A Complete Detail on GST on Liquidated Damages

Deepti Shikha

18 Feb, 2021

Liquidated damages are a common term used by the parties under a contract. Concerning the implication of indirect taxes, both in the previous law and also the present GST law, there has always been an issue on the taxability of the liquidated damages, and the Government has never clarified this issue. Liquidated Damages are charged for Non-Performance or Breach of Contract or Late Delivery of Supplies etc. According to S 7(1) (d) of the GST Act consists of activities which are referred to in Schedule II within the scope of supply. Entry 5(e) declares that amount of service will be treated as agreeing to accountability to exempt from an act, or to tolerate an act or a situation, or to do an act. 

What is the Meaning of Liquidated Damages?

According to Black’s Law Dictionary -Liquidated damages are a fixed amount contractually specified as a reasonable estimate of actual damages to be recovered by one party in case the other party breaches the contract. If the parties in a contract have properly settled the amount of liquidated damages, the sum fixed is the measure of damages for breach of contract, it does not matter if the actual damages is more than or less than the fixed damage amount. The difference between penalty and substantial liquidated damages is difficult to apply.

What is the Need of Liquidated Damages?

The main essence of a contract is performance. The parties in contract generally include their expectation in terms of damage, which is caused by the failure of either party to perform its duty as per the terms in the agreement. The contract may mention the costs for deficiency in the performance of a contract, which is known as ‘liquidated damages.’ It is to deter unsatisfactory performance or non-performance of a contract. For instance, a contract mentions in its clauses that time is the essence in the contract, then any delay would invite liquidated damages fixed in the contract.

What is the Basic Difference Between Liquidated Damages and Unliquidated Damages?

Liquidated Damages

Liquidated damages, which are also referred to as liquidated and ascertained damages, are those damages of which the amount is fixed by the parties during the formation of a contract. The injured party in the contract can collect the compensation upon a specific breach. The clauses of liquidated damages are used in various types of contracts like Construction contracts or IT. The liquidated clause in a contract provides certainty to the parties. It also assists in the recovery of the amount breached by avoiding the requirement of the proof of loss. Liquidated damages simplify the procedure relating to any types of disputes and may persuade the performance of a contract. The liquidated damage clause regulates the right of the parties after the breach of contract.

Unliquidated damages

Unliquidated damages are not a pre-fixed or determined amount. A claim for unliquidated damages is generally governed by common law. Whenever the amount of damages is not decided in advance, then the amount to be recovered must be agreed or determined by a court or tribunal in the event of breach.

Why is GST on Liquidated Damages Levied?

The view which supported levy of tax on liquidated damages is based on the principle that the party has tolerated the non-performance of the contract.

In Notification number 25/2012, entry 573-Service Tax, 20th June, 2012 offered for exemption with respect to the Services given by the Government or a local authority for non-performance of a contract for which compensation in the form of fines or liquidated damages is payable to the Government or local authority as per the agreement.

The GST Act continued with the same scheme for taxation and exemption according to the Service Tax law.

As perEntry 5(e) in Schedule II of the GST Act is similarly worded and declares that “agreeing to the obligation or to refrain from an act, or to tolerate an act or a circumstance, will be treated as supply of service.

The Notification number 12/2017-Central Tax (Rate) dated 28th June, 2017 provides for exemption from tax. The appropriate entry in the Notification reads as below:

Advance Ruling of Taxability of GST on Liquidated Damages

In a case for Advance Ruling before the Maharashtra State Power Generation Company Ltd-2018

The matter on this case was on applicability of GST on Liquidated damages the on the outline, “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act,” mentioned in schedule II,  para 5 in clause (e) of the GST Act.

In this case, the authority held that GST on liquidated damages would be levied by observing the following facts:

In re Bajaj Finance Limited (GST AAAR Maharashtra); Order No. MAH/AAAR/SS-RJ/24/2018-19; 14/03/2019

Facts of the Case

1. The Appellant here is a non-banking financial company (NBFC). It provides various types of loans to the customers, such as loans against the property, auto loans, personal loans, consumer durable goods loans, etc. These loans are all interest-bearing loans.
2. The Appellant, among other things, makes agreements with its borrowers or customers for providing loans to them. The loan agreements offers repayment of the outstanding dues or equated Monthly Installments or (EMI) through cheque/ Electronic Clearing System (`ECS’) or National Automated Clearing House (‘NACH’) or any other electronic or clearing mandate. The descriptive copies of the loan agreement between the applicant and the customers have been enclosed. 
3. In case of dishonour of cheque or ECS or NACH or through any other electronic, the applicant collects penal or cheque bounce charges, which is as per the agreed terms and conditions between the borrower and the applicant. The bounce charges are primarily a fixed amount fixed as per the default of the customer. For instance. Rs.350 is charged for dishonour of cheque. Only the defaulting customers need to pay the bounce charges.

This Ruling also impacts many other similar transactions.For instance, if a builder forfeits a buyer’s earnest money after the buyer fails to buy a flat in a contracted period, GST will be levied on that forfeited amount since the builder has ‘tolerated your act’ of not paying the full amount. Therefore, it becomes a ‘deemed service,’ and GST is due.

Hence, GST applies on

• Liquidated Damages and other Penalties.
• Penal or Default Interest in case of any delay in repayment of EMI
• Advance Forfeited in case of  cancellation of the agreement,
• Forfeiture of Security for Damages.
• Compensation given for termination of contract,
• Non-Compete Fee for not Competing,
• Cancellation Charges charged for Cancelling Travel Ticket by way of train, bus, or air.

View Points opposing levy of GST on Liquidated Damages

By way of exception clause, the presence of levy  of GST on Liquidated damages cannot be denied:

• A person agrees for the payment of liquidated damages to guarantee the performance of a specific contract.
• The Liquidated damages is not a consideration to tolerate non-performance of a contract.
• The payments made as compensation or damages do not amount for supplies for tax purposes. This is because the compensation amount is made for settlement of financial loss caused by the breach of agreement or infringement of rights.
• Forfeiture of deposits or payment of damages does not restitute the person to whom loss or damage is caused.
• Liquidated damages are just a measure of damages to which parties give their approval, rather than being a remedy.
•  According to Section 73 and section 74 of the Indian Contract Act, 1872 –A recovery of liquidated damages is possible in case of breach of contract.

Case Laws

 In Kaira Can Company Ltd v DCIT [2010]

The taxpayer, in this case, made certain payments to SEBI as per a scheme framed by SEBI to regularise default of certain disclosures as prescribed in SEBI Substantial Acquisition of Shares and Takeovers) Regulations, 1997. The tribunal here held that such payments could not be said to be a penalty as per section 15A of the SEBI Act^[1]; hence it is not hit by explanation to section 37(1) of the Income-tax Act, 1961.

In Ashok Kumar Damani v Addl CIT [2011]

The taxpayer here made a short payment of margin money to the stock exchange. The assessee paid the penalty charged by the stock exchange during the period under consideration. Here It was held tribunal held that the payment had been made in the stock exchange on account of short payment of money. Payment made here is only a compensatory payment as per the rules of the stock exchange which is permittable as revenue expenditure as the same is not for infraction of the law.

In Agarwal Roadlines P Ltd v Dy. Comm. of Income Tax [2010] 129

In this case, the Government of Gujrat had introduced a Gold Card scheme according to which carrying of excess load in the vehicle was permitted on payment of some additional fees fixed in the given gold card. The assessee here was charged for overloading regularly. The tribunal here held that such fees were compensatory in nature and not a  penalty. Payment of these fees empowered the transporters to carry overloaded trucks to the final destination without stopping them from unloading the excess weightage from the vehicles. The fact that excess weight was not needed to be unloaded shows that payment made under the scheme was not penal as no Government machinery encourages violation or infringement of legal provisions. Expenditure incurred was allowed as deduction.

Post GST Act amendment

Schedule II of the GST Act was expected to be a mere authoritative declaration as to the nature of the activity, whether it involves the supply of goods or services. The Lok Sabha on 9th August, 2018 had passed four amendment bills relating to GST. Section 7 of the CGST Act defines ‘supply’ which was amended on 1st July, 2017 itself. Sub-section (1A) was inserted in section 7(d) .Hence the role of Schedule II is limited to classification of supply as goods or services. For charging tax on liquidated damage, the transaction must first pass the test of supply, which appears to be a difficult job. Previous service tax law, on the introduction of a negative list on taxation, declared activity of agreeing to an obligation to refrain from doing an act/to tolerate an act or a situation/ to do an act’, to perform as a service. The present GST law does not make any such declaration. It merely divides supply as ‘goods’ or ‘services.’ Though the levy of tax on these activities was not free from doubt in service tax law, under GST, it is more doubtful as there is no such statutory declaration. Liquidated damages may hardly satisfy the essentials of supply of service.

Conclusion