No Service Tax on liquidated damages recovered for not adhering to time limits mentioned in contract

The Hon’ble CESTAT, Chennai in the matter of 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] has held that, no service tax is to be imposed on liquidated damages recovered for not adhering to time limits mentioned in the contract as the same would not be covered in 'Declared Services’ mentioned under Section 66E(e) of the Finance Act, 1994 ("the Finance Act").

Facts

Neyveli Lignite Corporation India Limited("the Appellant") is a Public Sector Undertaking engaged in excavation of lignite from captive mines. The Appellant executed a contract with Bharat Heavy Electricals Limited ("BHEL") for design, engineering, manufacture, supply, erection, testing, commissioning, and supply etc. wherein, BHEL failed to adhere to the time limits as per the contract, for which the Appellant recovered liquidated damages in terms of the contract for non-adherence to the time schedule for supplies from other contractors/vendors.

Subsequently, a Show Cause Notice dated June 3, 2015 ("SCN") was issued by the Revenue Department ("the Respondent") to the Appellant for alleged non-submission of service tax on liquidated damages received for not adhering to time limits, since the same is covered under Section 66E(e) of the Finance Act and imposing interest and penalty on the same under Section 75, Section 76 and Section 78 of the Finance Act respectively.

Accordingly, the Appellant submitted a detailed reply to the SCN requesting to drop the proceedings for the reason that no service tax was payable on liquidated damages and penalties recovered under the contract. The Respondent vide order ("the Impugned Order") rejected the contentions raised by the Appellant and confirmed the proposed demand.

Being aggrieved, this appeal has been filed.

Issue

Whether the Appellant is liable to pay service tax under Section 66E(e) of the Finance Act on liquidated damages recovered on account of non-adherence to the time limits mentioned in the contract?

Held

The Hon’ble CESTAT, Chennai in Final Order No. 41702-41706 of 2021, dated July 26, 2021 held as under:

· Relied on the decision of the Hon’ble CESTAT, New Delhi in M/s. South Eastern Coalfields Ltd. v. CCE & ST Service Tax Appeal No. 50567 of 2019, dated December 22, 2020]wherein, the Tribunal set aside the order passed by the Revenue Department holding that the amount received towards penalty, earnest money deposit forfeiture and liquidated damages would be tantamount to a consideration, for which service tax would be levied.

· Observed that, there has to be a flow of consideration from one person to another when one person agrees to the obligation to refrain from an act, or to tolerate an act, or a situation, or to do an act.

· Further noted that, the activities mentioned under Section 66E of the Finance Act arewhere the agreement specifically refers to such an activity or activities which have an expectation of flow of consideration of such service.

· Stated that, in view of the decision inSouth Eastern Coalfields Ltd. (ibid), it is not possible to sustain the view taken by the Respondent that since BHEL did not complete the task within the time schedule, the Appellant agreed to tolerate the same for a consideration in the form of liquidated damages, which would be subjected to service tax under Section 66E(e) of the Finance Act.

· Held that, service tax could not be levied, and the imposition of interest and penalty also cannot be sustained.

· Set aside the Impugned Order.

Our Comments

Issue under the GST regime

Earlier (before the Central Goods and Services (Amendment) Act, 2018) the same was dealt under Section 7(1)(d) of the Central Goods and Services Act, 2017 ("CGST Act"), which included activities referred to in Schedule II to CGST Act, in the scope of supply. Paragraph 5 of Schedule II to the CGST Act provides a list of activities to be treated as either as 'supply of goods’ or 'supply of services’ wherein inter alia comprised Para 5– "(e) agreeing to the obligation to refrain from an act, or to tolerate an act or situation, or to do an act".

Thereafter, vide Central Goods and Services (Amendment) Act, 2018, Section 7(1)(d) of the CGST Act was retrospectively omitted and a new sub-section i.e., Section 7(1A) of the CGST Act was inserted w.e.f. July 1, 2017. Consequently, all activities which were specified in Schedule II to the CGST Act would be only for determination of classification of transactions either as 'supply of goods’ or supply of services’ but, it would be chargeable to GST only if such transaction qualify as a supply in terms of Section 7(1) of CGST Act.

Jurisprudence evolving on this issue

The Hon’ble Maharashtra AAR in the matter of Maharashtra State Power Generation Company Limited [Order No. GST-ARA- 15/2017-18/B-30, dated May 8, 2018] held that GST at the rate of 18% would be payable on liquidated damages received by the assessee for delayed supply under a contract and considered liquidated damages to be a consideration for agreeing to the obligation to tolerate an act or a situation, which is treated as a supply of service under Para 5(e) of Schedule II of the CGST Act.

Further, a similar view has been taken by the Hon’ble Gujarat AAR, in the matter of M/s. Dholera Industrial City Development Project Ltd. [Advance Ruling No. GUJ/GAAR/R/2019/06, dated March 4, 2019] wherein it was held that assessee is liable to collect GST on amount recovered from contractors on account of breach of conditions specified in the contract and the transaction shall be treated as supply of services. Moreover, as violation charges are payable by the contractors, the same are required to be treated as consideration. Therefore, the transaction is liable to GST.

The Hon’ble Gujarat AAR in the matter of M/s. Fastrack Deal Comm Pvt. Ltd. [Advance Ruling No. GUJ/GAAR/R/58/2020, dated July 30, 2020] has held that GST is leviable on the amount forfeited on the ground of breach of agreement of sale of land, in terms of clause 5(e) of Schedule II to CGST Act

In our considered view, the levy of GST on recovery of compensation/penalty/damages depends upon the "test of supply" i.e., one has to satisfy that recovery of compensation/penalty/damages in itself is a supply, then only GST could be levied on it in terms of the insertion of sub-clause (1A) in Section 7 of the CGST Act read with omission of sub-section (d) of Section 7(1) of the CGST Act (vide Central Goods and Services Tax (Amendment) Act, 2018 w.e.f. July 1, 2017).

The Schedule II of the CGST Act is confined to define as to what constitute supply of goods or supply of services and does not defines supply per se. Schedule II of the CGST Act has to be read along with Section 7 of the CGST Act, which means if an activity does not constitute a "supply" in itself as per Section 7(1) of the CGST Act, mere coverage of the same under the entry Schedule II ibid cannot make it liable to GST.

Further, there is no positive act of supply of services between the parties and there is no agreement between the parties to cause loss or damage by breaching terms and conditions of an agreement for a consideration. The expression 'to tolerate an act’ relates to situations where a person commissions another person to do or commit a particular act for a consideration. The payment of damages is a condition of contract and not a consideration for any service in the nature of forbearance or tolerating an act.

Relevant Provisions

Section 65B(44)(a) of the Finance Act

(44) "service" means any activity carried out by a person for another for consideration, and includes a declared service, but shall not include-

(a) an activity which constitutes merely,-

(i) a transfer of title in goods or immovable property, by way of sale, gift or in any other manner; or

(ii) such transfer, delivery or supply of any goods which is deemed to be a sale within the meaning of clause (29A) of Article 366 of the Constitution; or

(iii) a transaction in money or actionable claim;

Section 66E(e) of the Finance Act

"66E. The following shall constitute declared services, namely

(e) agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act;"