GST circular 178/10/2022 - Liquidated damages and other issues

Background

Under GST, there has been confusion on whether tax is applicable on liquidated damages paid for breach of contract, compensation given, Fines/penalties, amounts recovered from an employee leaving the employment, cancellation charges recovered etc.

It would do well to recollect that Schedule II to the GST law has set out activities to be treated as supply of goods/service. Therein there is entry 5(e) which covers 'agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act', to be a service.

Based on retrospective amendment done [Feb 2019] in CGST Act 2018 for "supply" w.e.f. 01-07-2017, the term 'supply' is amended to exclude activities/ transactions listed in Schedule II. This is to ensure the activities/ transactions as per Schedule II are merely to decide whether the same is the supply of goods or services.

The supply definition is excluding the Schedule II with retrospective effect from July 2017. Extract as under:

Section 7[(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.

Hence, as a consequence the activities/ transactions listed in Schedule II (as supply of service or supply of goods) would not be taxed just because it is set out in Schedule II. Such activities would be taxed instead only when they constitute 'supply' in accordance with provisions of Section 7(1)(a), (b) and (c) of the CGST Act, 2017 ("the CGST Act").

In light of this retrospective amendment, when there is no supply of goods/services, then the amounts paid would not be taxed to GST at all.

Circular No. 178/10/2022-GST has been issued recently clarifying on the tax implications of the damages/compensations/other few recoveries made.

In this backdrop the validity of circular and clarifications therein has been examined by paper writer along with past relevant decisions.

Recent circular No. 178/10/2022-GST

• "Agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act" has been specifically declared to be a supply of service in para 5 (e) of Schedule II of CGST Act if the same constitutes a "supply" within the meaning of the Act.
• The element of contractual relationship, where one supplies goods or services at the desire or another, is an essential element of supply.
• The agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act in para 5 (e) of Schedule II of CGST Act is similar to the definition of contract in the Contract Act, 1872.
• The Contract Act defines 'Contract' as a set of promises, forming consideration for each other. 'Promise' has been defined as willingness of the 'promisor' to do or to abstain from doing anything. 'Consideration' has been defined in the Contract Act as what the 'promisee' does or abstains from doing for the promises made to him.
• 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, one of the parties to such agreement/contract (the first party) must be under a contractual obligation to either (a) refrain from an act, or (b) to tolerate an act or a situation or (c) to do an act.
• Further some "consideration" must flow in return from the other party to this contract/agreement (the second party) to the first party for such (a) refraining or (b) tolerating or (c) doing.
• There has to 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.
• Payments such as liquidated damages for breach of contract, penalties under the mining act for excess stock found with the mining company, forfeiture of salary or payment of amount as per the employment bond for leaving the employment before the minimum agreed period, penalty for cheque dishonour etc. are not a consideration for tolerating an act or situation.

Specific clarifications set out in circular

• Liquidated Damages: Black's Law Dictionary defines 'Liquidated Damages' as cash compensation agreed to by a signed, written contract for breach of contract, payable to the aggrieved party. Breach or non-performance of contract by one party results in loss and damages to the other party. The law provides in Section 73 of the Contract Act, 1972 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;

Such compensation specified in a written contract for breach of non-performance of the contract or parties of the contract is referred to as liquidated damages.

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. Liquidated damages are a measure of loss and damage that the parties agree would arise due to breach of contract.

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. Such payments do not constitute consideration for a supply and are not taxable.

Examples of such cases are damages resulting from damage to property, negligence, piracy, unauthorized use of trade name, copyright, etc. Other examples are the penalty stipulated in a contract for delayed construction, forfeiture of earnest money.

If a payment constitutes a consideration for a supply, then it is taxable irrespective of by what name it is called;

• Cancellation of coal block/mine allocations: There was no agreement between the prior allottees of coal blocks and the Government that the previous allottees shall agree to or tolerate cancellation of the coal blocks allocated to them if the Government pays compensation. No such promise or offer was made by the prior allottees to the Government. The allottees had no option but to accept the cancellation. The compensation was given to them for such cancellation, not under a contract between the allottees and the Government, but under the provisions of the statute and in pursuance of the Supreme Court Order. Therefore, the compensation paid for cancellation of coal blocks pursuant to the order of the Supreme Court in the above case was not taxable.
• Cheque dishonour fine/ penalty: Cheque dishonor fine or penalty is not a consideration for any service and not taxable.
• Penalty imposed for violation of laws: Penalty imposed for violation of laws such as traffic violations, or for violation of pollution norms or other laws are also not consideration for any supply received and are not taxable, which are also not taxable. Same is the case with fines, penalties imposed by the mining Department of a Central or State Government or a local authority on discovering mining of excess mineral beyond the permissible limit or of mining activities in violation of the mining permit. Violation of law is never a lawful object or consideration. It was also clarified vide Circular No. 192/02/2016-Service Tax, dated 13.04.2016 that fines and penalty chargeable by Government or a local authority imposed for violation of a statute, bye-laws, rules or regulations are not leviable to Service Tax. The same holds true for GST also.
• Forfeiture of salary: In the event of the employee leaving the employment before the minimum agreed period. Premature leaving of the employment results in disruption of work and an undesirable situation. 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.
• Compensation for not collecting toll charges: The toll reimbursements were calculated based on the average monthly collection of toll. It has been clarified vide Circular No. 212/2/2019-ST dated 21.05.2019 that the service that is provided by toll operators is that of access to a road or bridge, toll charges being merely a consideration for that service. During the period from 8.11.2016 to 1.12.2016, the service of access to a road or bridge continued to be provided without collection of toll from users. Consideration came from the project authority. The fact that for this period, for the same service, consideration came from a person other than the actual user of service does not mean that the service has changed.
• 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. 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.
• Fixed Capacity charges for Power: The minimum fixed charges have to be paid by the SEBs/DISCOMS/individual customers irrespective of the quantity of electricity scheduled or purchased by them during a month. They take care of the fixed cost of generating/ supplying electricity. The variable charges are charged per unit of electricity purchased and increase or decrease every month depending on the quantity of electricity consumed. Both the components of the price, the minimum fixed charges/capacity charges and the variable/energy charges are charged for sale of electricity and are thus not taxable as electricity is exempt from GST.
• Cancellation charges: In case the customer does not show up for availing the service, the supplier may retain or forfeit part of the consideration or security deposit or earnest money paid by the customer for the intended supply. 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. The amount forfeited in the case of non-refundable ticket for air travel or security deposit or earnest money forfeited in case of the customer failing to avail the travel, tour operator or hotel accommodation service or such other intended supplies should be assessed at the same rate as applicable to the service contract, say air transport or tour operator service, or other such services.

Paperwriter comments

Liquidated damages and compensation paid: The clarifications in respect of non taxability of liquidated damages, compensation paid is in line with the correct interpretation that GST cannot be levied in the absence of supply of goods/services being done.

This view has found support in plethora of decisions under erstwhile indirect tax laws, such as Collector vs Spring Fresh Drinks [1997 (92) ELT A70 (SC)], K.N. Food Industries Pvt. Ltd Commissioner Of CGST & C. Ex [2020 (38) G.S.T.L. 60 (Tri. - All.], Neyveli Lignite Corporation Ltd. v. Commissioner of Customs, Central Excise & Service Tax, Chennai [Final Order No. 41702-41706 of 2021 in ST Appeal Nos. 41666, 41747 of 2016 & Ors., dated July 26, 2021]to name a few.

Notice period recovery

The circular seems to be in line with intent of law. It was held that notice period recovery cannot be taxed in plethora of decisions under erstwhile ST law as well in following:

• GE T & D India Limited v. Deputy Commissioner of Central Excise [2020 (35) G.S.T.L. 89 (Mad.)] held that service tax is not leviable on the payment received by the Petitioner in lieu of notice period paid by the outgoing employees. Employer not rendered any taxable service or tolerated any act of the employee but has merely facilitated sudden exit of employees by imposing cost upon them for such an act - Notice pay in lieu of sudden termination does not give rise to rendition of service either by employer or by employees.
• Similarly in the case of M/s. Gujarat State Fertilizers & Chemical Ltd (2016) and Allahabad CESTAT in case of M/s. HCL Learning Systems Vs CCE, Noida (TS-1125-CESTAT-2019-ST).

Penalties for infraction of law

The clarification on non levy of GST on penalties for infraction of law also was supported in ST education guide under erstwhile negative list based taxation.

No GST on electricity

The clarification on no tax on electricity is also validly in line with intention of the law, wherein electricity is exempted goods in notification 2/2017-CT(R).

Other pointers

• The circular seems to have erred to observe that late payment surcharge and cancellation fee to be taxed. It has over looked that in the absence of any corresponding supply being done against such cancellation charges, levy itself would not get attracted. In International experience elsewhere, European Court of Justice (ECJ) in case C-277/05 Sociéte thermal d'Eugenie- Les-Bains it was held that "a sum is retained by the hotelier, as a fixed cancellation charge paid as compensation for the loss suffered as a result of client default and which has no direct connection with the supply of any service for consideration and, as such, is not subject to that tax".
• On the whole, based on this circular, and the assesses can claim the shelter of the beneficial portions thereunder to claim exclusion from tax net.
• It has been the experience of assessees that the dept at time of audit also commonly is seen to raise frivolous demands of tax along with interest and penalty on the compensation/liquidated damages, notice period recoveries made. In such instances assesses can take support this circular why there should be no levy of GST on same before GST dept officers. Also the dept officers are bound to follow their circulars. This view has been confirmed in the decision of the Apex Court in Dhiren Chemicals [2002 (143) ELT 19 (SC)].

Conclusion

In this article the paper writer has examined the latest circular and its impact for various kinds of recoveries made under GST law.

The author can also be reached at roopa@hiregange.com