Does any amount received by a person become liable to GST, irrespective of its nature and purpose? The answer is a clear no. However, entry 5(e) of Schedule II of the CGST Act, was interpreted by many to have broadened the horizon of taxable services, thereby including within its ambit several such payments received by taxpayers which otherwise does not form consideration for a supply.
Let us first discuss some basics:
Section 7 of the CGST Act governs the provision for supply. It is an inclusive definition and therefore has a wide scope. Schedule II of the CGST Act classifies a supply as goods or services. Hence, it is indisputable that we need to first establish whether an activity is a supply or not from Section 7 and thereafter refer to Schedule II for its classification.
Relevant extract of Section 7 and entry 5 (e) of Schedule II are reproduced hereunder for ease of reference:
Scope of supply.
7. (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;
(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.
ACTIVITIES OR TRANSACTIONS TO BE TREATED AS SUPPLY OF GOODS OR SUPPLY OF SERVICES
5. Supply of services
(e) agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act;
There has been confusion going on in the minds of people with regard to the aforesaid entry 5(e) as to which activities shall be covered within its purview.
On August 03, 2022, CBIC issued Circular No. 178/10/2022-GST to clarify whether GST is applicable on liquidated damages, compensation and penalty arising out of breach of contract, or other such receipts. The clarifications provided by the Circular have been analyzed hereafter.
Understanding Entry 5(e) of Schedule II of CGST Act
The Circular extends to Entry 5(e) of Schedule II of the CGST Act which considers agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act as a supply of service. The Entry could be divided into three parts as discussed below.
Agreeing to the obligation to refrain from an act
Agreeing to refrain usually implies ensuring the omission of an act. The most common example would include a lawful non-competing agreement where one party agrees to refrain from doing his business or practicing profession for consideration by another party.
Agreeing to the obligation to tolerate an act or a situation
Tolerating an act would mean not taking any action against the nuisance/obstruction caused by another party. An example would be a shopkeeper allowing a hawker to put his stall in his shop premises for a consideration.
Agreeing to the obligation to do an act
Doing an act involves an active step to do something in lieu of consideration paid by another. For example, as mentioned in the Circular, residents of a society or complex paying consideration to a factory for installing zero-emission equipment (i.e. doing an act), despite emissions being within the permissible limits.
Analyzing the Circular - What cannot be considered to fall under Entry 5(e)?
It is clear that the said transactions of agreeing to the obligation to refrain from an act, tolerate or do an act arise from the contractual relationship between two parties. Provision of service by way of refraining from an act, tolerating or doing an act must be explicitly or impliedly agreed upon by the parties and cannot be presumed to exist merely because consideration flows from one party to the other. To exemplify, an amount payable as compensation or damages for breach of contract cannot be considered to fall under Entry 5(e) for the reason that such amount is payable as a result of non-tolerance or non-performance of the concerned act. Such payments are in the nature of compensation and cannot be considered to constitute consideration. Therefore, unless payment has been made for an independent activity of refraining from an act, tolerating or doing an act under an independent arrangement, such activities cannot constitute a valid supply of service as per Entry 5(e) of Schedule II of the CGST Act. At this juncture, it is important to understand the difference between compensation and consideration.
Difference between Consideration and Compensation
The most striking difference between the two terms is that the consideration is paid as part of the contract whereas compensation is paid for breach or non-performance of the contract. A consideration is naturally bound with any contract unless it meets the conditions under Section 25 of the Contract Act which deals with agreements made without consideration. On the contrary, compensation may not necessarily exist in every contract since it shall be payable only when there is an occurrence of breach by either or both of the parties.
Instances where GST would be applicable
Liquidated damages refer to the fixed sum of compensation/penalty payable by one party in case of breach or non-performance of the contract. Such compensation paid in the form of liquidated damages is not a consideration for the performance of a contract, rather it is a device to deter non-performance or unsatisfactory performance of the contract. In such a scenario, it cannot be said that such compensation is a valid consideration for refraining from an act, tolerating or doing an act and hence, it cannot be considered to constitute supply under Entry 5(e). However, if such compensation forms consideration for an independent contract, it shall be correct to consider the transaction as supply.
Such liquidated damages may be payable by way of forfeiture or cancellation charges depending upon the facts and circumstances of the case. it is important to understand the primary difference between the two terms. A case of forfeiture arises due to an inactive step or omission on part of the service recipient whereas, in the case of cancellation, the service recipient makes an active step to not avail the services.
In case of cancellation charges, a service provider allowing cancellation of service against some cancellation charges is to be considered as a taxable event, as per the Circular, since the service provider, in such a case, is enabling the service recipient to cancel the availment of service. This component of cancellation is naturally bundled with the provision of service and forms a composite supply. Hence, it shall be leviable to GST at the same rate which is applicable for the primary service.
Forfeiture of any amount, being non-leviable to GST, has been discussed in the latter part in greater detail.
Late Payment Surcharge/Fee
A transaction allowing the provision of a late payment fee constitutes a valid supply of service which is naturally bundled with the principal supply. Such late fee is usually provided for in the terms of contract and it can be considered as an agreement to tolerate the act. Hence, such late payment fee is taxable at the same rate as the principal supply and forms part of the supply of service.
Fixed Capacity Charges
The Circular provides for a special emphasis on the taxability of fixed capacity charges in the case of electricity. Electricity has been kept outside the purview of GST. The electricity charge consists of two components namely, the fixed price i.e. base price and the variable price i.e. price depending on the consumption of electricity. The fixed price, as evident, remains the same for all the service recipients, however, it cannot be construed as consideration for tolerating the act of not consuming the minimum units of threshold. Hence, both the fixed and variable prices would form part of the transaction while computing the total price of sale. However, since electricity is exempted from GST, none of the two components would be leviable to GST.
It can thus be inferred that both fixed and variable components would form part of the value of supply and the taxability would be determined based on the nature of the primary service, which in the above example is electricity services.
Instances where GST will not be applicable
Fine or Penalty
Any fine or penalty imposed by an authority for a violation of the law cannot form a taxable event and therefore, it would not constitute a supply. Any fine or penalty imposed by an authority cannot be said to form consideration for refraining or tolerating an act. It is to ensure its compliance as well as to create a deterring effect among people against such violations. Even in the erstwhile regime, such fine or penalty was not subjected to service tax (clarified vide Circular No. 192/02/2016-ST dated 13.04.2016) and the same shall be applicable even for the current GST regime, as has been clarified in the Circular.
The same logic holds true for even private individuals/entities. Fine/penalty recovered (for the dishonor of cheque) from a defaulting entity cannot be construed as consideration and hence, it shall not be taxable.
Usually, the compensation payable for non-performance of contract cannot be leviable to GST for the reason that there is no mutual benefit accruing to parties and such a transaction cannot be considered to refrain from an act, tolerate or to do an act. For example, payment of allotment money along with compensation to the allottees of a plot by the plot developer would not constitute a valid supply. This is because the allottees of the plot are not receiving such amounts for tolerating the non-allocation.
Forfeiture of Payment
Forfeiture of any amount cannot be subjected to GST because no benefit accrues to the entity forfeiting the amount. A company forfeiting the amount for non-payment of call money or an employer forfeiting salary for leaving employment before the agreed period cannot be said to form a valid supply. Such instances lead to undesirable results for the entity and no benefit is received by them, as a result of which, no GST is payable on such forfeited amount.
To conclude, any transaction involving consideration for refraining from an act, tolerating or doing an act would be taxable under GST law under Entry 5(e) of Schedule II as a supply of service. Such supply of service should accrue benefit to both parties and should not be a payment charged for non-performance of the contract.
Lastly, as mentioned earlier, the Circular is a welcoming piece of legislation since it clarifies the law on many points. The Circular would provide relief to entities who had been discharging GST on such non-taxable transactions in order to avoid litigation and penalty under the GST law.
Disclaimer: Views expressed above are personal and may vary on case-to-case basis. Readers must take legal advice before acting upon the content mentioned above.