Untangling the realm of GST on Liquidated Damages

The taxability of liquidated damages has been a subject matter of dispute since the erstwhile Indirect Tax regime. While lately, various benches of the Hon’ble Customs Excise and Service Tax Appellate Tribunal (CESTAT) have held that service tax shall not be applicable on liquidated damages, the State Advance Ruling Authorities have ruled otherwise in the GST regime, thereby creating a sense of confusion in the trade and industry.

Hence, to settle the dust, the Central Board of Indirect Taxes and Customs (CBIC) issued Circular No. 178/10/2022-GST dated 3 August 2022, which appears to be in line with the CESTAT rulings. The Circular discusses the intent of the law behind the entry in Schedule II - “agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act” and provides guidelines for determining the taxability of contractual payments or penalties or recoveries on account of unforeseen events.

A few scenarios highlighted in the Circular are compiled below:

Sr. No. Nature of Transaction Probable GST impact as per the Circular Rationale as per the Circular
1. Liquidated damages for breach of contract/delayed or deficiency in performance/ damage to property Not Taxable Non-performance of a contract is not the essence of the contract.
The rationale emphasized for determining the taxability is that these amounts are recovered for not tolerating the breach.
2. Cheque Dishonour Charges
3. Unauthorized use of tradename, copyright Not Taxable
Exception: If payment constitutes consideration for an independent contract of doing an act, tolerating an act or refraining from doing an act, it would be treated as 'taxable supply'		 Damages are mere a flow of money from the party who causes a breach to the party who suffers loss or damage due to such breach.
Party making the payment does not get anything in return for such forfeiture.
4. Forfeiture of Earnest Money Deposit by the seller in breach of 'agreement to sell' an immovable property by the buyer
5. Forfeiture of Earnest Money Deposit by Government if successful bidder fails to act after winning the bid
6. Compensation for cancellation of coal blocks pursuant to the Supreme Court’s order Not Taxable There is no underlying supply, allottees had to accept the cancellation rather than opting for it.
7. Penalty imposed for violation of law Not Taxable Levy is a violation of law and not for tolerating the violation itself, accordingly not a 'supply.'
8. Penalty imposed by mining department for mining excess minerals
9. Compensation/forfeiture of salary for breach of bond by an employee Not Taxable The employee does not get anything in return from the employer against such recovery made from him.
Note: The same analogy may be applied to notice pay recovery.
10. Compensation by the National Highways Authority of India (NHAI) to toll plaza for not collecting toll charges during a specific period Receipt of consideration from NHAI as against the users of toll road does not change the nature of service provided by toll plaza, which is of ‘access to toll road/ bridge’, which is an exempt service.
11. Penalty for delayed payment Taxable
To be assessed as the principal supply; If the principal supply is exempt, such payments will also be exempt		 Such charges constitute a consideration for acceptance of the 'act' of the buyer.
The facility of allowing cancellation of the intended supply is naturally bundled with the principal supply.
12. Ticket cancellation charges/ forfeiture of full/partial amount for no-show, cancellation charge by hotels, entertainment event, etc.
13. Forfeiture of security deposit for cancellation of tour
14. Early termination of loan agreement/lease agreement/ pre-payment of loan
15. Late payment charges for electricity/telecom/water/etc. bills The facility of late payment is naturally bundled with the principal supply.
16. Fixed capacity charges for power The fixed capacity and variable charge are for the principal supply. The fixed charge cannot be said to be collected for tolerating non-consumption of minimum contracted quantity.

It may be pertinent to note that while the Circular has discussed various examples of such payments, the tax position on either of the transactions has not been concluded. In fact, in Para 12, CBIC has advised field formations “that while the taxability in each case shall depend on facts of that case, the above guidelines may be followed in determining whether tax on an activity or transaction needs to be aid treating the same as service by way of agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act.”

Given the above, it would be expedient to understand the key principles emerging from the Circular to attract the levy of GST, which are as follows:

  • A necessary and sufficient nexus between the supply (i.e., agreement to do or to abstain from doing something) and the consideration;
  • An express or implied agreement - oral or written, to do or abstain from doing something against payment of consideration;
  • A person (the first party) can be said to be making a supply by way of refraining from doing something or tolerating some act or situation to another person (the second party) if the first person was under an obligation to do so and then performed accordingly;
  • Consideration must flow in return from the party to contract/ agreement (the second party) to the primary party for such (a) refraining or (b) tolerating or (c) doing;
  • “Consideration” cannot be considered de hors (i.e., outside the scope) an agreement/ contract between two persons wherein one person does something for another and that other pays the first in return;
  • The contractual arrangement must be an independent arrangement in its own right - either through an independent, stand-alone contract or may form part of another contract;
  • Mere flow of money from one party to another cannot be treated as consideration for a taxable supply.

Although the clarification could serve as a guidance in determining the taxability and resolving disputes vis-à-vis contractual payments/ liquidated damages, litigation exposure cannot be ruled out basis deliberation and interpretation!

Tax Street September 2022