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TAXABILITY OF LIQUIDATED DAMAGES UNDER GST |
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TAXABILITY OF LIQUIDATED DAMAGES UNDER GST |
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Scope of Liquidated Damages ‘Liquidated damages’ is a common prevalent business terminology comprising of two words – liquidated and damages. This can be found in business agreements or contracts to protect the interests of the principal or the other party from any specified action arising out of performance or non-performance or breach of any conditions of the contract. Literally ‘to liquidate’ implies the winding up of affairs of a business by ascertaining assets and liabilities, a plan to liquidate, process of liquidation. ‘Damages’ refer to detrimental effects. Damages are a sum of money claimed or awarded in compensation for a loss or an enquiry. Liquidated damages are damages or a sum of money which is agreed upon in a contact to be paid to a party by another party in the event of breach of any term or condition of the contract. According to P. Ramanatha Aiyar’s Advanced Law Lexicon (4th ed), ‘liquidated damages’ have been assigned the following meanings and are the form of a penal clause: “A fixed periodic amount payable as a sanction for delays or sub-standard performance under a contract, also known as a penalty clause. When the sum fixed represents a genuine pre-estimate of the probable damage which is likely to result from the breach, it is called liquidated damages. Damages of an amount already specified in a contract. A sum stated and agreed to be paid as damages between the parties to a contract, in the event of default by either; the primary meaning of that phrase is, that the sum has been "assessed between the parties" (per COTTON, L. J., Wallis v. Smith, 52 LJ Ch 154). Liquidated damages in a contract mean the payment of a certain and reasonable sum of money which should operate to extinguish any claim of plaintiffs for damages by reason of the breach of the contract by defendants. Where, from the nature of the transaction, the actual damages consequent on a breach of the contract are incapable of accurate measurement, or where the sum specified is not out of all proportion to any damages which could arise, the provision will be treated as liquidated damages. But where these facts do not exist the tendency of the Court is to treat the stipulation in the nature of a penalty. The essence of liquidated damages is a genuine pre-estimated damage and the estimate of penalty is a payment of money stipulated as in terrorem of the offending party and the question whether the sum stipulated is penalty or liquidated damages is a question of construction to be decided upon the terms of the surrounding circumstances in the context of which the contract had been made. Prahled Bhagirath Firm v. Badrilal Bhalooram, MLJ: QD (1956-1960) Vol. II CI026: 1959 MPLJ (Notes) 171. [Contract Act (9 of 1872), S.74]. Contracts often contain provisions for the payment of sums of money or the forfeiture of goods or other property in the event of the particular specified branches of the contract. These provisions vary considerably but their main objectives are to act as an inducement to due performance of a particular contractual obligation, or to regulate beforehand in an agreed and certain manner the rights of the parties, rather than leave them to the less predictable remedies otherwise available, and in particular the assessment of damages in the event of the breach of the obligation in question. [Hudson's Building and Engineering Contracts, 11th Edn., Vol. 2, para 10.001, p. 1131]. Where the terms of a contract specify a sum payable for non-performance, it is a question of construction which this sum is to be treated as a penalty or as liquidated damages. The difference in effect is this, the amount recoverable in case of a penalty is not the sum named, but the damage actually incurred. The amount recoverable as liquidated damages is the sum named as such. In construing these terms a judge will not accept the phraseology of the parties; they may call the sum specified 'liquidated damages' but if the judge finds it to be a penalty, he will treat it as such. WILLIAM R. ANSON, Principles of the Law of Contract 470 (ARTHUR L. CORBIN ed., 3d Am. ed. 1919). The distinction between a penalty and genuine liquidated damages, as they are called, is not always easy to apply, but the Courts have made the task simpler by laying down certain guiding principles. In the first place, if the sum payable is so large as to be far in excess of the probable damage on breach, it is almost certainly a penalty. Secondly, if the same sum is expressed to be payable on anyone of a number of different breaches of varying importance, it is again probably a penalty, because it is extremely unlikely that the same damage would be caused by these varying breaches. Thirdly, where a sum is expressed to be payable on a certain date, and a further sum in the event of default being made, this latter sum is prima facie a penalty, because mere delay in payment is unlikely to cause damage. Finally, it is to be noted that the mere use of the words 'liquidated damages' is not decisive, for it is the task of the Court and not of the parties to decide the true nature of the sum payable. P.S. ATIYAH, An Introduction to the Law Contract 316-17 (3d ed. 1981).” ‘Liquidated damages’ was not defined in the Finance Act, 1994 but is a common concept in business. Literally, it means monetary compensation for a loss, detriment, or injury to a person or a person’s rights or property, awarded by a court judgment or by a contract stipulation regarding breach of contract. Indian Contract Act, 1872 deals with ‘liquidated damages’ in section 73 and 74 of the said Act. Accordingly, these are reproduced below: “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 as the case may be, the penalty stipulated for.” Liquidated damages are nothing but monetary compensation for suffering arising out of breach of contract. Taxation under Service Tax regime In Service Tax regime, there was a declared service under section 66E(e) of the Finance Act, 1994 whereby an activity to the obligation to retrain from an act, or to tolerate an act or a situation or to do an act, was considered as a service and liable to levy of Service Tax. In terms of this entry, the following activities if carried out by a person for another for consideration were treated as provision of service: • Agreeing to the obligation to refrain from an act. • Agreeing to the obligation to tolerate an act or a situation. • Agreeing to the obligation to do an act. Entry (e) covered the activities relating to refraining from an act or tolerating an act or situation or doing an act. In case of liquidated damages, nothing of these sorts take place. The damages come without any agreement to obligation. It is a consequence of a breach which was neither agreed to nor obligated. The compensation is not a result of any action or inaction on the part of service provider, i.e., recipient of damages. Further, Rule 6(2)(vi) of Service Tax (Determination of Value) Rules, 2006 excludes ‘accidental damages due to unforeseen actions not related to the provision of service’. This covered consideration or amount arising out of two situations - there is no provision of service and there exists unforeseen actions. Liquidated damages also are the outcome of these two situations. GST on Liquidated Damages Under the GST law, scope of supply is defined in section 7 and charging section levy and collection) is governed by section 9 of CGST Act 2017. ‘Supply’ is defined as an inclusive definition which shall include:
It further provides that certain supplies shall be treated neither as supply of goods nor as supply of services. According to Schedule-II to the Act, certain services have been specified to be treated as supply of services which inter alia includes: “5(e) agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act”. This entry is similar to declared services as defined in section 66E(e) of the erstwhile Finance Act, 1994. Advance Ruling on Liquidated Damages Recently, Authority for Advance Ruling (AAR), Maharashtra had an occasion to examine the taxability of liquidated damages for GST in the matter of Re: Maharashtra State Power Generation Company Ltd. 2018 (5) TMI 1332 - AUTHORITY FOR ADVANCE RULING - MAHARASHTRA Apart from taxability, the issues of time of accrual of GST (time of supply and rate of tax on such damages were also determined. In the present case, agreement provided that the liability of payment of these liquidated damages by the contractor will be established once the delay in successful completion of trial operation is established on the part of the contractor. Thus, the act of delayed supply has happened. The same was being tolerated by an additional levy in the nature of liquidated damages. The agreement had also provided that the payment by contractor or deduction by owner of any sums under the provision of this clause shall not relieve the contractor from his obligations to complete the works or from his other obligations under the contract. This provision just ensured that the obligations under the contract are fulfilled. The facts are much obvious that the empowerment to levy liquidated damages is for the reason that there had been a delay and the same would be tolerated, but for a price or damages. The income though presented in the form of a deduction from the payments to be made to the contractor was the income of the applicant and would be a supply of ‘service’ by the applicant in terms of clause (e) of para 5 of Schedule II appended to the Central Goods and Services Tax Act, 2017. Based on the agreement, AAR ruled that GST would be applicable on the liquidated damages treating it as supply of services under section 7 read with clause 5(e) of the Schedule-II to the CGST Act, 2017. On classification and rate of GST applicable to liquidated damages, it was ruled that levy of GST on liquidated damages would be could by para 5(e) of Schedule-II to the GST Act. The following scheduled entry under the Notification No. 11/2017-Central/State Tax (Rate) [as amended from time to time] for taxable services would cover the impugned levy of liquidated damages –
Another important issue of levy of GST is that at what time the liability to pay GST would occur. This would be governed by time of supply provision as stipulated in section 13 and 14 the GST law. Section 13(1) provides that the liability to pay tax on services shall arise at the time of supply for which agreement and section 14 are relevant. Accordingly, liquidated damages is determined and imposed upon the contractor after in-depth study. In terms of the agreement, the clauses revealed that the levy of liquidated damages is not when the delay is occurring but the liability of payment of these liquidated damages by the Contractor will be established once the delay in successful completion of trial operation is established on the part of the Contractor. This would define the time of supply. In terms of Section 13(1) of Central Goods and Services Tax Act, 2017, liability to pay tax on services arose at time of supply. If contractor fails to achieve trial operation of unit within specified time period which fells under GST regime, then levy of liquidated damages would be attracted and this levy would attract GST levy. Section 14 of CGST Act should be referred to by the applicant. Liquidated damages if any collected/received under previously applicable Service Tax regime before coming into effect of GST, would be dealt with in accordance with then existent provisions under applicable laws. In view of the above discussion, following assertions could be made:
By: Dr. Sanjiv Agarwal - July 21, 2018
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