In our experience while dealing with corporate clients in representing them in an action for damages, contractual claims etc. in arbitration proceedings or in court of law and in advising them afterwards, we have seen many companies having a question as to whether a receipt pursuant to settlement in a lawsuit or in an arbitration matter or a receipt pursuant to court decree or arbitration award after successful prosecution of claims is taxable under Income Tax Act, 1961("ITA"). We have indeed seen some clients offering such amount under ITA and some settlements prescribing that the payee will raise invoice along with Goods and Service Tax("GST") and payor will consequently remit amount along with GST.
Such amount may or may not be liable to be offered as income (although payor may be able to claim reduction in profit treating such payment as revenue expenditure) and may or may not be subject to GST.
Broder proposition is that a receipt under decree or settlement towards supply of specific goods or services will be both liable to be offered under ITA and be subject to GST whereas receipt pursuant to settlement of a claim for damages or compensation for loss suffered or a receipt pursuant to decree to that effect may be out of the purview of GST and also may not be liable to be offered under ITA while allowing the payor to deduct such amount from taxable income.
We seek to deal with treatment of such amount under GST and under income Tax Act, 1961.
A. TREATMENT OF RECEIPT UNDER A DERCEE/ AWARD OR SETTLEMENT AMOUNT UNDER GST
Section 7(1) of the CGST Act provides that "supply" includes
- 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.
- The activities speicified in Schedule I, made or agreed to be made without a consideration; and
- The activities to be treated as supply of goods or supply of services as referred to in Schedule II.
Apparently receipt of amount towards damages or compensation for loss is not supply. GST authorities however frequently treat such receipts towards damages / liquidated damages as supply of goods or services considering such receipt to be following within ambit of ‘agreeing to obligation to refrain from an act, or to tolerate an act or a situation, or to do an act’ as appearing in Entry No.5, Clause (e). Sometimes, tax authorities treat such receipts as a consideration for supply of service of ‘tolerating an act’ or breach or non performance.
Some advance rulings in favor of department further complicate the situation. We believe that such receipts have to be out of purview of GST and they cannot be treated as any sort of service and they lack the element of mutual consideration as well. There could be further and detailed arguments in support of such proposition; we however refrain from elaborating the arguments in this article.
While actual taxability could depend on specific facts, we seek to highlight for our readers that:-
- The Bombay High Court, in the case of Bai Mamubai Trust, VithaldasLaxmidas Bhatia, Smt. InduVithaldas Bhatia vs. Suchitra, has held that GST is not payable on damages/compensation paid for a legal injury as payment lacking the element of mutuality of consideration.
- In the case of Southern Eastern Coalfields Ltd. v. Commissioner of Central Excise and Service Tax, CESTAT reversed the decision holding there could be no demand of service tax on amount of liquidated damages or forfeiture of EMD amount. Though the case pertains to pre-GST regime, the analogy will squarely apply to GST.
B. TREATMENT OF RECEIPT UNDER A DERCEE/ AWARD OR SETTLEMENT AMOUNT UNDER ITA AT THE END OF RECIPIENT
Under ITA, all revenue receipts are taxable unless specifically exempted and all capital receipts are not taxable unless specifically held to be taxable. Broader principles for determination as to whether a receipt is a capital receipt or a revenue receipt is that capital receipts are not obtained in regular course of business whereas revenue receipts are, capital receipts are normally non-recurring ones whereas revenue receipts are recurring ones and also that the nature of receipt is decided by virtue of its character in the hands of person receiving it. Receipt of amount under a decree/ award or settlement, if towards damages/ breach of contract/ compensation for loss, are not in regular course of business but by way of compensation and are capital receipts. Such receipts do not fall within ambit of any sub sections of s.45 and are not therefore subject to capital gains tax. A couple of relevant decisions elucidating the position are Aberdeem Claims Administration Inc., In re [2016] (AAR) 1971 AIR 2129 and DCIT Vs Rishabh Infrastructure Pvt. Ltd. (ITAT Raipur) (2018).
C. TREATMENT OF PAYMENT UNDER A DERCEE/ AWARD OR SETTLEMENT AMOUNT UNDER ITA FOR PAYOR
The position that receipt of amount under decree/ award or settlement is treated as capital receipt for recipient if it is towards damages/ breach of contract etc., does not necessarily imply that payment of such amount is a capital expenditure for payor and could not be used for reduction in taxable income.
Whether a settlement amount is a revenue expenditure or not depends upon the payment being penal or compensatory in nature. While any amount paid for infraction of law and by way of statutory penalty is punitive in nature and is not deductible under section 37 of ITA, settlement amount towards damages arises out of contractual obligations and if the same is by way of normal incidence of business of payor, it is generally treated as revenue expenditure at the end of payor and could be deducted under section 37 of ITA. One of the relevant decisions elucidating the position is of Gujarat High Court in the case of Principal Commissioner of Income Tax v. Mazda Ltd, wherein the Court held that the deduction claimed on account of liquidated damages was allowable as revenue expenditure as damages for delay was an inbuilt feature and inherent part of business of assesee and could not be disassociated from taxpayer’s normal business activities.
In practice, nature of receipt shall be determined by extensive scrutiny of pleadings in suit and / or recitals contained in the settlement agreement and careful drafting will be quintessential.
R & D Law Chambers is a full service firm providing Commercial, Legal and International and Domestic Tax Advisory services with operations in India and UK/EU. To know more visit https://rdlawchambers.com/
*The content of this article is intended to provide general information. No reader or user should act or refrain from acting on the basis of information written above without first seeking legal advice from qualified law practitioner
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