BY: CA MANU KATARE
Meaning of Liquidated Damages:
Liquidated Damages a nomenclature used very commonly in construction industry, engineering, procurement and commissioning (EPC) contracts to recovery losses or levy penalty for non- performance or deviation from the terms agreed in the supply agreement by vendor/supplier.
The vendor may also recover Interest for delay in payment or forfeit advance in case of cancellation of the Contract etc in case the same is agreed in the Contract.
In any recovery of liquidated damage case, the following component will form the transaction:
- There is a supplier of services, goods or both as per agreement
- There is a recipient of Service or goods or both
- There is quantification of liquidated damages in monetary term as per the agreement.
- Taxability of Liquidated Damages in Pre-GST Era
Prior to 30th June, 2012, only those services were taxable under Service Tax which were notified by CBIC. However, there was a paradigm shift from 1st July, 2012 through Finance Act 2012 whereby all the services were brought into the ambit of Service Tax except those explicitly mentioned in Negative List (Section 66D of the Finance Act, 1994) or mentioned in the mega exemption Notification (Notification No. 25/2012).
In addition to above to settle the dispute between the State Government and Central Government for charging of Value Added Tax (VAT) or Service Tax the Government brought in a concept of deeming fiction through Declared Service (Section 66E of Finance Act, 1994) whereby all those activities are treated as Services and liable to Service Tax irrespective of the fact they could have been classified as goods and chargeable to VAT.
One of the entry mentioned in the Section is reproduced below which is important to study the taxability of Liquidated Damage.
“Agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act;”
The toleration of an act or situation is an entry by virtue of which liquidated damage were brought into the ambit of Service Tax and Service Tax was charged respectively.
- Taxability of Liquidated Damage in GST Era
The issue of taxability of liquidated damages was settled until Finance Act, 2018 in GST regime as well and had similar taxability as it used to be under Service Tax Regime.
However, amendment in the definition of “Supply” through Finance Act, 2018 retrospectively from 1st July, 2017 and exclusion of Schedule II from taxability of such goods and services by default and restriction of scope of Schedule II only for the purpose of classification between goods and services that to once it qualifies the definition of supply has led to a dispute on taxability of Liquidated damages.
GST is levied or leviable on supply of goods or services or both. The CGST Act defines Supply as:
Section 7 defines the Supply as:
Scope of supply:
(1) For the purposes of this Act, the expression ―”supply” includes––
(a) all forms of supply of goods or services or both such as sale, transfer, barter, exchange, licence, rental, lease or disposal made or agreed to be made for a consideration by a person in the course or furtherance of business;
(b) import of services for a consideration whether or not in the course or furtherance of business; and
(c) the activities specified in Schedule I, made or agreed to be made without a consideration;
(1A) where certain activities or transactions constitute a supply in accordance with the provisions of sub-section (1), they shall be treated either as supply of goods or supply of services as referred to in Schedule II.]2
To understand the amendment and its implication on liquidated damage, it is important to find solution to below mentioned questions
- Is recovery of liquidated damages can be said to be in respect of supply of services or goods or both?
- Can there be said to be supply of “non-performance” resulting in liquidated damages or can tolerance of an act be classified as Supply?
- Is monetary value assigned to Liquidated damages a “consideration”?
- What are Goods?
Section 2 clause (52) defines goods as ―
Goods means every kind of movable property other than money and securities but includes actionable claim, growing crops, grass and things attached to or forming part of the land which are agreed to be severed before supply or under a contract of supply
- What are Services?
Section 2 clause (102) defines services as ―
Services means anything other than goods, money and securities but includes activities relating to the use of money or its conversion by cash or by any other mode, from one form, currency or denomination to another form, currency or denomination for which a separate consideration is charged.
Based on the above definition following conclusions can be drawn
1 Deleted with effect from 01st July, 2017 by The Central Goods and Services Tax (Amendment) Act, 2018
2 Inserted w.e.f. 01st July, 2017 by The Central Goods and Services Tax (Amendment) Act, 2018
a. Non-performance is neither goods nor services.
With the change in definition of Supply, deeming fiction of classifying certain transaction/activities through Schedule II under the category of Services or goods has now done away with.
The following transactions or activities which formed part of Schedule -II of CGST Act are no more supply of Services by default until they themselves qualify as supply:
- agreeing to the obligation to refrain from an act, or
- to tolerate an act or a situation, or
- to do an act
Since Liquidated Damages cannot be categories as goods or services and does not qualify or both therefore now GST cannot be levied on these payments.
With the change in the scope of supply, it is difficult to identify whether such amendment is intentional or a drafting error because other component of supply still has not been amended and contains the provisions which indicates that this transaction can still be brought to tax into the ambit of GST.
For Example, the term Consideration: The term consideration is defined in CGST Act as:
- Section 2 clause (31) ―
consideration in relation to the supply of goods or services or both includes–
(b) the monetary value of any act or forbearance, in respect of, in response to, or for the inducement of, the supply of goods or services or both, whether by the recipient or by any other person but shall not include any subsidy given by the Central Government or a State Government: Provided that a deposit given in respect of the supply of goods or services or both shall not be considered as payment made for such supply unless the supplier applies such deposit as consideration for the said supply;
The definition of consideration as reproduced above includes the monetary value of any act or forbearance so if any monetary value is given to the act of forbearance, then it can be coloured as Consideration.
Thus, looking at the intention of the Government to tax the activities/transaction which fall within the ambit of “tolerance of an act” to Service Tax and later carrying it into GST through Schedule II and then amending the definition of scope of supply retrospectively since the inception of GST and a recent judgement of CESTAT of Service Tax regime has unsettled the settle law and has given a rise to the dispute on taxability of all those activities/transactions which earlier were taxed on the ground of deeming fiction of “tolerance of an act” or “obligation to refrain from an act” such as Liquidated damages, Non-compete fees, Notice period recovery from employees and others.
A suitable clarification is required from the GST department’s side to decide the fate of the taxability of the issue of liquidated damages as mentioned above.
3 South Eastern Coalfields Ltd. Vs Commissioner of Central Excise and Service Tax (CESTAT Delhi),Service Tax Appeal No. 50567 of 2019, Order Date 22nd December, 2020