“Sometimes in waves of change, we find our true direction”
The taxability of liquidated damages has always been questioned under Indirect Tax. Liquidated Damages are per se not defined under the CGST Act, 2017, hence a reference may be made to other acts and judgments made thereunder. Although the Indian Contracts Act, 1872 doesn’t define Liquidity damages, te exegesis of Section 73 and Section 74 of the Contract Act, elaborates on the recovery of damages on account of breach of contract as under:
“When a contract has been broken, the party who suffers by such breach is entitled to receive, from the party who has broken the contract, compensation for any loss or damage caused to him thereby, which naturally arose in the usual course of things from such breach, or which the parties knew, when they made the contract, to be likely to result from the breach of it”.
“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 provided to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named, or the case may be, the penalty stipulated for.”
Concisely, damages are payable only if some loss has occurred due to breach of contract. Thus, an aggrieved due to cancelation of contract may get compensation. However, an excerpt from the book titled The Indian Contract and Specific Relief Acts (Fourteenth Edition) by Pollock & Mulla refers to liquidated damages as:
“Liquidated Damages- Liquidated damages’ means shall be taken as the sum which the parties have by the contract assessed as damages to be paid whatever may be the actual damage. A fixed figure of damages, which is not assessed for all circumstances, but is graduated to correspond with passage of time between the making of a contract and its breach, is a proper estimate of the damages to be anticipated from the breach, and is liquidated damages.”
The Hon’ble Apex Court in the case of Fateh Chand {1963 AIR 1405 1964 SCR (1) 515 CITATOR INFO: RF 1970 SC1955 (3,5) E&D}, where the sale deed couldn’t be registered in entirety within limited time and accordingly balance amount was forfeited, the bench of 5 judges held that the scenario is covered under Section 74 of the Contract Act, and stated,
“The expression if the contract contains any other stipulation by way of penalty widens the operation of the section to make it applicable to all stipulations by way of penalty, whether the stipulation is to pay an amount of money, or is of another character, as, for example, providing for forfeiture of money already paid.”
Further, in case of “Kailash Nath v. Delhi Development Authority” { Civil Appeal No. 193 OF 2015 [Arising Out Of SLP (Civil) No.32039 OF 2012]}, the Apex Court laid down the guidelines for determining whether parties are entitled to liquidated damages or reasonable compensation based on following principles:
- ‘genuine pre-estimate of damages’ otherwise the parties are entitled to only reasonable compensation not exceeding the fixed sum mentioned in the contract;
- If any penalty is stipulated in the contract then only reasonable compensation is awarded not exceeding the amount so fixed for the penalty;
- In case the court decides to award reasonable compensation, the basic principles of section 73 shall apply in the assessment of compensation;
- Proof of damage or loss is a sine qua non for grant of reasonable compensation under Section 74 and such proof is dispensed only if damages are difficult or impossible to prove and liquidated damages are genuine pre-estimate of damages.
Similar jurisprudence was held in the case of Indian Oil Corporation Vs. Messrs Lloyds Steel Industries Limited; 2007 (144) DLT 659 by Delhi High Court on similar grounds.
In pursuance of above, the liquidated damages cannot be claimed if it is proved that no actual damages were caused by the breach as mere delay in construction and commissioning of the terminal at Jodhpur by the contractor did not entitle IOC to recover Liquidated Damages because there was no loss suffered by IOC.
Eligibility of Goods and Services Tax on Liquidated damages
Levying GST is concluded through taxable supplies. The apprehension of amended Section 7 of the CGST Act deliberates the scope of supply as under:
(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; and
(d) the activities to be treated as supply of goods or supply of services as referred to in Schedule II.
(2)(1) 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.
*(2)(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.”; (*w.e.f. February 01, 2019, Amendment in CGST Act, 2018).
The acuteness of amendment made in Section with the introduction of sub-section 2(1A) to Section 7 is that the goods or services as mentioned in Schedule II may be considered as supply only if the same is considered as supply per sub-section 1.
Thus, it may be noticed although anything agreed as an obligation to refrain from an act, or to tolerate an act or a situation, or to do an act is treated as supply of service as per Schedule II, the same may not be treated as supply if it does not comply with any of the following condition as referred in Section 1:
- sale, transfer, barter, exchange, license, rental, lease or disposal made or agreed to be made of goods or service
- for consideration
- in the course or furtherance of business
- Activities under Schedule I
Thus, in the pertinence of above understanding, the liquidity damages should not be subject to GST liability, if same is arising from anything other than in consistence of Agreement and may involve performance.
Further, distinct views have been taken by different authorities under a plethora of jurisprudences under GST Law, briefed hereunder:
1. Rashtriya Ispat Nigam Limited- AAR Andhra Pradesh
{AAR NO.01 /AP/GST/2019 dated: 11.01.2019}
The word ‘obligation’ used in entry 5(3) indicates the need for the existence of the desire in the person for whom the activity is done. In other words, when the service receiver requests the service provider to tolerate an act/situation and the service provider obliges to tolerate, provided consideration is paid, then such a contractual relationship will get covered by entry 5(e) of Schedule II.
It was held that, In terms of the aforesaid contract agreement, GST would apply to the Liquidated Damages.
The liability of payment of these liquidated damages by the contractor will be established once the delay in the successful execution of work is established on the part of the Contractor. The time of supply may be determined on execution and not on delay in supply.
2. Maharashtra State Power Generation Company Ltd.– AAR Maharashtra
{MAH/AAAR/SS-RJ/09/2018-19 dated 11.09.2018}
It was 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%. The said ruling has been further affirmed by the Maharashtra Appellate AAR also.
*(However, it may be noticed that both the above judgments relate to pre-amendment in GST Law)
3. Bai Mamubai Trust, Vithaldas Laxmidas Bhatia, Smt. Indu Vithaldas Bhatia vs. Suchitra- Mumbai High Court
{Court Receiver’s Report No. 213 of 2017, in Commercial Suit (l) no. 236 of 2017, September 13, 2019}
The Court pronounced 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. Thus GST is not payable on damages or compensation paid for legal injury.
It is further highlighted that though the court has not considered Clause 5(e) of Schedule II, but even if the same is considered it should align with supply u/s 7(1) first.
4. Repco Home Finance Ltd. v/s Commissioner of Service Tax Chennai, at CESTAT Chennai
{Service Tax Cross Application No. 40320 of 2018}
It was held that no Service Tax may be levied on miscellaneous income on premature termination of loans. Further foreclosure charges collected by the bank and non-banking financial companies on premature termination of loans are not leviable to Service Tax.
After contemplating the above, despite distinct views under aforesaid jurisprudences, we are of the view that the liquidated damages should not be subject to Goods and Services Tax.
(The comments added in the above article is as per Author’s view and understanding, which may vary from views of others).
This Article is written by CA Shruti Kabra. She as an Indirect tax professional has experience in Goods and Services Tax, Indirect Taxes laws advisory, compliance and Litigation. Has advised large multi-national and Indian companies in Automotive industry, Telecom, Hospitality, Defence and Aerospace, e-commerce, Oil & Gas, Transportation, Consumer Goods, Pharma, Information Technology, FMCG, Beverages, Real Estate, Media.
Her involvement has been across various industries and includes both domestic and cross-border transactions involving structuring of transactions along-with meeting and discussion with Government, Tax and Regulatory Authorities.
She represents clients before assessing/adjudicating and appellate authorities up to Tribunal.
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