Preamble:
Ever since GST was implemented, the issues in relation to liquidated damages and services in relation (an act of tolerance) has been vexating. This is more so as in the case of earlier legacy laws. The liability of indirect taxes was either on manufacturer for clearance in the case of excise duty, rendition of services or sale of goods. While a high degree of seamlessness of liability of GST has been achieved by ensuring that the point of taxation is supply.
However, the revenue authorities have sort to distinguish application of GST on the issues referred supra contending that the GST law handles issues in a different way.
Challenges on applicability of GST in the nature of liquidated damages, compensation, penalty, cancellation charges, late payment surcharge etc arising out of breach of contract or otherwise are sought to be put to rest by virtue of circular of 178/10/2022-GST dated 3rd August 2022 has been issued by the tax research in F. No. 190354/176/2022/TRU.
Background of Parameters set
The Circular sets out that the description “agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act” was intended to cover the following services. The different elements that have been addressed in the circular are given below with the impact thereof:
- Agreeing to the obligation to refrain from an act-
- Agreeing to the obligation to tolerate an act or a situation-
- Agreeing to the obligation to do an act-
Some of the parameters (illustrative) arising from the above three elements as set out in the circular are set out below:
- Refraining from an Act is committing to not specifically act or work on something.
- Even as set out by the circular example of activities that would be covered by this part of the expression would include non-compete agreements, where one party agrees not to compete with the other party in a product, service or geographical area against a consideration paid by the other party.
- An act of tolerance in terms of activity by another person.
- An act of rendition even where legally not required to arising as a result of a contractual commitment.
The Circular itself also explains that while the above was the intended causative for the purpose of eligibility of the taxes, the Revenue over a period of time has also sought to levy tax on some of the illustration provided in the circular per se.
The circular brings on the corollary of Service tax guide as well as Contract Act to brings out the issue of taxability or otherwise on the following issues.
While drawing relevance of the description to that of the Contract Act, the Circular states that the service of agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act is nothing but a contractual agreement. A contract to do something or to abstain from doing something cannot be said to
have taken place unless there are two parties, one of which expressly or impliedly agrees to do or abstain from doing something and the other agrees to pay consideration to the first party for doing or abstaining from such an act. There must be a necessary and sufficient nexus between the supply (i.e., agreement to do or to abstain from doing something) and the consideration.
A perusal of the entry at serial 5(e) of Schedule II would reveal that it comprises the aforementioned three different sets of activities viz.
- the obligation to refrain from an act,
- obligation to tolerate an act or a situation and
- obligation to do an act. All the three activities must be under an “agreement” or a “contract” (whether express or implied) to fall within the ambit of the said entry.
In a very important move, the Circular has said that the agreement to do or refrain from an act should not be presumed to exist.
There must be an express or implied agreement; oral or written, to do or abstain from doing something against payment of consideration for doing or abstaining from such act, for a taxable supply to exist especially with a consideration payable towards the same.
Liquidated Damages
On liquidated damages, the Circular sets out that when a contract has been broken, the party which suffers by such breach is entitled to receive from the other party compensation for any loss or damage caused to him by such breach. The compensation is not by way of consideration for any other independent activity; it is just an event in the course of performance of that contract.
It is argued that performance is the essence of a contract. Liquidated damages cannot be said to be a consideration received for tolerating the breach or non-performance of contract. They are rather payments for not tolerating the breach of contract. They do not act as a remedy for the breach of contract. They do not restitute the aggrieved person. It is further argued that a contract is entered into for execution and not for its breach.
In this background a reasonable view that can be taken with regard to taxability of liquidated damages is 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 and 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, in such cases 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.
Payments being merely flow of money are not a consideration for any supply and are not taxable. The key in such cases is to consider whether the impugned payments constitute consideration for another independent contract envisaging tolerating an act or situation or refraining from doing any act or situation or simply doing an act. If the answer is yes, then it constitutes a ‘supply’ within the meaning of the Act, otherwise it is not a “supply”.
The circular therefore holds that consideration received towards liquidated damages will not be exigible to GST
Cheque dishonor fine/ penalty
On the basic ground that there is never an implied or express offer or willingness on part of the supplier that he would tolerate deposit of an invalid, fake or unworthy instrument of payment against consideration in the form of cheque dishonour fine or penalty the circular holds that the fine or penalty that the supplier or a banker imposes, for dishonour of a cheque, is a penalty imposed not for tolerating the act or situation but a fine, or penalty imposed for not tolerating, penalizing and thereby deterring and discouraging such an act or situation.
The cicurlar clearly holds that cheque dishonor fine or penalty is not a consideration for any service and not taxable.
Forfeiture of salary or payment of bond amount in the event of the employee leaving the employment before the minimum agreed period
It has been a long vexating issue as to whether the forfeiture of the salary amount during notice period if an employee wants to exit earlier than the deemed time he has to serve during the notice period.
The provisions for forfeiture of salary or recovery of bond amount in the event of the employee leaving the employment before the minimum agreed period are incorporated in the employment contract to discourage non-serious candidates from taking up employment. The said amounts are recovered by the employer not as a consideration for tolerating the act of such premature quitting of employment but as penalties for dissuading the non-serious employees from taking up employment and to discourage and deter such a situation. Further, the employee does not get anything in return from the employer against payment of such amounts.
Therefore, such amounts recovered by the employer are not taxable as consideration for the service of agreeing to tolerate an act or a situation.
Late payment surcharge or fee
The facility of accepting late payments with interest or late payment fee, fine or penalty is a facility granted by supplier naturally bundled with the main supply. It is not uncommon or unnatural for customers to sometimes miss the last date of payment of electricity, water, telecommunication services etc. Almost all service providers across the world provide the facility of accepting late payments with late fine or penalty. Even if this service is described as a service of tolerating the act of late payment, it is an ancillary supply naturally bundled and supplied in conjunction with the principal supply, and therefore should be assessed as the principal supply. Since it is ancillary to and naturally bundled with the principal supply such as of electricity, water, telecommunication, cooking gas, insurance etc. it should be assessed at the same rate as the principal supply.
The circular therefore holds that the late payment fee by whatever terminology is called is liable to GST
Cancellation charges
Cancellation fee can be considered as the charges for the costs involved in making arrangements for the intended supply and the costs involved in cancellation of the supply.
The facilitation service of allowing cancellation against payment of cancellation charges is also a natural part of this bundle. It is invariably supplied by all suppliers of passenger transportation service as naturally bundled and in conjunction with the principal supply of transportation in the ordinary course of business.
Therefore, facilitation supply of allowing cancellation of an intended supply against payment of cancellation fee or retention or forfeiture of a part or whole of the consideration or security deposit in such cases should be assessed as the principal supply.
However, forfeiture of earnest money by a seller in case of breach of ‘an agreement to sell’ an immovable property by the buyer or such forfeiture by Government or local authority in the event of a successful bidder failing to act after winning the bid for allotment of natural resources, is a mere flow of money, and is stipulated in such cases not as a consideration for tolerating the breach of contract but as a compensation for the losses suffered and as a penalty for discouraging the non-serious buyers or bidders. Such payments being merely flow of money are not a consideration for any supply and are not taxable.