3 July, 2018
Parties entering into contractual arrangements usually insist on including a clause for liquidated damages to pre-emptively agree upon the amount of reparation that would be payable by either Party on failure to meet its commitment. Generally, such commitments are in the nature of adhering to timelines, fulfillment of conditions, quality of products, etc.
The levy of an indirect tax on the amount of liquidated damages, has faced a series of challenges under the erstwhile service tax regime. Agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act was deemed to be service under the service tax regime[1] . Where liquidated damages were in the nature of accidental damages caused due to unforeseen actions and not relatable to the provision of service, these were not included in the value of the service, and hence not to be taxed[2] .
Additionally, it was clarified that security deposits forfeited[3] for damages done by the service receiver in the course of receiving a service were not to be regarded as consideration[4]. Hence, there existed a lack of clarity whether the failure to adhere to timelines was an “act of toleration” or was merely the consequence of breach of contract, i.e. the treatment of liquidated damages.
Notification No. 25/2012 – Service Tax dated June 28, 2012, was amended on April 13, 2016, exempting liquidated damages payable to the Government or local authority from the levy of service tax[5]. Post the amendment show cause notices were issued to taxpayers demanding service tax in the instances where the damages were not payable to the Government or local authority.
The aforesaid issue was still at a preliminary stage at the time of the introduction of the Goods and Service Tax (GST). Entry 5(e) of Schedule II to the Central GST Act, 2017 replicates the entry of the erstwhile service tax regime. Thus, the act of tolerating the failure to adhere to timelines, condition or quality continues to remain a concern.
AAR Ruling
Recently, the Authority of Advance Ruling (AAR), Maharashtra in Maharashtra State Power Generation Company Limited[6], has ruled that liquidated damages are to be viewed as consideration for an act of tolerance of non-performance, and thus are exigible to GST.
In the instant case, the Applicant had entered into contracts with various contractors for “construction and renovation of its power plants” and “operation and management activities”.
The Applicant was contractually entitled to collect liquidated damages from the supplier in case of deficiency in services. Further, the contracts provided that where a contractor failed to pay any amount of damages or costs to the Applicant, it could deduct such amount from the consideration payable to the contractor.
In other words, this arrangement between the Applicant and contractors resulted in reduction in the consideration payable for the main supply of “construction and renovation of its power plants” or “operation and management activities” in cases where the contractor had delayed successful completion of operations and had not paid the Applicant. The Applicant contended that the payment of liquidated damages could not be viewed as a consideration for a separate service covered by the term ‘obligation to tolerate an act or a situation.” The Applicant placed reliance upon Tribunal rulings[7] on similar issues from the erstwhile regime as well as precedents under Australian GST laws to support its argument that such payments were not consideration for separate supply of tolerating an act or a situation. It was argued that the payment of liquidated damages was part of the main supply and was for the purpose of re-determination of the consideration of the main supply.
The AAR in its ruling emphasised that the mere act of adjustment to facilitate the settlement of the accounts, would not lead to an inference that the act of toleration was a part of the main supply. It observed that the provisions of contract clearly brought out the fact that levy of liquidated damages was for the act of toleration of delay in fulfillment of obligations of the contract. Further, in the absence of price variation clauses for reducing the contractual price in case of liquidated damages, the payment of liquidated damages was to be considered as consideration for an independent supply of tolerating an act.
Key Takeaways
A review of the AAR suggests that the manner of computing the consideration is relevant and a determining factor in understanding the scope of supply. In the instance case, the AAR has acted in keeping with earlier judicial precedents in relation to the valuation context. The Tribunals have in the past allowed a reduction in transaction value on account of liquidated damages only in cases where the clauses stipulating variation in price included liquidated damages as a factor.
A contrary view which also functions as a criticism of the AAR, is that the act of tolerance requires the willful agreement of certain situations, wherein the party agrees to suffer or restrain from doing something for some pre-fixed consideration, for example non-compete agreements. In case of payment of liquidated damages, the party is already facing the consequences of breach of contract and the other party has not agreed to refrain from anything or tolerated anything. Therefore, such amount collected as liquidated damages could not be treated as analogous to the consideration for ‘obligation to tolerate an act or a situation’. Hence, the most common form of remedy arising out of a termination or breach of contract must not be characterised as a supply of service.
For example, in the United Kingdom, VAT laws subscribe to this view and do not treat the payment received as liquidated damages as a consideration for any supply[8]. Further, set-off of liquidated damages towards any payment due from other parties, is not considered as a reduction in value of taxable supply.
Nevertheless, the AAR leads to the inference that the contractual terms are relevant for determining whether the payment of liquidated damages could be considered as a consideration for an independent supply of tolerating an act.
Such contractual terms are: clauses that reflect the linkage of payment to milestone events; those that include liquidated damages as a variation factor in the price variation/ deduction clause; or general clauses that reflect redetermination of the consideration of supply. Accordingly, companies would need to structure their transactions keeping in mind the aforementioned parameters in order to mitigate GST implications on liquidated damages.
[1] Section 66E (e) of Finance Act, 1994
[2] Rule 6 (2)(vi)of Service Tax (Determination of Value) Rules, 2006
[3] The same principle has been recognized in the case of Societe Thermal Case C-277/05, European Court of Justice dated September 13, 2006
[4] Education Guide issued by Central Board of Excise and Customs (CBEC) on June 20, 2012 dealing with the treatment of certain payments as to whether it could be considered as ‘consideration’
[5] Notification No. 22/2016 – ST, dated April 13, 2016
[6] Maharashtra State Power Generation Company Limited, 2018-VIL-33-AAR
[7] Commissioner of C. Ex., Chandigarh v. H.F.C.L, 2015 (11) TMI 893 (CESTAT – New Delhi); M/s. Victory Electricals Ltd. 2013 (298) ELT 534
[8] Entry 22.3 of VAT Notice 708 issued by HM Revenue and Customs, UK
For further information, please contact:
Mekhla Anand, Partner, Cyril Amarchand Mangaldas
mekhla.anand@cyrilshroff.com
