What is liquidated damages (LD)?
Liquidated Damages (LD) is levied or imposed when some specific task or work is not performed as per the agreed terms or condition, means that there is breach of contract terms. LD is generally levied at fixed rated irrespective of actual damages. Generally in large quantum work like infrastructure projects where performance of the contract is very essence of project, then there is specific clause for LD in the contract. Example situation in which LD is levied is like when milestone is not performed within specific time frame then LD is levied at 1% of milestone amount.
Relevant provisions to consider under GST Act
Section 7 – Scope of supply
Section 15 – Value of Supply
Schedule – II of CGST Act (Refer to Section 7(4) of CGST Act)
Paragraph 5 of Schedule II to CGST Act provides a list of activities to be treated as ‘supply of services’ which inter alia comprises – “(e) agreeing to the obligation to refrain from an act, or to tolerate an act or situation, or to do an act”.
What are unliquidated damages?
Unlike LD, unliquidated damages are not fixed or pre-determined or ascertained, claim for same is governed by common laws. Unliquidated damages can be claimed based on actual loss or injury to the contracting party.
Present Rulings on Liquidated Damages
Recently Maharashtra State Power Generation Company Limited (Company) made an application to Maharashtra Authority for Advance Ruling (AAR) to get the view on applicability of GST on LD charged to its sub-contractors. Company has entered to contracts with its various sub-contractors on turnkey basis for construction of new power plants and O&M activities. Within the contracts as per standard practice in Infrastructure sector, company has kept LD clause which becomes applicable on occurrence of specific events like delay on execution of contract, deficiency in Quality etc. On these example events LD is imposed on sub-contractors at pre-determined lump sum rate.
AAR ruled that Liquidated Damages is also subject to levy of GST;
AAR Observed that income from the present case by way of deduction is liable to GST in terms of Paragraph 5 of Schedule II to CGST Act which provides a list of activities to be treated as ‘supply of services’ which inter alia comprises – “(e) agreeing to the obligation to refrain from an act, or to tolerate an act or situation, or to do an act”.
AAR ruled on the ground that act of delayed supply has happened and same is being tolerated by way of liquidated damages. AAR also observed that overall value of the contract has not changed.
AAR is of the view that charging liquidated damages is mere the settlement of the account of parties and has not relation with contract value, hence GST should be applicable.
AAR held it taxable supply of service, the AAR placed the supply in the category of Heading 9997 – ‘Other Services’ in Notification No. 11/2017 – Central / State Tax (Rate) (“Notification”) taxable at the rate of 18% [9% CGST + 9% MGST].
Why GST should not be applicable on liquidated damages?
- Company has no explicit agreement with sub-contractors wherein company is agreeing to supply services like the obligation to refrain from an act, or to tolerate an act or situation, or to do an act.
- To Levy LD is not any supply of service, it is merely the recovery of damages from sub-contractor for the breach of contract terms.
- LD is not intentional from the contract, when party deviate from the contract imposing LD is expression of displeasure.
- Clause (e) of Paragraph 5 of Schedule II to CGST Act provides that agreeing to the obligation to refrain from an act, or to tolerate an act or situation, or to do an act is regarded supply of service. Here in the present LD clause in contract does not fulfil the requirement of clause (e) mentioned as above;
- If we read word by word, clause says that there should be obligation to refrain from act, or to tolerate an act or situation, in the contract entered with sub-contractor there is no obligation on the part of company to tolerate any act or situation. The clause clearly says that there should be obligation and contract for tolerance of any act or situation which is missing in the present case
- Liquidated damages are not desired income for which contract is entered in to; it is only compensation for damages suffered.
Amendment in GST Act
The Lok Sabha on 9th August, 2018 has passed four amendment bills relating to GST. Section 7 of the CGST Act, 2017 defining ‘supply’ is being amended w.e.f. 1st July, 2017 itself. A new sub-section (1A) is inserted in section 7 and clause (d) of sub-section (1) is omitted. Thus now the role of Schedule II will be limited to classification of supply as ‘goods’ or ‘service’. For levying tax on liquidated damage, transaction will have to first pass the test of supply, which appears to be a difficult proposition.
Although AAR ruled against the company, but the same is rulling is applicable to that company only. AAR failed to analyse the very basic fundamental of levying LD and then co-related LD with income. It is essential to understand that levying LD is not consideration for the obligation to tolerate any act and also need to understand that contract is entered for the performance of the work and not for levying LD. So in the contract if there is any clause for liquidated damages then it does not mean that there is obligation to tolerate any act.
Moreover with insertion of new subsection (1A) under section 7, which clarify that for any activities/ transactions listed in Schedule II (as supply of service or supply of goods) shall be taxed only when they constitute ‘supply’ in accordance with provisions of Section 7(1)(a), (b) and (c) of the CGST Act.
However current AAR ruling will surely invite scrutiny for various companies in which LD is involved in their transaction. Proper clarification within the act or any high court or Supreme Court decision can clarify this position.