Introduction

Liquidated damages are damages which an injured party is entitled to receive on account of breach by the other contracting party. They refer to a pre-determined amount of compensation as stipulated in the contract which the parties before entering into a contract agree upon, will be payable in case there is a breach of the terms of the agreement by any of the contracting parties as provided in Sections 73 and 74 of the Indian Contract Act, 1872. It is common for the parties entering into a contract to specify in the contract itself, as to what compensation would be payable in the event of a breach of the contract. Black's Law Dictionary defines 'Liquidated Damages' as cash compensation agreed to by a signed, written contract for breach of contract, payable to the aggrieved party.

Examples of Liquidated damages include those would be damages resulting from damage to property, negligence, unauthorized use of trade name, copyright, etc. Another example would be covered here are the compensation stipulated in a contract for delayed completion of construction of residential or commercial structures. It is a penalty paid by the builder to the buyers to compensate them for the loss that they suffer due to such delayed construction.

Pre-GST Regime

The taxability of liquidated damages has been largely debated since Service Tax regime. Under the erstwhile Service Tax law, Section 66E of the Finance Act 1994 included "agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act" as taxable service. However, a few judicial judgments like in the case of Neyveli Lignite Corporation. Ltd. v. CCE & Service Tax held that the receipt of liquidated damages on the grounds of breach of contract or non-performance by the defaulting party cannot be subjected to service tax.

GST Regime

With the introduction of GST, an approach was taken in the Goods and Service Tax (GST) regime by inserting Entry 5(e) in Schedule II of CGST Act, 2017 that classified such transactions as a supply of 'service'. It states that "agreeing to the obligation to refrain from an act, or to tolerate an act or situation, or to do an act" would constitute as supply of service. Based on the above-mentioned legal provisions, various courts have pronounced contrasting judgements on the taxability of liquidated damages.

Judgments around this issue

Judgements that held Liquidated Damages are taxable:

In the matter of Maharashtra State Power Generation Company Ltd1, Authority for Advance Ruling (AAR) has held that liquidated damages are to be viewed as consideration of tolerance of non-performance, and thus is subject to GST at 18%.

h3>Judgements that held that Liquidated Damages are not taxable:

The Hon'ble High Court of Madras in the matter of GE T & D India Ltd. v. Deputy Commissioner of Central Excise2 held that notice pay is not taxable under service tax as the employer has not "tolerated" an act of the employee. Rather, employer has permitted a sudden exit upon being compensated by the employee in this regard.

Clarification made through Circular No. 178/10/2022 - GST dated 03 August 2022 ("Circular")3

To provide clarification regarding the tax position in relation to liquidated damages and resolve the litigative point of views, the Central Board of Indirect Taxes and Customs ("Board") issued a circular clarifying the applicability of GST on various charges arising out of the breach of contract. The Board has divided and explained the scope of Entry 5(e) in Schedule II in following three segments:

  1. Agreeing to the obligation to refrain from an act- For eg- Non-compete agreements, where one party agrees not to compete with the other party in a product.
  2. Agreeing to the obligation to tolerate an act or a situation- For eg- shopkeeper allowing a hawker to operate from the common pavement in front of his shop against a monthly payment by the hawker.
  3. Agreeing to the obligation to do an act - For eg- agreement by Industrial unit to install equipment for zero emission/discharge.

As per the Circular, to classify any transaction under the scope of Entry 5(e) of Schedule II, there should be nexus between the supply (i.e., agreement to do or to abstain from doing something) and consideration. In addition to the said nexus, following essentials are required to classify the activity or transaction under the relevant entry:

  1. There must be a contract or agreement (whether implied or expressed) for the activity or transaction;
  2. The contractual obligation should be an independent arrangement (It could be independent stand-alone contract or may form part of another contract);
  3. Consideration must flow in return from one party to another party of the agreement/contract.

Therefore, briefly stated if the aforesaid essentials are fulfilled/complied with, the activity or transaction would be subject to GST.

Liquidated Damages are not taxable under GST

On application of the above parameters, liquidated damages cannot be said to be a consideration received for tolerating the breach or non-performance of contract. They are rather amounts recovered for not tolerating an act or situation and to deter such acts, i.e., such amounts are for preventing breach of contract or non-performance and thus, no GST liability arises on liquidated damages.

Takeaways

Hence, a reasonable view that can be taken with regard to taxability of liquidated damages that where the amount paid as 'liquidated damages' is an amount paid only to compensate for injury, loss or damage suffered by the aggrieved party due to breach of the contract. There is no agreement, express or implied, by the aggrieved party receiving the liquidated damages, to refrain from or tolerate an act or to do anything for the party paying the liquidated damages. Liquidated damages are mere 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 consideration for a supply and do not attract GST.

Footnotes

1. Maharashtra State Power Generation Company Ltd [2018] 93 taxmann.com 266

2. GE T & D India Ltd. v. Deputy Commissioner of Central Excise [2020] 119 taxmann.com 55

3. CircularNo. 178/10/2022-GST [F. NO. 190354/176/2022-TRU],Dates 3-8-2022

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.