'Liquidated Damages' means a compensation specified under the contract agreed between the parties for an estimated loss and which is required to be paid upon failure of either party to perform its obligations. It is important to note that 'Liquidated Damages' is not defined under the Indian Contract Act, 1872. However, there are provisions that protect rights and privileges of parties in case of non-performance of contract by either of the parties.
DIFFERENCE BETWEEN LIQUIDATED DAMAGES AND UNLIQUIDATED DAMAGES
Liquidated damages are considered as compensation which is already agreed upon by the parties in a contract. On the other hand, unliquidated damages are awarded by a consequence of an order passed by a court or tribunal and such compensation is not determined or agreed in a contract entered between parties.
TAXABILITY OF 'LIQUIDATED DAMAGES' UNDER GST
Taxability of liquidated damages has always been an unsettled issue in erstwhile indirect taxes and continues to be so under GST too. Under the erstwhile service tax regime, 'agreeing to the obligation of refraining from an act, or tolerating an act or a situation, or to do an act' was considered as 'declared service' and accordingly, Service Tax was sought to be levied on liquidated damages. Taxability on the same has been extended under GST regime wherein 'agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act' is treated as 'supply of service' and subject to GST@18%.
The important issue which needs consideration is whether liquidated damages is to be considered as tolerating an act for non-performance of contract. The significance must be given to intention of parties during execution of a contract while determining taxability on liquidated damages. Mere mentioning of liquidated damages in a contract would not conclude that party has been given an option to violate the contract. Non-performance of contract results into unilateral act of one-party claiming compensation from the other party which cannot be foreseen during formation of the contract. Liquidated damages are a compensation for an unforeseen event which is solely dependent on non-performance of contract. Under a contract, parties thereto do intend to avoid non-performance of terms and conditions agreed by them and do not enter into the contract with a probable intention to breach the contract. Thus, contract is entered between parties for performance of contract and not for tolerating non-performance of contract.
Thus, it can be said that compensation received by the aggrieved parties is not towards any 'consideration' for a service but as a consequence for not performing one's obligations as per the contract. Liquidated damages cannot be treated as a chosen income, but it is rather payment to compensate loss suffered by receiving party. The compensation so received from unintended events and does not arise from any obligation on part of any parties to tolerate an act or situation. Hence, it is incorrect to equate compensation with consideration or payment for supply of taxable services.
Recently, the hon'ble Customs, Excise and Customs Appellate Tribunal (CESTAT) in the case of MNH Shakti Limited vs The Commissioner, CGST, Rourkela [Final Order No. 75619/2021 dated November 10, 2021] observed that where any amount is received under a contract as a compensation or liquidated or unliquidated damages, it cannot be termed as 'consideration' against provision of service for the purpose of levying tax. Further, the hon'ble CESTAT in case of M/s South Eastern Coalfields Limited vs Commissioner of Central Excise and Service Tax, Raipur [Final Order No. 51651/2020 dated December 22, 2020] held that penal clauses in an agreement are in the nature of providing a safeguard to the commercial interest of parties and cannot by any stretch of imagination, be said that recovering any sum by invoking the penalty clauses is the reason behind the execution of the contract for an agreed consideration. Accordingly, 'compensation received' cannot be considered as synonymous with 'tolerating or that the one party tolerates an act or situation'.
Needless to say that such judicial precedents will definitely have an impact as a reference or reliance in present GST regime.
However, as it is in vogue, there are various adverse advance rulings passed by the AAR under GST regime wherein in some states liquidated damages has been treated as consideration for tolerance of non-performance and held that such liquidated damages are subject to GST @18% while some have held it to be outside the purview of the GST laws. It is pertinent to mention that adverse rulings have ignored the very important aspect that the contract cannot be entered with an intention of parties with non-performance of contract and compensation cannot be equated with consideration.
CONCLUSION
GST authorities while deciding on taxability of a transaction or any payment must give importance to intention of parties during formation of contract. In case of liquidated damages, the parties to the contract do not have any intention to receive compensation during execution of contract. Further, amount received as compensation to offset losses incurred by a party cannot be treated as consideration against forbearance or tolerating an act for purpose of determining its taxability. Hence, liquidated damages cannot be treated as 'tolerating of an act' and therefore, is not subject to GST.
Originally Published December 2021
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