Liquidated Damages v. Tolerating an Act: A CLEAR PICTURE

[YOGESH HARJAI]

Unarguably, Performance is the very soul of each and every contract. A contract is normally entered into to ensure specific performance of the parties based on agreed terms.

Contracts often provides for damages, for failure on part of other party to perform as per agreed terms, known as ‘Liquidated Damages’. The intention behind such damages is not only to deter unsatisfactory or non-performance on part of the parties but also helps in safeguarding the interest of the intended parties.

As per the oxford dictionary meaning Liquidated Damages are defined as “An amount owed to a plaintiff in a lawsuit by the defendant that is determined by operation of law, such as the unpaid amount in a breach of contract”

In simpler terms, it means a compensation agreed upon by the parties entering into a contract and is payable by the failure of either party to ‘perform’ its obligations completely or as per the agreed terms.

From the above inferences it won’t be wrong to consider liquidated damages being a compensatory amount, or any other amount by whatsoever name it may be called, mutually agreed by the designate by the parties during the formation of a contract or any amount designate by the order of any court, forum etc, in order to make good the loss caused to injured party in the event of a specific breach (e.g. late performance).

A contract is usually entered for performance and to benefit the parties involved. It cannot be misinterpreted as any contract for toleration, unless and until specifically mentioned.

Its taxation under the indirect tax regime has always been a contentious issue. Under the erstwhile service tax regime, through the concept of declared service, the tax was levied in terms of section 66E of the Finance Act 1994 ‘agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act’.

It still continues to grab the eyeballs as it is exactly worded under present GST law. Section 7(1) of the CGST Act, 2017, includes activities referred to in Schedule II in the scope of supply. Clause 5(e) to Schedule II declares that ‘agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act’ shall be treated as supply of service.

Based on this, Revenue Department has formed a persistent view that the liquidated damages are consideration for tolerating an act of non-performance/unsatisfactory performance. The Authority for Advance Ruling (‘AAR’), Maharashtra, in the case of IN RE : MAHARASHTRA STATE POWER GENERATION COMPANY LIMITED [2018 (5) TMI 1332 - AUTHORITY FOR ADVANCE RULING - MAHARASHTRA] 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%. The said ruling has been further affirmed by the Maharashtra Appellate AAR also vide order no. MAH/AAAR/SS-RJ/09/2018-19. [IN RE: MAHARASHTRA STATE POWER GENERATION COMPANY LIMITED - 2018 (9) TMI 1185 - APPELLATE AUTHORITY FOR ADVANCE RULING MAHARASHTRA]

Similar Rulings are pronounced in following cases:

• IN RE : M/S NORTH AMERICAN COAL CORPORATION INDIA PRIVATE LIMITED [ 2018 (10) TMI 1339 - AUTHORITY FOR ADVANCE RULING - MAHARASHTRA]
• IN RE: M/S. RASHTRIYA ISPAT NIGAM LTD. [2019 (1) TMI 1668 - AUTHORITY FOR ADVANCE RULING, ANDHRA PRADESH]
• IN RE: M/S. DHOLERA INDUSTRIAL CITY DEVELOPMENT PROJECT LTD. [2019 (8) TMI 1217 - AUTHORITY FOR ADVANCE RULING, GUJARAT]
• IN RE: M/S. BAJAJ FINANCE LIMITED [2019 (8) TMI 31 - APPELLATE AUTHORITY FOR ADVANCE RULING MAHARASHTRA]

Amendment has been brought to section 7 of CGST Act, 2017 whereby clause (d) of section 7(1) has been deleted and new sub-section (1A) has been inserted indicating that merely the presence of entry in Schedule II does not ipso facto means supply rather all activities which are specified in Schedule II would have to first qualify as a supply in terms of section 7(1) of the act, thereafter to determine whether same is supply of goods or services, schedule II is to be referred. AAR has not appreciated and discussed at length the amendment brought with retrospective effect.

In determining the tax implications of a contract, one needs to consider the intention of the parties based on the conduct of parties. A mere receipt of Liquidated damages cannot be equated with supply of taxable services falling under Schedule II. Liquidated Damages may not always satisfy the requisites of supply and unless it falls under the scope of supply, it cannot be treated as supply of services under GST.

Aforesaid rulings contradict the commercial understanding of damages as a measure of compensation from breach of contract, and not a fee for agreeing to tolerate an act or situation. The very purpose of agreeing to payment of liquidated damages is to ensure performance and not for tolerating non-performance. Damages result from failure to perform as per agreed terms. A contract is never entered into with intent of non-performance or to tolerate non-performance. By charging damages one does not accept the deviation on part of other party, rather it is a fine levied in any contract to mitigate such losses which may be incurred by recipient in case of cancellation or completion within the specified time period in the contract. Liquidated damages are not the desired income 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.

In order to understand a clear intention of the legislature reliance is drawn towards Schedule II (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.

A mere clause in the agreement for payment of liquidated damages cannot be read as agreeing to tolerate an act as these are just to ensure performance embedded under the contract. A contract is for performance and not for breach. An agreement to tolerate an act or situation can be understood with help of following illustration:

Illustration: Mr. A runs a famous coffee shop situated at a market in Delhi with name Starbugs. Now Mr. B opens another coffee shop with name Star Baksh right across the road and pays Mr. A compensation under a contract that Mr. A will tolerate the act of opening of a new coffee shop with similar name and carrying on the business by Mr. B.

Here 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, therefor 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’ and hence will not be subject to GST.

Similar view has been adopted by Hon’ble CESTAT Allahabad in the case of M/S K.N. FOOD INDUSTRIES PVT. LTD. VERSUS THE COMMISSIONER OF CGST & CENTRAL EXCISE, KANPUR [2020 (1) TMI 6 - CESTAT ALLAHABAD]

• In the instant case, if the delivery of project gets delayed, or any other terms of the contract gests breached, which were expected to cause some damage or loss to the appellant, the contract itself provides for compensation to make good the possible damages owning to delay, or breach, as the case may be, by way of payment of liquidated damages by the contractor to the appellant.

• As such the present ex-gratia charges made by the M/s Parle to the appellant were towards making good the damages, losses or injuries arising from "unintended" events and does not emanate from any obligation on the part of any of the parties to tolerate an act or a situation and cannot be considered to be the payments for any services."

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

1. 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 Justice in 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.

Conclusion

Liquidated damages occur as an unintentional event wherein both the parties intend to avoid such a situation, but due to unforeseen events one has to suffer the consequence as fixed in the main contract. A contract is usually entered for performance and to benefit the parties involved. Misinterpreting any liquidated damages arising out of a contract or any contract involving liquidated damages being a contract for toleration is nowhere justified. A clear distinction may be adopted unless and until a contract itself specifically mentions the same.

In our view any demand raised in such instances must be contested as the same shall not sustain for long. Under the Hon’ble Indian judicial system justice is guaranteed, there may be a delay, but there won’t be any injustice.

 

Contact us:-

CA YOGESH HARJAI - FCA, LL.B, B.Com(H)

Yogeshharjai_ca@yahoo.co.in     9582444281

 

ADV. SIDDARTH MALHOTRA  -  BA.LL.B     

advsiddarthmalhotra@gmail.com     9999280696