Whether liquidated damages received due to delayed supply of machinery is taxable as revenue receipt or non-taxable as capital receipt?

In the matter of Rai Bahadur Jairam Valji (supra), it was observed thus, honorable Supreme Court had said that, "The question whether a receipt is capital or income has frequently come up for determination before the courts. Various rules have been enunciated as furnishing a key to the solution of the question, but as often observed by the highest authorities, it is not possible to lay down any single test as infallible or any single criterion as decisive in the determination of the question, which must ultimately depend on the facts of the particular case, and the authorities bearing on the question are valuable only as indicating the matters that have to be taken into account in reaching a decision"

Since the matter is controversial and subject to judicial scrutiny from time to tome, another issue in respect of liquidated damages went upto Honorbale Supreme Court in the matter of  "Commissioner Of Income Tax, Gujarat Versus M/S. Saurashtra Cement Limited [2010 -TMI - 76690 - SUPREME COURT OF INDIA].

Facts of the Case:

The assessee, engaged in the manufacture of cement etc; entered into an agreement with M/s Walchandnagar Industries Limited, Bombay, (hereinafter referred to as "the supplier") on 1st September, 1967 for purchase of additional cement plant from them for a total consideration of Rs.1,70,00,000/-. As per the terms of contract, the amount of consideration was to be paid by the assessee in four instalments.

The agreement contained a condition with regard to the manner in which the machinery was to be delivered and the consequences of delay in delivery. Insofar as the present appeal is concerned, clause No.6 of the agreement is relevant and it reads as follows:

"6. xxx xxx xxx Delayed Deliveries:

In the event of delays in deliveries except the reason of Force Majeure at para 5 mentioned above, the Suppliers shall pay the Purchasers an agreed amount by way of liquidated damages without proof of damages actually suffered at the rate of 0.5% of the price of the respective machinery and equipment to which the items were delivered late (sic), for each month of delay in delivery completion. It is further agreed that the total amount of such agreed liquidated damages shall not exceed 5% of the total price of the plant and machinery."

As per the said clause in the agreement, in the event of delay caused in delivery of the machinery, the assessee was to be compensated at the rate of 0.5% of the price of the respective portion of the machinery for delay of each month by way of liquidated damages by the supplier, without proof of actual loss.

However, the total amount of damages was not to exceed 5% of the total price of the plant and machinery.

The supplier defaulted and failed to supply the plant and machinery on the scheduled time and, therefore, as per the terms of contract, the assessee received an amount of Rs.8,50,000/- from the supplier by way of liquidated damages.

During the course of assessment proceedings for the relevant assessment Year, a question arose whether the said amount received by the assessee as damages was a capital or a revenue receipt. The Assessing Officer negatived the claim of the assessee that the said amount should be treated as a capital receipt. Accordingly, he included the said amount in the total income of the assessee.

Decision of the Apex Court

It is clear from clause No.6 of the agreement dated 1st September 1967, extracted above, that the liquidated damages were to be calculated at 0.5% of the price of the respective machinery and equipment to which the items were delivered late, for each month of delay in delivery completion, without proof of the actual damages the assessee would have suffered on account of the delay. The delay in supply could be of the whole plant or a part thereof but the determination of damages was not based upon the calculation made in respect of loss of profit on account of supply of a particular part of the plant. It is evident that the damages to the assessee was directly and intimately linked with the procurement of a capital asset i.e. the cement plant, which would obviously lead to delay in coming into existence of the profit making apparatus, rather than a receipt in the course of profit earning process. Compensation paid for the delay in procurement of capital asset amounted to sterilization of the capital asset of the assessee as supplier had failed to supply the plant within time as stipulated in the agreement and clause No.6 thereof came into play. The afore-stated amount received by the assessee towards compensation for sterilization of the profit earning source, not in the ordinary course of their business, in our opinion, was a capital receipt in the hands of the assessee.

"Commissioner Of Income Tax, Gujarat Versus M/S. Saurashtra Cement Limited [2010 -TMI - 76690 - SUPREME COURT OF INDIA].