India: Controversy Related To Taxability Of Liquidated Damages Refuses To Perish

There are few controversies under the indirect taxes that refuse to settle down. One such issue is related to the taxability of 'Liquidated Damages'. Typically, 'Liquidated Damages' are recovered by the recipient of service, in the event of non-fulfilment of terms of a contract or for deficiency in provision of services or breach of a contract by the contractor.

The industry has been struggling to get clarity on whether 'liquidated damages' recovered are in the nature of a penalty levied on the Contractor for non-performance of its obligations under a contract or whether such charges are a consideration towards provision of a service in terms of 'agreeing to tolerating an act' of non-performance or deficiency in services and thus these should be subjected to levy of service tax. The issue almost attained finality under the service tax regime with the CESTAT holding in various decisions that 'Liquidated damages' are in the nature of penalty levied for non-performance of the obligation under a contract and hence cannot be charged to service tax as a consideration for provision of any service.

With the introduction of GST regime, the GST authorities re-ignited the controversy by raising objections and demands of GST on 'Liquidated Damages'. The matter got murkier with conflicting rulings from different state GST Advance Ruling Authorities taking a view that the liquidated damages should be subject to levy of GST.

To provide certainty on the matter, the Central Board of Indirect Taxes and Customs (CBIC) issued a detailed clarification vide Circular No. 178/10/2022 dated August 03, 2022, stating that 'liquidated damages' paid in lieu of breach of contract are not consideration for tolerating breach / non-performance and accordingly GST will not be leviable on such charges. The clarification was welcomed by the industry at large with gratitude and was considered as an end to the long-standing controversy. The CBIC further issued Circular No. 214/1/2023-Service Tax dated February 28, 2023 providing similar clarifications on the issue and also directing the department officers to follow the guidelines in handling the matters pending under erstwhile service tax regime.

However, the controversy has again re-surfaced with the observations made by the Andhra Pradesh Authority for Advance Ruling (AP AAR) in a recent ruling. In the matter of AP Power Development Co. Ltd.¹, the AAR-AP has held that Circular No. 178/10/2022 dated August 03, 2022 is "not universal and absolute" and each case must be dealt with the specific facts pertaining to that case. While dealing with the specific facts of the applicant, the AP AAR held that 'liquidated damages' collected by the applicant from service provider for non-performing an act constituted a 'supply' as per section 7 of CGST Act and therefore should be subject to levy of GST.

Although, an AAR is binding only on the applicant and on the concerned jurisdictional authorities, the ruling will certainly stimulate the authorities across the country to kick start another round of queries and issue notices, leading to prolonged litigation on the matter.

Footnote

1 [TS-117-AAR(AP)-2023-GST]

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