating contractual default; and that the appellant had rendered declared service of ^„agreeing to the obligation to refrain from an act, or to tolerate an act or a situation or to do an act^‟ contemplated under section 66E(e) of the Finance Act, 1994¹.

3. The appellant, formerly known as Neyveli Lignite Corporation India Limited, Neyveli, is a Public Sector Undertaking engaged in excavation of lignite from the captive mines at Neyveli in Tamil Nadu and at Barsingsar in Rajasthan. Lignite is principally consumed in the generation of electricity at the thermal power stations of the appellant.

4. All the five appeals have identical facts and so the facts of Service Tax Appeal No. 41666 of 2016 are being narrated. The appellant executed a contract dated 10.08.2006 with Bharat Heavy Electricals Limited² for design, engineering, manufacture, supply, erection, testing, commissioning, and supply of two Circulating Fluidised Bed Combustion steam generators, complete with all accessories and auxiliaries and two Steam Turbines. Schedule IV to the Contract stipulates “Times schedule and implementation strategy^“. Clause 4.7.1 sets out the timelines. BHEL was required to complete successful performance guarantee tests for UNIT 1 within 35 months of date of Letter of Award and for UNIT 2 within 39 months of date of Letter of Award. Clause 4.9.1. states that time is the essence of the contract and liquidated damages would be levied in case BHEL fails to adhere to the time stipulated in clause 4.7.1. As BHEL failed to adhere to the above time limits, the appellant recovered liquidated damages in terms of the contract. Likewise, the appellant recovered liquidated damages for non-adherence to the time schedule for supplies from other contractors/Vendors.

5. A show cause notice dated 03.06.2015 was issued to the appellant calling upon the appellant to show cause as to why:

“(a) the amount of Rs. 8,52,58,879/- (Rupees Eight crore fifty two lakhs fifty eight thousand eight hundred and seventy nine only), being the service tax due on the liquidated damages recovered from the supplier / contractors by NLC, for the period July 2012 to Mar. 2015, should be recovered from them under proviso to Section 73(1) of the Finance Act, 1994;

(b) appropriate interest should not be charged on the said amount under Section 75 of the Finance Act, 1994;

(c) Penalty should not be imposed on them under Section 76 and 78 of the Finance Act, 1994.”

6. Similar show cause notices were issued containing the same

7. The details of the period of dispute, the demand proposed, various sections under which penalty was imposed and the date of impugned order in the five appeals is provided in the following chart:

8. The appellant submitted a detailed reply dated 03.07.2015 to the aforesaid show cause notice with a request that the proceedings may be dropped for the reason that no service tax was payable on liquidated damages and penalties recovered under the contract.

9. The Commissioner did not accept the contentions raised by the appellant and confirmed the demand proposed. The relevant portion of the order dated 04.05.2016 passed by the Commissioner which has been impugned in is reproduced below:-

“14.5 In terms of Section 66E(e) above, the following activities, if carried out by a person for another for consideration would be treated as provision of service:

a. Agreeing to the obligation to refrain from an act.

b. Agreeing to the obligation to tolerate an act or a

c. Agreeing to the obligation to do an act.

The Taxpayer vide their reply has stated that the expression to tolerate an act under the declared services should be understood to cover instance where the consideration is being charged by one person in order to allow another person to undertake any particular activity. I find that in the present case, if BHEL not completed the task agreed upon within the time schedule, NLC agreed to tolerate the same for a consideration in the form of Liquidated damages as per the Schedule 4 of the Agreement. I find the above act of NLC are in relevance to the service covered under the term “Agreeing to the obligation to tolerate an act or situations the service” stated in Section 66E(e) of the Finance Act, 1994 and hence the same is taxable Service.”

10. Ms. Krithika Jaganathan, learned counsel appearing for the appellant in all the five appeals made the following submissions:

(i) A similar issue concerning service tax liability on liquidated damages has been decided in favour of the appellant in M/s South Eastern Coalfields Ltd. Commissioner of Central Excise and Service Tax, Raipur³;

(iii) Reliance has also been placed on the decision of the Tribunal P. Poorva Kshetra Vidyut Vitran Co. Ltd. vs. Principal Commissioner CGST & Central Excise Bhopal⁴, in support of the contention that the amount of liquidated damages/penalty collected for non-compliance of the terms of the contracts cannot be subjected to levy of service tax; and

(iii) Reliance has also been placed on a Larger Bench decision of the Tribunal in Commissioner of Service Tax, Chennai vs. REPCO Home Finance Ltd.⁵, wherein it has been held that ^“foreclosure charges” collected by banks from borrowers for premature closure of loan account are not ^“consideration” for banking services as foreclosure charges are ^„damages^‟ collected for breach of terms and conditions in the loan agreement and cannot be construed as ^„consideration^‟ for banking and other financial services.

11. Shri Balakumar and Shri L. NandKumar learned Authorized Representatives appearing for the Department have, however, supported the impugned orders and have submitted that they do not call for any interference as the demands have been confirmed in accordance with the provisions of section 66E(e) of the Finance Act.

12. The submissions advanced by the learned counsel for the appellant and the learned Authorized Representatives of the Department have been considered.

13. There is substance in the submission advanced by the learned counsel for the appellant that no service tax is payable on the amount collected towards liquidated damages as this issue has been decided by the Tribunal in favour of the appellant in South Eastern

14. Various commercial contacts had been executed by South Eastern Coalfields and certain clause provided for levy of penalty for non-observance / breach of the terms of the contract. A show cause notice was issued with an allegation that the amount charged by the appellant during the period from July 2012 to March 2016 appeared to be taxable as a ^“declared services” under section 66E(e) of the Finance Act.

15. The Principal Commissioner, however, did not accept the contention advanced on behalf of the appellant and confirmed the demand of service tax holding that the amount received by the said appellant towards penalty, earnest money deposit forfeiture and liquidated damages would tantamount to a consideration “for tolerating an act” on the part of the buyers of coal/contractors, for which service tax would be levied under section 66 E(e) of the Finance

16. The Tribunal rejected the contentions advanced on behalf of the Department that penalty amount, forfeiture of earnest money deposit and liquidated damages had been received by the said appellant towards “consideration” for “tolerating an act” leviable to service tax under section 66E(e) of the Finance Act.

17. In this connection it would be appropriate to reproduce the relevant portions of the decision of the Tribunal in South Eastern Coalfields

18. and they are as follows:

“25. It is in the light of what has been stated above that the provisions of section 66E(e) have to be analyzed. Section 65B(44) defines service to mean any activity carried out by a person for another for consideration and includes a declared service. One of the declared services contemplated under section 66E is a service contemplated under clause (e) which service is agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act. There has, therefore, to be a flow of consideration from one person to another when one person agrees to the obligation to refrain from an act, or to tolerate an act, or a situation, or to do an act. In other words, the agreement should not only specify the activity to be carried out by a person for another person but should specify the:

(i) consideration for agreeing to the obligation to refrain from an act; or

(ii) consideration for agreeing to tolerate an act or a situation; or

(iii) consideration to do an act.

26. Thus, a service conceived in an agreement where one person, for a consideration, agrees to an obligation to refrain from an act, would be a ^“declared service” under section 66E(e) read with section 65B (44) and would be taxable under section 68 at the rate specified in section Likewise, there can be services conceived in agreements in relation to the other two activities referred to in section 66E(e).

27. It is trite that an agreement has to be read as a whole so as to gather the intention of the parties. The intention of the appellant and the parties was for supply of coal; for supply of goods; and for availing various types of services. The consideration contemplated under the agreements was for such supply of coal, materials or for availing various types of services. The intention of the parties certainly was not for flouting the terms of the agreement so that the penal clauses get attracted. The penal clauses are in the nature of providing a safeguard to the commercial interest of the appellant and it cannot, by any stretch of imagination, be said that recovering any sum by invoking the penalty clauses is the reason behind the execution of the contract for an agreed consideration. It is not the intention of the appellant to impose any penalty upon the other party nor is it the intention of the other party to get penalized.

28. It also needs to be noted that section 65B(44) defines “service” to mean any activity carried out by a person for another for consideration. Explanation (a) to section 67 provides that “consideration” includes any amount that is payable for the taxable services provided or to be The recovery of liquidated damages/penalty from other party cannot be said to be towards any service per se, since neither the appellant is carrying on any activity to receive compensation nor can there be any intention of the other party to breach or violate the contract and suffer a loss. The purpose of imposing compensation or penalty is to ensure that the defaulting act is not undertaken or repeated and the same cannot be said to be towards toleration of the defaulting party. The expectation of the appellant is that the other party complies with the terms of the contract and a penalty is imposed only if there is non-compliance.

29. The situation would have been different if the party purchasing coal had an option to purchase coal from ^“A” or from ^“B” and if in such a situation ^“A” and ^“B” enter into an agreement that ^“A” would not supply coal to the appellant provided ^“B” paid some amount to it, then in such a case, it can be said that the activity may result in a deemed service contemplated under section 66E (e).

30. The activities, therefore, that are contemplated under section 66E (e), when one party agrees to refrain from an act, or to tolerate an act or a situation, or to do an act, are activities where the agreement specifically refers to such an activity and there is a flow of consideration for this activity.”

19. This decision of the Tribunal in South Eastern Coalfields was followed by the Tribunal in P. Poorva Kshetra Vidyut Vitran.

20. In view of the aforesaid decisions of the Tribunal, it is not possible to sustain the view taken by the Commissioner that since BHEL did not complete the task within the time schedule, the appellant agreed to tolerate the same for a consideration in the form of liquidated damages, which would be subjected to service tax under section 66E(e) of the Finance Act.

21. As service tax could not be levied, the imposition of interest and penalty also cannot be sustained.

22. Thus, for all the reasons stated above, the orders dated 05.2016, 20.06.2016, 20.02.2018, 20.02.2018 and 22.06.2018 impugned in Service Tax Appeals No’s 41666/2016, 41747/2016, 41427/2018, 41428/2018 and 42203/2018 respectively are set aside and the Appeals are allowed.

(Order pronounced on 26.07.2021)

Notes:-

1 the Finance Act

2 BHEL

3 2020 (12) TMI 912 –CESTAT NEW DELHI

4 2021 (2) TMI 821 –CESTAT NEW DELHI

5 2020 (42) G.S.T.L. 104 (Tri. –LB)

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