Recently, the Tax Research Unit of the Ministry of Finance, Department of Revenue (TRU) has issued a clarificatory circular1 (Circular) on taxability of ‘liquidated damages’, and other payments in the nature of compensation, penalty, cancellation charges arising out of a breach of contract, under the Central Goods and Services Tax Act (CGST Act).
Specifically, the Circular examines applicability of CGST on aforementioned payments in light of the scope of entry at Paragraph 5(e) of Schedule II of the CGST Act:
Schedule II – Para 5(e) - “agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act”
The Circular has clarified various scenarios as enumerated herein below:
A. Liquidated damages paid for breach of contract
B. Compensation given to previous allottees of coal blocks for cancellation of their licenses pursuant to Supreme Court Order
C. Cheque dishonour fine/ penalty charged by a supplier
D. Penalty paid by a mining company to Central or State Government for unaccounted mining and mining beyond permissible limits
E. Forfeiture of salary/ recovery of bond amount from an employee leaving the employment before the agreed period
F. Late payment charges collected by any service provider for late payment of bills
G. Fixed charges collected by a power generating company from State Electricity Boards (SEBs) or by SEBs/ DISCOMs from individual customer for supply of electricity
H. Cancellation charges recovered by railways for cancellation of tickets, etc
I. Compensation for not collecting toll charges
All the above scenarios have at different points of time been held to be exigible to GST by various State-wide Appellate/ Authorities of Advance Ruling by treating the same as a supply of service under para 5(e) of Schedule II.2 Also, with several conflicting judgments, including from the erstwhile service tax regime, there was widespread confusion and resistance on the taxability. This ultimately led to enough number of representations by the industry which culminated in the issuance of the present Circular.
The Circular has now clarified as under:
| Sr No | Liable to GST | Not liable to GST |
|---|---|---|
| 1 | Late payment charges collected for failure to make payment on time | Liquidated damages |
| 2 | Cancellation charges or any fee recovered for cancellation of tickets, hotel accommodation, etc | Compensation for cancellation of allotted coal blocks, pursuant to the Supreme Court Order |
| 3 | Forfeiture of ticket amounts or any deposit towards ‘no-show’ by a passenger or cancellation of tour | Cheque dishonour fine/ penalty |
| 4 | Compensation for not collecting toll charges | Penalty paid by a mining company for any excess stock |
| 5 | Pre-payment charges levied by a bank for early repayment of loan by a borrower | Forfeiture of salary/ bond amount recovered from an employee leaving the employment before the agreed period |
| 6 | Non-compete fees | Fixed charges collected by a power generating company for supply of electricity |
| 7 | - | Penalty for violation of legal provisions |
| 8 | - | Forfeiture of earnest money by the seller of an immovable property for breach of any agreement |
Reasoning in the Circular
The primary theme of the Circular revolves around the necessity of a ‘contractual relationship’ for an activity to constitute a ‘supply’ under GST, to be exigible to tax. Under such a contractual relationship, a person is required to undertake an activity at the desire of another person for whom the activity is undertaken, in exchange for a consideration.
Applying the aforementioned principles to para 5(e) of Schedule II, a contractual relationship cannot be presumed to exist simply because there is a flow of money from one party to another. There ought to be an express or implied promise by the recipient of money to agree to do or abstain from doing something or to tolerate something in return for the money paid to him.
For scenarios at points A to E above, the Circular states that these are amounts received for not tolerating an act or a situation and to deter such acts leading to breach of contract. Such amounts are for preventing a breach of contract or non-performance and are thus mere ‘events’ in a contract. The Circular clarifies that there cannot be any contract with an intent to allow:
(a) a breach thereof, or
(b) for holding more stock than permitted under the mining contract, or
(c) for leaving the employment before the agreed minimum period, or
(d) for doing something leading to the dishonour of a cheque
Such transactions are merely 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 a consideration for a supply and are thus not taxable.
Alternate view
Unsurprisingly, the Circular continues to treat certain similarly placed scenarios exigible to GST by treating them as supply of service either independently or part of the bundle of services or ancillary to a main service. In the following scenarios, the TRU has reached a conclusion that the same entails a supply of service:
| Sr No | SCENARIO | WHAT IS THE SUPPLY OF SERVICE? |
|---|---|---|
| 1 | A contract may provide that payment by the recipient of goods or services shall be made before a certain date and failure to make payment by the due date shall attract late fee or penalty | Acceptance of late payment |
| 2 | A contract for transport of passengers may stipulate that the ticket amount shall be partly or wholly forfeited if the passenger does not show up | Making arrangements for the intended supply of bundle of services by the tour operator |
| 3 | A contract for package tour may stipulate forfeiture of security deposit in the event of cancellation of tour by the customer | Making arrangements for the intended supply of bundle of services by the tour operator |
| 4 | A contract for lease of movable or immovable property may stipulate that the lessee shall not terminate the lease before a certain period and if he does so he will have to pay certain amount as early termination fee or penalty | Acceptance of early termination of a lease agreement |
| 5 | A charge pre-payment penalty if the borrower wishes to repay the loan before the maturity of the loan period | Acceptance of pre-payment of loan |
In each of the aforementioned scenarios, the following contrary views are possible:
1. The payment results out of non-performance or delay in performance or breach
2. Such payments act as deterrent for non-performance or breach
3. Such payments are compensatory in nature to make up for the injury/ loss suffered due to non-performance or breach
Only because the contract stipulates provides for compensatory/ liquidated damages, the same does not become a contract to tolerate
However, as per the TRU, the aforesaid payments are actually consideration for supply. These supplies are considered ancillary to the principal supply for which the contract was signed and therefore, exigible to same rate as the principal supply.
Such a reasoning appears to be misplaced and leaves room for misapplication of the law on treatment of supply of service under para 5(e) of Schedule II. As highlighted above, the considerations are again compensatory payments and/ or damages for loss or injury suffered. The only difference is the method of computation of the damages.
In this context, it is pertinent to highlight here that a similar erratic set of reasonings were incorrectly adopted by the Appellate Authority of Advance Ruling (AAAR), Maharashtra in the case of Maharashtra State Power Generation Company Ltd. where the learned AAAR came to a similar conclusion by holding that:
1. The contract stipulates a provision on liquidated damages, independent of contract price or value;
2. Because the contract was not terminated, the party has tolerated an act or situation; and
3. Lastly, the acceptance of the amount in damages is a voluntary act.
That, the Hon’ble Bombay High Court3 ruling on a similar scenario has pointed out the very characteristics of damages and their exigibility under GST as follows:
“60. Damages may arise in an action in tort, or one in breach of contract as they both entail civil wrongs. Damages represent the compensation or restitution for the loss caused to the plaintiff for the violation of a legal right. It may even be the closest monetary alternative to a remedy in specific performance. The term ‘Damages’ may be used to include payments towards contractual obligations which are performed yet unpaid for, but the law of damages is not restricted to ordering that what ought to have been done or ought to have been paid under contract. The law recognizes and awards damages between persons who do not have privity, if there is a violation of a legal right resulting in a civil wrong which must be remedied.”
The Hon’ble Court further relying on the ruling in Senairam Doongarmall vs. Commissioner of Income Tax4 has held that the quality of the payment and not the method used to determine its measure determines its character namely whether it is ‘consideration’ or damages. The method of computation is not material. While holding so the Hon’ble Court states:
72. I am of the view that although the measure for quantifying a payment of royalty to the Court Receiver may be determined by looking at consideration payable under a contract or arising out of a business relationship, the royalty may still be in the nature of payments towards a potential award of damages or Mesne Profits, and therefore not liable to attract GST for reasons separately stated.”
Lastly, the Hon’ble Court held that enforceable reciprocal obligations are essential to a supply. The supply doctrine does not contemplate or encompass a wrongful unilateral act or any resulting payment of damages.
Conclusion
The Circular is a welcome development, especially in the matter of liquidated damages which have been a subject of dispute; the Circular should now result in disposal of pending litigation. Taxpayers should proactively file early hearing applications, if any of their existing litigations squarely find favour with the clarification of this Circular. Also, taxpayers should analyse their business transactions/ tax positions adopted and re-determine the taxability based on the principles laid down by the Circular.
While the clarification on liquidated damages has correctly summarized that the same ought not to be characterized as a ‘consideration’, similar reasoning could also have been extended to the other scenarios/ examples in the Circular. It appears that there is a misplaced understanding of the concept of supply in the Circular, leading to uncertain outcomes in similarly placed scenarios. Given the fact that an advisory has been issued to field formations to follow the Circular as a guideline, litigation on several scenarios is likely to continue where a clear line has not been drawn by the instant Circular.
Authors: Deni Shah, Shreyas Shrivastava and Karan Vin
The information contained in this document is not legal advice or legal opinion. The contents recorded in the said document are for informational purposes only and should not be used for commercial purposes. Acuity Law LLP disclaims all liability to any person for any loss or damage caused by errors or omissions, whether arising from negligence, accident, or any other cause.
1 Circular No. 178/10/2022-GST dated: 03.08.2022
2 In Re.: Fastrack Deal Comm (P.) Ltd. (GUJ/GAAR/R/58/2020 dated 30.07.2020); In Re.: Amneal Pharmaceuticals (P.) Ltd. (GUJ/GAAR/R/51/2020 dated 30.07.2020); In Re.: M/S TP Ajmer Distribution Limited [(2019) 103 taxmann.com 227 (AAAR-RAJASTHAN)]; M/S Bajaj Finance Limited (MAH/AAAR/SS-RJ/24/2018-19); In Re.: Maharashtra State Power Generation Company Ltd. [2018 (70 GST 411)]
3 Bai Mamubai Trust v. Suchitra TS-736-HC-2019(BOM)-NT]
4 (1962) SCR 1 257