India: Another Damaging GST Ruling; AAR Levies 18% GST On Liquidated Damages

Recently, the Maharashtra Authority for Advance Ruling ("AAR") in the case of Maharashtra State Power Generation Company Limited ("Applicant") held that Goods and Services Tax ("GST") at the rate of 18% would be payable on liquidated damages ("LD") received by the Applicant for delayed supply under a contract. The AAR has considered LD to be a consideration for agreeing to the obligation to tolerate an act or a situation, which is treated as a supply of service under para 5(e) of Schedule II of the Central Goods and Services Act, 2017 ("CGST Act") / Maharashtra Goods and Services Act, 2017 ("MGST") (as the provisions of CGST Act and MGST are almost identical, they are collectively referred to as "GST Act").

This ruling is one among a series of unsettling GST rulings passed by state AARs in recent times. The ruling digresses from the legal and commercial understanding of LD as a measure of compensation for a pre-estimated loss from breach of contract, and not a fee for agreeing to tolerate an act or situation. This ruling poses a risk of GST scrutiny for parties enforcing LD clauses in a contract.

Facts

Applicant is a State Power Utility engaged in the generation of power with the objective to make power available to all at affordable rates. The Applicant enters into contracts with various contractors on a turnkey basis for (a) construction of new power plants or renovation of old plants, and (b) operation and maintenance activities ("Applicant Contracts"). The Applicant Contracts fix the period of completion and also stipulate the manner of calculation of LD payable by the contractor if there is a delay in completion on account of the contractor.

The sample contract examined in the ruling is one for erection, testing and commissioning of the main plant package ("ETC Contract"). As per the ETC Contract, the contractor is required to commence trial operation of two units within a stipulated period of time. In the event of delay for reasons attributable to the contractor, the ETC Contract provides for payment of LD at the rate of 0.5% of the contract price, up to a maximum of 10% of the contract price. The liability to pay LD is established after the delay in successful completion on account of the contractor is established.

The Applicant approached the AAR for a ruling, inter alia, on whether GST is applicable on LD in case of the Applicant Contracts, and if GST applies, whether it is covered under Schedule II entry no. 5(2)(e) under HSN Code 9997 – Other Services at the rate of 18%;

Relevant Provisions

GST is applicable on 'supply' of goods or services or both and is charged on the 'value of supply'. Section 15(1) of the GST Act defines 'value of taxable supply' as the transaction value, which is the price actually paid or payable for the said supply where the supplier and the recipient of supply are unrelated and the price is the sole consideration.

Paragraph 5 of Schedule II to CGST Act provides a list of activities to be treated as 'supply of services' which inter alia comprises – "(e) agreeing to the obligation to refrain from an act, or to tolerate an act or situation, or to do an act".

Applicant's Position

The Applicant argued that LD being a compensation towards deficiency of services reduces the value of the contract. Therefore, far from being a separate supply chargeable to GST, the consideration paid by the Applicant to the contractor reduces to the extent of LD, thereby reducing the tax base, i.e., value of supply on which GST is levied. The various facets of the Applicant's submissions are set out below –

  1. Applicant relied on the definition of 'value of taxable supply' under Section 15 of the GST Act and concluded that the resultant price after payment of LD would be the transaction value. The Applicant placed reliance on the rulings of Customs, Excise and Service Tax Tribunal ("CESTAT") in the cases of Commissioner of Chandigarh v. M/s HFCL 1 and Commissioner of Customs and Central Excise v. Victory Electricals Ltd 2 where it has been held that LD reduces the contract price for the purpose of levying excise duty. Applicant argued that these rulings are based on the definition of 'transaction value' under the erstwhile Central Excise Act, 1944, which is similar in its construction to the definition of 'value of taxable supply' under the GST Act.
  2. Applicant relied on the legal position adopted in a public ruling by the Australian Tax Authority in respect of payment of damages on early termination of lease of goods. There it was clarified that such damages, if specified in the contract, would be considered as adjustment in relation to the earlier supply.
  3. Performance is the essence of a contract, while damages result from failure to perform as per agreed terms. LD is prescribed to deter or dissuade unsatisfactory performance or non-performance and is an expression of displeasure. Hence, LD cannot be said to be the desired income but is paid to compensate for loss suffered by the recipient.
  4. In determining the tax implications of a transaction, it is important to consider the intention of the contracting parties as gathered from the contract or conduct of the parties. In lump sum turnkey contracts like the Applicant Contracts, settlement amounts do not represent the primary intent of the parties and are only incidental to the primary intent and objective, which is to construct and deliver a power plant. These settlement amounts could at best be considered as an adjustment or reduction in contractual consideration. On the contrary, para 5(e) of Schedule II of the GST Act targets arrangements where the primary intention is to tolerate an act or situation.
  5. Deduction of LD from the consideration amount cannot be enforced separately and will always be preceded by delay in supply. Hence, it cannot be construed as a separate supply which is independently performed.

Ruling

The AAR ruled against the Applicant and held that LD under the Applicant Contracts constitute payment for a separate supply of service under the category of 'agreeing to tolerate an act or situation'. It observed that deduction of LD from the contract consideration is a mere facilitation towards settlement of accounts and it does not actually result in reduction in the value of the main supply.

The AAR observed that the ETC Contract specifically mentions that the contractor's liability for LD will be established once the delay in successful completion on part of the contractor is established. Hence, the ETC Contract contemplates two separate events. The obligation on the contractor to supply his deliverables under the contract is the first event. Occurrence of this event is followed by an evaluation of whether the deliverables were supplied within the timeframe agreed upon by the contractor. If such evaluation finds a delay, the contingent liability of LD translates into an actual recoverable liability, which is the second event. While the consequence of the first event is the payment of contract price, the consequence of the second event is the payment of LD. Accordingly, payment of LD is part of a separate event and constitutes a distinct supply.

The AAR examined specific clauses of the ETC Contract and held that deduction of LD from the contact price was only a means to recover LD from the contractor, and this cannot be construed to mean that the two are not distinct events. It ruled that the ETC Contract does not support the argument that LD reduces the contract price basis the following observations –

  • Clauses which define 'contract price' and 'contract value' only refer to the lump-sum payment made for the services plus price variations, if any. The clause which sets out contract price adjustment / variation also makes no reference to the levy of LD.
  • Clause 16 provides that the Applicant is entitled to claim all costs, damages, etc. which he may have paid for which the contractor is liable. The Applicant may recover these amounts by raising a bill on the contractor, which if not paid in time, would entitle the Applicant to deduct these from any amounts due or becoming due by him to the contractor. Hence, there are other mechanisms to recover damages apart from recovery by way of adjustment against contract price.
  • Clause 21 titled 'Contractor's Default' provides that the Applicant may adjust the cost of employing another person to execute a work neglected by the contractor against any amount due by him to the contractor. The excess, if any, of such cost shall be paid by the contractor to the Applicant. This clause specifically provides that the payment of such excess amount is independent of LD for delay. The AAR construed this to mean that payment of LD is an independent liability under the ETC Contract and is not to be mixed with the payments due to the Applicant from the contractor.

Further, the AAR rejected the Applicant's argument that neither the contractor nor the Applicant had intended the delay thereby causing the Applicant to tolerate it. In this regard, the AAR observed that the ETC Contract specifically provides for the eventuality of delay to result in a liability to pay LD, while the GST Act has also provided for this eventuality by specifically deeming the act of agreeing to tolerate an act or situation as a supply of service. Since the delay has taken place, the same is being tolerated by the Applicant in consideration for a price, i.e., LD and should therefore qualify as a supply of service by the Applicant in terms of para 5(e) of Schedule II to the GST Act.

The AAR distinguished the cases cited by the Applicant (please see above) and observed the holding of CESTAT that the "transaction value" for the levy of excise duty reduces on account of a price variation clause in cases where LD results in the taxpayer having to pay a lesser amount than an agreed price. The AAR held that this rationale cannot be applied to the instant case where the agreement does not contemplate a price variation or reduction of contract price / contract value owing to LD.

Having held it to be a supply of service, the AAR placed the supply in the category of Heading 9997 - 'Other Services' in Notification No. 11/2017 – Central / State Tax (Rate) ("Notification") taxable at the rate of 18% [9% CGST + 9% MGST]. 3

Analysis

The ruling has entangled two broad and independent aspects – (i) whether LD could be treated as a deduction from the contract price for the purpose of levying GST, and (ii) whether LD should itself be chargeable to GST. The AAR has failed to sufficiently differentiate these aspects in its ruling and has applied the same brush across both to rule that LD does not reduce the contract price because it is a distinct supply (or vice-versa) and hence chargeable to GST.

Examination of the contractual clauses to see whether the contract price and price variation clauses account for LD should be relevant only for the purpose of the first aspect. To that extent, the AAR is not entirely off the mark in distinguishing the cases cited by the Applicant and holding that the contracts in the instant case do not envisage reduction of contract price / value by the amount of LD. In clauses where it is specified that LD shall be deducted from the total contract price, the AAR has understandably read this to only indicate a mechanism for recovery of LD. In the cases cited by the Applicant, namely Victory Electricals and HFCL (which relied on Victory Electricals), the CESTAT has stressed on price variation clauses and observed that –

"wherever the assessee, as per the terms of the contract and on account of delay in delivery of manufactured goods is liable to pay a lesser amount than the generically agreed price as a result of a clause (in the agreement) stipulating variation in the price, on account of the liability to "liquidated damages"............the resultant price would be the "transaction value"; and such value shall be liable to levy of excise duty, at the applicable rate." [Emphasis added]

Therefore, we believe that there may be some merit in the AAR rejecting the Applicant's argument to reduce the contract price.

On the second aspect, however, the AAR has missed the mark and has over-emphasized on literal interpretation of the contract while ignoring the fundamental concept of LD. The Indian Contract act, 1872 provides for both unliquidated damages ("UD") and LD in Section 73 and 74 respectively. In case of UD, there is no pre-determined sum specified in the contract and actual loss caused due to the breach has to be proved in order for the court to grant appropriate damages. On the other hand, when LD is stipulated in the contract, the suffering party prima facie becomes entitled to a pre-determined sum of money upon breach by the other party. However, if a dispute arises, the court goes into the genuineness of the sum stipulated in the contract and grants reasonable compensation not exceeding such sum. Hence, while existence of loss or injury is still required to be proved in case LD, proving the extent of the loss may be dispensed with if the court finds that LD so stipulated is bona fide and a fair estimate of loss / injury arising from the breach. There may also be cases where disproportionate or exorbitant sums are prescribed as LD in the contract for the purpose of terrorizing or dissuading the other party from committing a breach. In such cases, courts identify such sums as being in the nature of penalty and not damages, in which case the court may require the party claiming damages to prove actual loss. Therefore, fundamentally damages represent compensation for loss or injury caused from a breach, whether they be pre-estimated or determined post-facto. This ruling places a misplaced connotation on the concepts of breach and damages in a contract. While acknowledging that damages are payable upon breach, the AAR has conceptually re-characterised damages as some form of consideration paid for agreeing to an obligation to tolerate a breach of contract. This is contrary to the concept of damages as being a compensation for loss, or in some cases, even a penalty. Even assuming that LD specified in the ETC Contract was one in the nature of penalty, it cannot be construed as a consideration for tolerating breach but is in fact a deterrence to ensure performance of the contract. 4 A basic aspect which has been ignored by the AAR is that a contract is entered into for performance and not for breach. 5 To classify payment of LD as a distinct supply in the contract is to read a contract to be agreeing to its breach.

The category of taxable service under para 5(e) of Schedule II to GST Act (agreeing to tolerate) has been followed from an identical category of 'declared services' under the former service tax regime. While there have always been academic debates on whether damages would fall under the ambit of service tax, there has never been a legislative clarification or judicial pronouncement on this until now. This ruling by the AAR increases the risk of GST scrutiny for entities enforcing LD clauses for breach of contract. While AAR rulings are only binding on the Applicant and the Revenue in respect of the particular issue in question, they are often considered as having a persuasive precedential value. Therefore, in light of this ruling, contracting parties may consider revisiting their LD clauses so as to clearly provide for reduction in contract price / value by the LD amount and to clearly state that payment of LD is not a distinct event in the contact. Further, parties may also consider protecting themselves from the burden of GST by providing for the defaulting party to bear the GST, if any, levied on LD.

Footnotes

1 2015-(11)-TMI-893-CESTAT

2 [2014] 43 GST 649 (Chennai - CESTAT)

3 AAR referred to the Scheme of Classification of Services annexed to the Notification which provides for the entry 'Agreeing to tolerate an act' against Service Code 999794.

4 From the Applicant's submissions reproduced in the ruling, we believe that the concept of LD was not clearly elucidated as it was explained to represent both, compensation and penalty. Therefore, conceptually the difference between the two was blurred in the Applicant's submissions. The Applicant could probably have been better off had the LD been pitched as compensation rather than penalty.

5 Krithika Jaganathan and V. Pandhanthan, Why tax liquidated damages?, https://www.lakshmisri.com/News-and-Publications/Publications/Articles/Tax/why-tax-liquidated-damages

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