10 September 2021
With the ongoing pandemic, the odds of invocation of clauses such as liquidated damages, price variation clause, compensation clause or forfeiture of deposits for the delay in adhering to contractual timelines, etc. have become very high. Such additional payments could also bring out an exposure on account of taxability under Goods and Services Tax (“GST”) legislations.
Remarkably, the whole ruckus over exigibility to GST revolves around the application of Entry 5(e) of Schedule II to the Central GST Act, 2017 (“CGST Act”), which is a verbatim replica of the erstwhile service tax regime[1]. The said entry provides that agreeing to an obligation, refraining from an act, tolerating an act or a situation, or doing an act are deemed to be supply of services which attract GST.
Rulings under erstwhile service tax legislations
While the tax department has tried to levy service tax on liquidated damages, the Hon’ble CESTAT had held a contrarian view[2]. For instance, in the case of M/s. Neyveli Lignite Corporation Limited (NLCL)[3], BHEL had entered into a contract with NLCL (engaged in excavation of lignite) for designing, manufacturing, erection of certain equipment. BHEL failed to adhere to the timeline and had to pay liquidated damages to NLCL. The revenue department alleged that the owner of project had agreed to tolerate the breach of timeline for monetary compensation. However, the Hon’ble CESTAT held that liquidated damages / penalties collected from the other party could not have been towards any service per se, since the NLCL was neither carrying on any activity to receive compensation nor had any inkling that the other party would breach or violate the contract and suffer a loss. The tribunal observed that the purpose of providing for liquidated damages in the contract was merely to ensure that the other party adheres to the terms of the contract and the levy of penalty for any violation was to prevent its occurrence or safeguard any reoccurrence of similar breach. The same cannot be said towards toleration of the defaulting party.
Similar stand has been taken in relation to compensation/penalty for short lifting of commodity by the buyers[4], penalty for theft of electricity[5], foreclosure charges collected by banks for premature closure of loan accounts[6], cancellation charges for booking of hotel.[7] Even the Madras HC, in relation to compensation paid by employee to employer in lieu of not serving the notice period, held that the employer has not tolerated any act of the employee and compensation was not subject to service tax.[8]
However, in relation to non-compete fee, the Hon’ble CESTAT had held that the same would be subject to levy of service tax. The non-compete fee is the consideration for the support service provided by a person/ an entity to a business and commercial activities of another entity, who is otherwise a competitor and engaged in a common business (i.e. fees relating to discourage of competition in promoting the sales of the said dealers/retailers).[9] It appears that a distinction exists between paying for not adhering to the contractual provisions agreed with another party vis-à-vis positively agreeing not to undertake certain activities and getting compensated for the same.
Rulings under GST legislations
Interestingly, under the GST legislations, the Authority for Advance Ruling (“AAR”) [10] and appellate authority (“AAAR”) have confirmed the levy of GST on damages. For instance, the Maharashtra AAAR[11] upheld AAR ruling in MSGPL[12], that liquidated damages are exigible to GST. According to AAAR, the delay in the completion of the project stipulated the payment of liquidated damages and did not lead to the termination of the contract. Thus, the contracting party had in fact agreed to tolerate an act and hence, any amount paid on account of the same shall be liable to GST. Similar position was also taken by the Andhra Pradesh AAR[13].
Several state AARs have also upheld various additional payments, having different nomenclature, to be subject to GST. For example, Gujarat AAR in relation to advance forfeited for violating terms of contract[14] and for compensation paid by an employee to the employer in lieu of not serving the notice period [15], Rajasthan AAAR for cheque dishonour fees[16], Uttarakhand AAR for penalty paid towards unaccounted stock of river-bed material in relation to forbearance of the non-performance [17] and penalty for damage of material by labour[18], Maharashtra AAR for penalty collected towards non-payment of equated monthly instalments[19] and compensation amount paid by the owner to the tenant for temporary relocation [20], Tamil Nadu AAAR for grant of access to pathways[21], etc.
Moreover, question no. 15 of the FAQ[22], issued by the CBIC for the mining sector, dealt with the issue of deduction of liquidated damages / penalty from the contractor’s bill and imposition of penalty for non-lifting of coal upto the actual contractual quantity. The FAQ answers stating that such payments are for services covered by entry ‘tolerating an act’ as per Schedule II to CGST Act.
Analysis
It is worth considering that while the provisions treating ‘agreeing to an act’ as a service under the erstwhile service tax legislations and the GST legislations are same, contrarian views have been adopted by the AAR and the AAAR, unlike the CESTAT. The dichotomy in this interpretation under both legislations may have a huge impact on the businesses.
Nevertheless, review of Entry 5(e) of Schedule II to the CGST Act, makes it clear that the act of tolerance requires the willful agreement of certain situations. In other words, the said clause can be made applicable only when there is an agreement to the obligation to tolerate/do an act or situation, and the word ‘obligation’ implies a duty or a liability on the person making the obligation, with a corresponding right to the other person to enforce such obligation. Considering the dichotomy in position taken under GST vis-à-vis erstwhile service tax legislation, it is essential to distinguish a positive act of agreeing to do an act vis-à-vis an involuntary act. The Bombay HC in Bai Mamubai Trust v. Suchitra[23] interpreted Entry 5(e) of Schedule II to the CGST Act while assessing whether royalty amount collected in terms of contract by court receiver for allowing illegal possession of property would attract GST. The HC stated that an act of illegal occupation, which may be compensated in damages, would not amount to a voluntary act of granting access of the property. Such payment lacks the necessary quality of reciprocity to make it a ‘supply’. Thus, the HC held that GST is not payable on damages/compensation paid for an involuntary act, i.e. a legal injury.
Closing Remarks
While the authorities may continue to think that compensation/penalty/ damages have reciprocity with supply, because parties have voluntary agreed to deal with contingency of breach while entering into contract, the same appears to be a flawed interpretation. The contract must be read as whole to determine the main supply and purpose of the contract. In a contract, where supply of goods/services is the main supply, liquidated damages for breach of contract must not qualify as a ‘service’. The person awarding the contract has no option but to suffer the delay or breach, i.e. such payments are towards unintended events and do not emanate from any obligation and are not a desired income for such person. The contract is for the execution of the agreed transaction and not for the breach. Such payment would lack the element of reciprocity and are merely the payment for involuntary act. The tax authorities must appreciate that every payment by a person to another is not a consideration. A payment can be treated as consideration only when it is made in respect of, in response to, or for the inducement of supply, i.e. a direct link with supply. Any interpretation contrary to this would have catastrophic impact for businesses. Thus, the fiasco of levy of GST on contractual payments needs clarity by a superior court or by the Central Board of Indirect Taxes and Customs.
It is also evident that while the abovementioned advance rulings were issued prior to the CESTAT judgement, it has been observed that several advance rulings have disrupted the settled positions on the basis of perfunctory reasoning. The pro-revenue bias being adopted by the AAR / AAAR is too stark to be taken lightly! The AAR comprises of existing officers with the tax department i.e. officers not below rank of joint commissioner while AAAR comprises of a chief commissioner appointed by the CBIC and Commissioners of State tax. Thus, there is no independence in the composition of the AAR / AAAR as it was in the case with the CESTAT. Thus, an urgent revamp of advance ruling authority is the need of the hour.
For further information, please contact:
S.R. Patnaik, Partner, Cyril Amarchand Mangaldas
srpatnaik@cyrilshroff.com
[1] Section 66E (e) of Finance Act, 1994
[2] Steel Authority of India Ltd. v. Commissioner of GST & Central Excise, Salem, [2021] 128 taxmann.com 400 (Chennai – CESTAT)
[3] M/s. Neyveli Lignite Corporation Limited v. Commissioner of Customs, Central Excise & Service Tax, LTU, 2021-VIL-338-CESTAT-CHE-ST
[4] M/s South Eastern Coalfields Ltd. v. Commissioner of Central Excise and Service Tax, Raipur 2020 (12) TMI 912 – CESTAT NEW DELHI;
[5] M.P. Poorva Kshetra Vidyut Vitran Co. Ltd. v. Principal Commissioner CGST & Central Excise Bhopal,2021 (2) TMI 821 – CESTAT NEW DELHI.
[6] Commissioner of Service Tax, Chennai v. REPCO Home Finance Ltd. 2020 (42) G.S.T.L. 104 (Tri. –LB).
[7] M/S Lemon Tree Hotel v. Commissioner, GST, Central Excise & Custom, 2019 (7) TMI 767 – CESTAT NEW DELHI
[8] GE T & D India Ltd. v. Deputy Commissioner of Central Excise, [2020] 115 taxmann.com 213 (Madras).
[9] Jamna Auto Industries Ltd. – 2017 (5) GSTL 410 (Tri-Del)
[10] M/s North American Coal Corporation India Private Limited, 2018 (10) TMI 1399.
[11] In re Maharashtra State Power Generation Company Limited, TS-464-AAAR-2018-NT.
[12] In re Maharashtra State Power Generation Company Limited, 2018 (5) TMI 1332.
[13] In re Rashtriya Ispat Nigam Ltd., [2019] 112 taxmann.com 5 (AAR – ANDHRA PRADESH)
[14] In re Fastrack Deal Comm (P.) Ltd., [2021] 124 taxmann.com 399 (AAR – GUJARAT)
[15] In re Amneal Pharmaceuticals (P.) Ltd., [2021] 123 taxmann.com 191 (AAR – GUJARAT)
[16] In re M/s TP Ajmer Distribution Limited, [2019] 103 taxmann.com 227 (AAAR-RAJASTHAN).
[17] In re Purewal Stone Crusher, 2018 (10) TMI 456.
[18] In re: Parvatiya Plywood (P.) Ltd., [2020] 115 taxmann.com 62 (AAR- UTTARAKHAND)
[19] In Re: M/S. Bajaj Finance Limited 2018 (11) TMI 884.
[20]In re Zavershankarlal Bhanushali, 2018 (7) TMI 227.
[21] In re: Chennai Metro Rail Ltd., [2021] 125 taxmann.com 352 (AAAR – TAMILNADU)
[22] https://www.cbic.gov.in/resources//htdocs-cbec/gst/faq-mining.pdf
[23] Bai Mamubai Trust v. Suchitra [TS-736-HC-2019(BOM)-NT]
