Levy of GST on Liquidated Damages

Liquidated damages are the common terminology used by the parties under a contract. It means a compensation agreed upon by the parties entering into a contract and is payable by the failure of either party to ‘perform’ its obligations completely or as per the agreed terms.

Concerning its taxation under the indirect tax, both in the erstwhile law, i.e., Service Tax and the present GST law, there has always been an issue regarding the taxability of the liquidated damages.

Under the erstwhile service tax regime, through the concept of declared service, the tax was levied on ‘agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act’.

Later on, the CBEC provided for exemption in respect of services provided by the Government or a local authority by way of tolerating non-performance of a contract for which consideration in the form of fines or liquidated damages is payable to the Government or the local authority under such contract. It is settled law that an exemption entry cannot presuppose the levy itself [CBEC vs. Larsen & Toubro Ltd. (2015) 39 S.T.R. 913 (SC)].

The issue, as mentioned earlier, still continues to remain a concern under GST, since it is similarly worded. Section 7(1) of the CGST Act, 2017, includes activities referred to in Schedule II in the scope of supply. Clause 5(e) to Schedule II declares that ‘agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act’ shall be treated as supply of service.

Generally, the liquidated damages may not satisfy the essentials of ‘supply’ or ‘service’. As discussed above, the purpose of agreeing to the payment of liquidated damages is to ensure performance. It cannot be said to be a consideration for tolerating non-performance.

The Authority for Advance Ruling (‘AAR’), Maharashtra, in the case of Maharashtra State Power Generation Company Ltd. (2018-VIL-33-AAR) has held that liquidated damages are to be viewed as consideration for an act of tolerance of non-performance, and thus are subject to GST at 18%. The said ruling has been further affirmed by the Maharashtra Appellate AAR also [2018 (70 GST 411)].

Further, there are similar rulings pronounced in the following cases:

• North American Coal Corporation India Pvt. Ltd. (GST - AAR Maharashtra);
• Rashtriya Ispat Nigam Ltd. (GST - AAR Andhra Pradesh); 
• Dholera Industrial City Development Project Ltd. (GST - AAR Gujarat); and
• Bajaj Finance Limited (GST - AAAR Maharashtra);

However, the Bombay High Court, in the case of Bai Mamubai Trust, Vithaldas Laxmidas Bhatia, Smt. Indu Vithaldas Bhatia vs. Suchitra (109 taxmann.com 200), has held that GST is not payable on damages/compensation paid for a legal injury. The principle laid down by the Court is that such payment does not have the necessary quality of reciprocity to make it a 'supply' and, therefore, GST is not payable on such amount.

In this case, there was a dispute between the landlord and an occupant of premises, and a Court Receiver was appointed by the High Court for maintenance of the property and to collect rent from the defendant. The Court Receiver received consideration in the form of an ad-hoc royalty amount from the defendant for occupying the disputed premises.

The plaintiff claimed that in case his right over the property is proved in Court and the royalty amount collected by the Court Receiver is paid to him, then the same will be an income earned by him for letting out the premises. This income will be a taxable income under the GST law. Therefore, the plaintiff moved an application to the Court to direct the defendant to pay royalty along with GST.

In this ruling, the Court has not discussed at length on the issue of whether the damages paid would fall under clause 5(e) of Schedule II of the CGST Act. However, it is to be noted that according to the amendment in the scope of ‘supply’ under Section 7 of the CGST Act, all activities which are specified in Schedule II would have to first qualify as a supply in terms of Section 7(1A) of CGST Act. Therefore, the reference to clause 5(e) of Schedule II will not be relevant in cases where supply is absent.

Thus, the principles laid down by the Bombay High Court will go a long way to determine the taxability of payments where an underlying ‘supply’ is unclear.

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