By Nikshetaa Jain and Tushar Chitlangia, students at National Law University Odisha
The setbacks created by COVID-19 had major ramifications across the world, and businesses were no exceptions. Due to the lockdowns, the supply chains were disrupted and as a consequence, some parties were not able to perform the contract.
Therefore, the parties either had to take a) contractual recourse i.e. Force Majeure clauses or; b) statutory recourse i.e. pleading frustration of contract under Section 56 of the Indian Contract Act, 1872. However, if the parties are unable to exercise either of the two alternatives, the contract will be termed as ‘breached’, and the defaulting party could be liable to pay the damages
In this regard, there is an ongoing tussle over the taxability of Liquidated damages under the Central Goods and Services Act, 2017 (“Act”). There is little clarification regarding this issue, and various Courts and Tribunals have interpreted it differently. Clearing the air is the need of the hour as ambiguities surrounding the taxability of damages can be subject to voluminous litigation claims, especially during this pandemic. Many contracts have already been breached, and many more could be breached due to the prevailing uncertainties. Thus, it becomes crucial for the government to ease out the whole process by giving more clarity.
The authors seek to critically analyse the taxability of liquidated damages in light of the decisions by different Tribunals and Courts. Further, the authors present reasoned opinions to concur that liquidated damages are not under the purview of supply under Goods and Services Tax (“GST”) which is an indirect tax. Lastly, the authors highlight the stance on the taxability of liquidated damages in different countries.
Meaning of Supply and Liquidated Damages
As per Section 9 of the CGST Act, 2017, GST shall be levied on the supply of goods and services. Supply is defined under Section 7 of the Act which states that supply, includes sale, transfer, barter, exchange, license, rental, lease or disposal of any goods or services. As per Section 7 of the Act supply is made for consideration in the course or furtherance of business. However, Schedule I of the Act specifies certain activities which are treated as supply of goods or services even without consideration.
Liquidated damages refer to an amount pre-determined by the contracting parties which are paid as compensation at the time of breach of the contract. Once a breach is committed, the defaulting party pays liquidated damages to the injured party for compensating its loss due to breach. Thus, liquidated damages are an estimate of loss which are determined at time of formation of the contract and are an estimate of loss which the party may suffer due to breach of contract.
As per the Act, the AAR is empowered to hear questions such as classification of goods or services, determining taxability on goods or service, and application of a notification issued under the Act. The rulings of AAR are binding only on the applicant and thus, AAR rulings do not set precedents for future cases. However, they do create an environment which has the potential to influence future rulings. This article tries to examine the trend created by an AAR ruling on the taxability of liquidated damages.
In the case of Maharashtra State Power Generation Company, the Maharashtra Authority for Advance Ruling (“AAR”) has taken the view that GST shall be levied on liquidated damages. The question before the AAR was whether payment of liquidated damages is a taxable supply under Schedule II clause 5(e) of the Act which states that “agreeing to an obligation to refrain from an act, or to tolerate an act or a situation, or to do an act is considered as supply of services”. The AAR held that the Applicant had tolerated an act (i.e. delayed supply) by the Contractor and has received liquidated damages as consideration for such delay. The Applicant has provided a service to the Contractor by tolerating an act, i.e. the delay of supply. The Contractor, being a service recipient, has paid the Applicant consideration in the form of liquidated damages. Thus, the AAR held that liquidated damages are to be considered as supply under clause 5(e) of Schedule II and hence 18% GST is to be levied on such damages. The Appellate Authority for Advance Ruling has also upheld the same view.
Similar view has been taken in the case of Rashtriya Ispat Nigam Ltd., where the Andhra Pradesh AAR held that based on the facts of the case, liquidated damages form a price for toleration of the occurred delay. The liquidated damages are to be treated as other miscellaneous income received for the supply of service, i.e. toleration of breach. Thus, the Authority held that liquidated damages are taxable under GST.
However, a contradictory view was taken in the case of Bai Mamubai Trust and Ors. v Suchitra and Ors.[i] The issue before the Court was whether GST was applicable on royalty paid for retention of the premises. Royalty is a compensation payable to the owner of the property by the occupier of the property. In this case, the tenant had violated the owner’s legal rights and was required to compensate such violation by paying royalty. The Court held that royalty paid is in the nature of damages and that supply does not include a unilateral wrongful act resulting in payment of damages. The Court emphasised on reciprocal and positive nature of an act to be considered as supply.
Liquidated Damages are not Taxable
The authors are of the view that liquidated damages are not taxable and present the following arguments.
It was held in Nathi Devi v Radha Devi Gupta[ii] that emphasis has to be given to every word used by the legislature. “Agreeing (emphasis supplied) to the obligation to…. tolerate any act or situation” implies that the party has to agree to tolerate any act explicitly. The provision cannot be extended to mean that the innocent party has agreed to tolerate a ‘breach’. This is because no party, in the reasonable nature of the business, will agree for the breach of contract. The purpose for inserting a clause of liquidated damages is only to ensure that work is completed within the specified time, and rather not to ensue punishment for a breach. Further, it was held in The Punjab National Bank v The Union of India[iii] that obligation means “a duty or liability arising in law or from the contract”. It can be safely concluded that there is no duty or liability in any law or in any contract to tolerate a breach. Additionally, in a recent order passed by Customs, Excise and Service Tax Appellate Tribunal, Allahabadit was held that there has to be a specific concurrence to assume an obligation. The concurrence of tolerating breach will always remain absent in an innocent party. Hence, from a plain reading of the relevant provision, it can be stated that liquidated damages are not taxable.
In Dr. Golak Bihari Mohanty v State of Orrisa,[iv] the Court held that it is essential to understand the primary object of the transaction to understand the true meaning of such transaction. The objective of payment of liquidated damages is to restore the innocent party to its original position, i.e. a position where there is no breach of contract. Therefore, if the objective of payment is to restore the original position, the payment of liquidated damages cannot be termed as a consideration as it will involve another separate act altogether. For example, let us assume that the contract is breached and the defaulting party has paid the damages. On account of payment of damages, we argue that the parties have been restored to their original position. There has been no supply as envisaged under Section 7 of the Act. Thus, charging GST on liquidated damages would breach the fundamental objective of levying such damages, which is to restore the original position of the parties.
It is a settled principle that if any clause or any provision is ambiguous, one of the safest recourses is to identify the legislative intent behind drafting it. talks about the price to be paid (consideration) for ascertaining the transaction value of supply of any service. The consideration for supply under this section includes, inter-alia, “interest or late fee or penalty for delayed payment of any consideration for any supply”. This means that any interest or late fee or penalty will form part of the consideration and not a separate “act of toleration”. Therefore, it is seen that the legislative intent was not to tax any sort of compensation separately. Had there been such an intent, this clause would have been subsumed under “toleration of act”. Therefore, as no compensation can be taxed separately, liquidated damages also cannot be taxed separately under “toleration of act”.
Foreign Jurisprudence on Taxability of Liquidated Damages
Common law countries such as Australia and England have similar views on taxation of liquidated damages. In the case of Vehicle Control Services Ltd., the Upper Tribunal, Tax and Chancery Chamber held that payment which represents damages for breach of contract is outside the scope of any indirect tax.
In the GSTR Ruling 2003/11, the Australian Tax Office held that a payment received to compensate the injured party for genuine damage or loss due to early termination as a result of default by the other party could not be termed as consideration for a supply. Since no supply has been made in respect of the payment, there is no GST liability.
After critically analysing the provisions of the Act, general principles of contract and principles followed in different countries, it is safe to conclude that liquidated damages should not be subject to any indirect tax. Liquidated damages are compensatory in nature and are levied to ensure performance. There are rulings of various tribunals which support this theory of compensation. Further, payment of liquidated damages cannot be considered as a consideration; hence no tax must be levied on them. In the recent rulings by AAR, there seem to be some uncertainties in the mind of contracting parties. The government would be well advised to explicitly clarify their stance by issuing a circular in this regard. Not only will this prevent parties from going into strenuous litigations but also bring clarity to the taxability of the liquidated damages.
[i] (2014) SCC OnLine Bo 1854.
[ii] (2000) 9 SCC 249.
[iii] (1986) 59 CompCas 35 Delhi.
[iv] (1974) 33 STC 514 Orissa.