2025 (6) TMI 912 - AAR - GST

Supply or not - Liquidated Damages (LD)/Penalty recovered from contractors/suppliers for breach of contract - Liquidated Damages (LD)/Penalty recovered from contractors/suppliers on Deposit Works/ Outright Contribution Works (ORC) - Forfeiture of Security Deposit or Earnest Money Deposit in case of refusal to accept the work order despite of being Lowest One (L1) or failure of performance by the supplier or contractor - Old and unclaimed Creditors balance written back to income A/c after Three (03) Years from the date of completion of the contract - Write back of Old and unclaimed Earnest Money Deposit (EMD) / Security Deposit (SD) to income A/c after Three (03) Years from the date of the completion of the guarantee period as per contract - Penalty or charges applied for violation of conditions of contract - time of supply - HSN/SAC Code and rate of GST for such supplies - utilization of ITC against payment of GST on such supplies - value of supply. Supply or not - Liquidated Damages (LD)/Penalty recovered from contractors/suppliers for breach of contract - Liquidated Damages (LD)/Penalty recovered from contractors/suppliers on Deposit Works/ Outright Contribution Works (ORC) - HELD THAT - In case of MSETCL if a contractor fails to complete all the works within the period stipulated as per the Terms Conditions of the Contract. then MSETCL recovers Liquidated Damages/Penalty for breach of contract. MSETCL is interested in getting services within stipulated time. The contract is for performance of work and not for breach of it. This issue is squarely covered by explanation given in para 7.1 and 7.1.4 of the aforesaid circular. The principle laid down in the circular is applicable to the penalties in the nature of liquidated damages. Advance ruling order in the case of MAHAGENCO was delivered on 08.05.2018 and AAAR in the said case was delivered on 11.09.2018 whereas the Circular no. 178/10/2022-GST has been issued on 03.08.2022. This circular reflects current understanding of the issue. Hence these activities are not in the nature of a consideration for an activity and hence would not constitute a supply of service. Supply or not - Forfeiture of Security Deposit or Earnest Money Deposit in case of refusal to accept the work order despite of being Lowest One (L1) or failure of performance by the supplier or contractor - HELD THAT - The provisions for Forfeiture of Security Deposit or Earnest Money Deposit in the event of non-acceptance of the work order despite the bid being Lowest One (L1) or failure of performance by the supplier or contractor are in place to discourage non-serious supplier/contractor. The said amounts are recovered by the MSETCL not as a consideration for tolerating the act but as penalties for dissuading the non-serious supplier/ contractor and to discourage and deter such a situation. Therefore such amounts recovered by the MSETCL are not taxable as consideration is not for any supply of service. Since EMD is a security deposit and does not have the character of a consideration its forfeiture does not amount to taxable supply. Supply or not - Old and unclaimed Creditors balance written back to income A/c after three years from the date of completion of the contract - HELD THAT - The company writes back old and unclaimed Creditors balance to income after three years from the date of completion of the contract. Supply or not - Write back of Old and unclaimed Earnest Money Deposit (EMD) / Security Deposit (SD) to income A/c after three years from the date of the completion of the guarantee period as per contract - HELD THAT - It is seen that this transaction is an accounting entry as income and not against any supply. In the above-mentioned transactions there are no services received or provided by the applicant. The act of writing back unclaimed creditors balances is a mere accounting adjustment and does not involve the supply of goods or services. Consequently such transactions fall outside the purview of GST and the mere write-back of unclaimed deposits does not constitute a supply since it lacks the element of consideration for any service rendered. Accordingly such transactions are not taxable under GST. Supply or not - Penalty or charges applied for violation of conditions of contract - HELD THAT - The recoveries of penalties for violations of conditions of contract made by MSETCL are not consideration for taxable supply. As all the activities are not held as the supply of services hence there is no need to answer other questions.

Summary

The core legal questions considered by the Authority for Advance Ruling (AAR) pertain to the classification of certain recoveries and accounting adjustments by a state electricity transmission company under the Goods and Services Tax (GST) regime. Specifically, the issues are whether the following constitute a "supply" under the GST Act, thereby attracting GST liability:

• Liquidated Damages (LD) or penalties recovered from contractors/suppliers for breach of contract;
• Liquidated Damages or penalties recovered on Deposit Works/Outright Contribution Works (ORC);
• Forfeiture of Security Deposit or Earnest Money Deposit (EMD) when a contractor refuses to accept a work order despite being the lowest bidder (L1) or fails to perform;
• Writing back of old and unclaimed creditors' balances to income account after three years from contract completion;
• Write-back of old and unclaimed EMD/Security Deposit to income account after three years from guarantee period completion;
• Penalties or charges applied for violation of contract conditions.

Further, if any of these are held to be "supply," the questions extend to determining the time of supply, applicable HSN/SAC codes and GST rates, eligibility for Input Tax Credit (ITC), and valuation of such supplies.

Issue-wise Detailed Analysis:

1. Taxability of Liquidated Damages (LD) and Penalties for Breach of Contract (including Deposit/ORC works)

Legal Framework and Precedents: The GST Act defines "supply" under Section 7(1)(a) as including all forms of supply of goods or services for consideration. Schedule II, Entry 5(e) includes "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 services. Circular No. 178/10/2022-GST dated 3rd August 2022 provides detailed guidance on the taxability of liquidated damages/penalties. The Circular clarifies that liquidated damages paid solely as compensation for breach of contract, without any agreement to tolerate or refrain from an act, do not constitute consideration for supply and hence are not taxable. This interpretation aligns with principles under the Indian Contract Act, 1872 (Sections 73 and 74), which provide for compensation for loss or damage due to breach but do not treat such compensation as consideration for a separate supply.

Earlier, some advance rulings (e.g., Mahagenco) had held liquidated damages as taxable, but these rulings predate the Circular and reflect an earlier understanding. The Circular represents the current authoritative position.

Court's Reasoning and Findings: The AAR examined the nature of liquidated damages recovered by the applicant, which are penalties for non-performance or delay in performance by contractors. The company's contracts are for execution of work, not for breach. The liquidated damages are compensation for loss due to breach and not consideration for tolerating breach or for any independent supply. The Circular's explanation, particularly paragraphs 7.1 to 7.1.5, was applied to conclude that such liquidated damages are mere flows of money to compensate loss and do not amount to supply under GST.

Application of Law to Facts: Since the liquidated damages are not paid for any independent activity or for tolerating an act, they do not constitute consideration for a supply. Therefore, they fall outside the scope of GST.

Treatment of Competing Arguments: The jurisdictional officer relied on earlier rulings and Circular No. 178/10/2022-GST, which treats liquidated damages as taxable if they are consideration for tolerating an act. However, the Circular also clarifies that when such damages are purely compensatory without any agreement to tolerate breach, they are not taxable. The AAR favored this latter interpretation, noting that the Circular reflects the current understanding and overrules earlier conflicting rulings.

Conclusion: Liquidated damages/penalties recovered for breach of contract, including those related to Deposit/ORC works, do not constitute supply and are not taxable under GST.

2. Forfeiture of Security Deposit or Earnest Money Deposit (EMD)

Legal Framework and Precedents: The Circular No. 178/10/2022-GST clarifies that forfeiture of earnest money or security deposits, when stipulated as penalties for breach or non-performance, are compensatory and do not constitute supply unless there is an agreement to tolerate an act in return for such payment. Forfeiture is intended to deter non-serious bidders or contractors and is not consideration for any supply.

Court's Reasoning and Findings: The applicant's forfeiture of EMD/security deposits upon refusal to accept work orders or failure to perform is a penalty to discourage non-serious participation. There is no supply of service or goods in return. The forfeiture is a mere flow of money as compensation and penalty, not consideration for supply.

Application of Law to Facts: Since the forfeiture is not in exchange for any supply or toleration of an act, it is not a supply under GST.

Treatment of Competing Arguments: The jurisdictional officer agreed that forfeiture of EMD is not a supply unless linked to an agreement to tolerate an act. The AAR concurred with this view.

Conclusion: Forfeiture of security deposits or earnest money deposits in the circumstances described is not a supply and hence not taxable under GST.

3. Writing Back of Old and Unclaimed Creditors' Balances and EMD/SD to Income Account

Legal Framework and Precedents: Writing back unclaimed balances to income accounts is an accounting adjustment and does not involve any supply of goods or services. GST applies only to supplies as defined under the Act.

Court's Reasoning and Findings: The applicant's write-back of old and unclaimed creditors' balances and EMD/SD after three years from contract or guarantee period completion is a mere accounting entry. No supply is involved.

Application of Law to Facts: Since no supply is involved, these transactions fall outside GST scope.

Treatment of Competing Arguments: The jurisdictional officer agreed these are not supplies and not taxable.

Conclusion: Writing back old and unclaimed creditors' balances and EMD/SD to income account does not constitute supply and is not taxable under GST.

4. Penalties or Charges for Violation of Contractual Conditions

Legal Framework and Precedents: Circular No. 178/10/2022-GST clarifies that penalties imposed as consideration for tolerating an act or breach may be taxable. However, if penalties are purely compensatory and not for tolerating breach, they are not taxable.

Court's Reasoning and Findings: The penalties charged by the applicant are for breach or violation of contract terms and are not consideration for tolerating breach. They serve as deterrents and compensation.

Application of Law to Facts: These penalties are not consideration for supply and thus do not attract GST.

Treatment of Competing Arguments: The jurisdictional officer initially considered such penalties taxable under the principle of tolerating an act but the AAR relied on the Circular's clarification that penalties not linked to toleration are not taxable.

Conclusion: Penalties or charges for violation of contract conditions do not amount to supply and are not taxable under GST.

5. Ancillary Questions on Time of Supply, HSN/SAC Code, GST Rate, ITC, and Valuation

Since all the above transactions are held not to be supply, questions regarding time of supply, classification codes, GST rates, input tax credit eligibility, and valuation do not arise and are not answered.

Significant Holdings:

The AAR, relying heavily on Circular No. 178/10/2022-GST, established the following core principles:

• "Where the amount paid as 'liquidated damages' is an amount paid only to compensate for injury, loss or damage suffered by the aggrieved party due to breach of the contract and there is no agreement, express or implied, by the aggrieved party receiving the liquidated damages, to refrain from or tolerate an act or to do anything for the party paying the liquidated damages, in such cases liquidated damages are mere a flow of money from the party who causes breach of the contract to the party who suffers loss or damage due to such breach. Such payments do not constitute consideration for a supply and are not taxable."
• "Forfeiture of earnest money is stipulated ... not as a consideration for tolerating the breach of contract but as a compensation for the losses suffered and as a penalty for discouraging the non-serious buyers or bidders. Such payments being merely flow of money are not a consideration for any supply and are not taxable."
• "There has to be an express or implied agreement ... to do or abstain from doing something against payment of consideration for doing or abstaining from such act, for a taxable supply to exist."
• "Payments such as liquidated damages for breach of contract ... are not a consideration for tolerating an act or situation. They are rather amounts recovered for not tolerating an act or situation and to deter such acts; such amounts are for preventing breach of contract or non-performance and are thus mere 'events' in a contract."

The final determinations on each issue are:

• Liquidated Damages/Penalties for breach of contract and Deposit/ORC works are not supply and not taxable.
• Forfeiture of Security Deposit or EMD is not supply and not taxable.
• Writing back of old and unclaimed creditors' balances and EMD/SD to income account is not supply and not taxable.
• Penalties or charges for violation of contract conditions are not supply and not taxable.
• Consequently, questions regarding time of supply, GST rate, classification, ITC, and valuation do not arise.