1. Show Cause Notice dated xx is issued upon M/s XXX alleging that while issuing the SCN dated xx had stated that on perusal of Trial Balance provided by the Noticee for the F.Y. 2017-18 (July 2017 onwards), it was found that the due to violation of service conditions shown in the contract, the awarder/recipient has deducted/withheld liquidated damages as penalty payment from the Noticee’s payments.
2. In response to the allegation as set out in the SCN dated XX, the Noticee submits that the findings of the concerned authority are not in line with the legal matrix and factual positioning of the case.
LIQUIDATED DAMAGES IS NOT TAXABLE UNDER GST AS WELL AS UNDER ERSTWHILE SERVICE TAX REGIME WHERE SIMILAR ENTRY WAS IN FORCE
1. That I Proper Officer has alleged that the said amount is covered under scope of Para 5(e) of Schedule II of CGST Act 2017 which provides for ‘agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act’ and accordingly, alleged such liquidated damages to be a supply. Further, alleging that the said activity should be treated as supply of service whose SAC code is 999794. Further, Section 15(2)(d) of the Acct was referred by the Ld. Officer to allege that said penalty is part of taxable supply of the Appellant and hence, amenable to 18% GST
2. In this regard, the Noticee submits that GST is not even leviable upon liquidated damages as already stands clarified by CBIC itself vide Circular bearing no. 178/10/2022 – GST dated 03 August 2022. The relevant portion of the circular dated 03 August 2022 is produced herein under as-
“2. “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 said expression has following three limbs: –
a. Agreeing to the obligation to refrain from an act –
Example of activities that would be covered by this part of the expression would include non-compete agreements, where one party agrees not to compete with the other party in a product, service or geographical area against a consideration paid by the other party. Another example of such activities would be a builder refraining from constructing more than a certain number of floors, even though permitted to do so by the municipal authorities, against a compensation paid by the neighbouring housing project, which wants to protect its sunlight, or an industrial unit refraining from manufacturing activity during certain hours against an agreed compensation paid by a neighbouring school, which wants to avoid noise during those hours.
b. Agreeing to the obligation to tolerate an act or a situation –
This would include activities such a shopkeeper allowing a hawker to operate from the common pavement in front of his shop against a monthly payment by the hawker, or an RWA tolerating the use of loud speakers for early morning prayers by a school located in the colony subject to the school paying an agreed sum to the RWA as compensation.
c. Agreeing to the obligation to do an act
This would include the case where an industrial unit agrees to install equipment for zero emission/discharge at the behest of the RWA of a neighbouring residential complex against a consideration paid by such RWA, even though the emission/discharge from the industrial unit was within permissible limits and there was no legal obligation upon the individual unit to do so.
3. The description “agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act” was intended to cover services such as described above. However, over the years doubts have persisted regarding various transactions being classified under the said description.
3.1 Some of the important examples of such cases are Service Tax/GST demands on –
i. Liquidated damages paid for breach of contract
ii. Compensation given to previous allottees of coal blocks for cancellation of their licenses pursuant to Supreme Court Order;
iii. Cheque dishonour fine/penalty charged by a power distribution company from the customers;
iv. Penalty paid by a mining company to State Government for unaccounted stock of river bed material;
v. Bond amount recovered from an employee leaving the employment before the agreed period;
vi. Late payment charges collected by any service provider for late payment of bills;
vii. Fixed charges collected by a power generating company from State Electricity Boards (SEBs) or by SEBs/DISCOMs from individual customer for supply of electricity;
viii. Cancellation charges recovered by railways for cancellation of tickets, etc.
In some of these cases, tax authorities have initiated investigation and in some advance ruling authorities have upheld taxability.
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Liquidated Damages
7.1 Breach or non-performance of contract by one party results in loss and damages to the other party. Therefore, 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; it is just an event in the course of performance of that contract.
7.1.1 It is common for the parties entering into a contract, to specify in the contract itself, the compensation that would be payable in the event of the breach of the contract. 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. 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.
7.1.2 Section 74 of the Contract Act, 1972 provides that when a contract is broken, if a sum has been named or a penalty stipulated in the contract as the amount or penalty to be paid in case of breach, the aggrieved party shall be entitled to receive reasonable compensation not exceeding the amount so named or the penalty so stipulated.
7.1.3 It is argued that performance is the essence of a contract. 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. Payment of liquidated damages is stipulated in a contract to ensure performance and to deter non-performance, unsatisfactory performance or delayed performance. Liquidated damages are a measure of loss and damage that the parties agree would arise due to breach of contract. They do not act as a remedy for the breach of contract. They do not restitute the aggrieved person. It is further argued that a contract is entered into for execution and not for its breach. The liquidated damages or penalty are not the desired outcome of the contract. By accepting the liquidated damages, the party aggrieved by breach of contract cannot be said to have permitted or tolerated the deviation or non-fulfilment of the promise by the other party.
7.1.4 In this background a reasonable view that can be taken with regard to taxability of liquidated damages is that 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.
7.1.5 Examples of such cases are damages resulting from damage to property, negligence, piracy, unauthorized use of trade name, copyright, etc. Other examples that may be covered here are the penalty stipulated in a contract for delayed construction of houses. It is a penalty paid by the builder to the buyers to compensate them for the loss that they suffer due to such delayed construction and not for getting anything in return from the buyers. Similarly, forfeiture of earnest money by a seller in case of breach of ‘an agreement to sell’ an immovable property by the buyer or by Government or local authority in the event of a successful bidder failing to act after winning the bid, for allotment of natural resources, is a mere flow of money, as the buyer or the successful bidder does not get anything in return for such forfeiture of earnest money. Forfeiture of Earnest money is stipulated in such cases not as a consideration for tolerating the breach of contract but as a compensation for the losses suffered and as a penalty for discouraging the non-serious buyers or bidders. Such payments being merely flow of money are not a consideration for any supply and are not taxable. The key in such cases is to consider whether the impugned payments constitute consideration for another independent contract envisaging tolerating an act or situation or refraining from doing any act or situation or simply doing an act. If the answer is yes, then it constitutes a ‘supply’ within the meaning of the Act, otherwise it is not a “supply”.
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11.5 However, as discussed above, forfeiture of earnest money by a seller in case of breach of ‘an agreement to sell’ an immovable property by the buyer or such forfeiture by Government or local authority in the event of a successful bidder failing to act after winning the bid for allotment of natural resources, is a mere flow of money, as the buyer or the successful bidder does not get anything in return for such forfeiture of earnest money. Forfeiture of earnest money is stipulated in such cases not as a consideration for tolerating the breach of contract but as a compensation for the losses suffered and as a penalty for discouraging the non-serious buyers or bidders. Such payments being merely flow of money are not a consideration for any supply and are not taxable.”
3. Further, owing to an entry similar to Para 5(e) of Schedule II in CGST Act existent in erstwhile Service tax law under Declared Services notified in Section 66E of the Finance Act, 1994, as amended, aforementioned Circular dated 03 August 2022 produced supra, was also adopted for the Service Tax regime vide Circular bearing No. 214/1/2023 – Service Tax dated 28 February 2023.
4. That in the erstwhile service tax regime, there are various jurisprudences on the similar issues that the amount/earnest money forfeited due to breach of conditions of the contract will be considered in the nature of penalty and ergo, no service tax shall be leviable on these amounts. Reliance in this regard is placed on the following decisions wherein it was held that–
- South Eastern Coalfields Ltd. v. Commr. of C. Ex. & S.T., Raipur, cited in 2020 Taxo.online 1033
“3. A show cause notice dated April 10, 2017 was issued to the appellant under Section 73(1) of the Finance Act mentioning therein that the appellant had collected an amount towards compensation/penalty from the buyers of coal on the short lifted/unlifted quantity of coal; collected amount towards compensation/penalty from the contractors engaged for breach of terms and conditions; and collected amount in the name of damages from the suppliers of material for breach of the terms and conditions of the contract. According to the Department this amount charged by the appellant during the period from July, 2012 to March, 2016 appeared to be taxable as a ‘declared service’ under Section 66E(e) of the Finance Act. The relevant portion of the show cause notice is reproduced below :-
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20. The Supreme Court in Commissioner of Service Tax v. M/s. Bhayana Builders cited in 2018 Taxo.online 578 while deciding the appeal filed by the Department against the aforesaid decision of the Tribunal, also explained the scope of Section 67 of the Act. The Supreme Court observed that any amount charged which has no nexus with the taxable service and is not a consideration for the service provided does not become part of the value which is taxable under Section 67. The observations are :
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21. The aforesaid view was reiterated by the Supreme Court in Union of India v. Intercontinental Consultants and Technocrats cited in 2018 Taxo.online 575 and it was observed that since service tax is with reference to the value of service, as a necessary corollary, it is the value of the services which are actually rendered, the value whereof is to be ascertained for the purpose of calculating the service tax payable thereupon.
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27. It is trite that an agreement has to be read as a whole so as to gather the intention of the parties. The intention of the appellant and the parties was for supply of coal; for supply of goods; and for availing various types of services. The consideration contemplated under the agreements was for such supply of coal, materials or for availing various types of services. The intention of the parties certainly was not for flouting the terms of the agreement so that the penal clauses get attracted. The penal clauses are in the nature of providing a safeguard to the commercial interest of the appellant and it cannot, by any stretch of imagination, be said that recovering any sum by invoking the penalty clauses is the reason behind the execution of the contract for an agreed consideration. It is not the intention of the appellant to impose any penalty upon the other party nor is it the intention of the other party to get penalized.
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43. It is, therefore, not possible to sustain the view taken by the Principal Commissioner that penalty amount, forfeiture of earnest money deposit and liquidated damages have been received by the appellant towards “consideration” for “tolerating an act” leviable to service tax under Section 66E(e) of the Finance Act.”
(Emphasis Supplied)
The above decision of Hon’ble Delhi CESTAT categorically holds that liquidated damages are not covered under ‘consideration’ as the primary intent of entering into an agreement is not that of charging penalty from the other person and instead, availing services of the other person. It is only when the other person breaches any conditions of the contract, a penalty or compensation by the name of ‘liquidated damages’ is charged from such other person which does not amount to any services rendered.
5. Further reliance is placed on following decisions wherein it was held that the transaction value should not include the amount of Liquidated Damages and hence the duty was payable on the transaction value after considering the amount of Liquidated Damages –
- of C. Ex., Chandigarh v. H.F.C.L. (Wireless Division) – 2015 (11) TMI 893 – CESTAT New Delhi = 2015 (321) E.L.T. 300 (Tri.-Del.)
- Victory Electricals Ltd. – 2016 Taxo.online 109 (Tri.-LB)
- United Telecom Ltd. – 2016 Taxo.online 60 (Tri.-Bang.)
6. It is submitted that above relied upon decision is that of erstwhile regime where Section 66E(e) of Finance Act, 1994, as amended, was similar to Para 5(e) of Schedule II of CGST Act, 2017 and thus, since the law, to this extent, remains same, these decision holds valid for the present regime also. In Bharat Sanchar Nigam Ltd. v. Union of India, cited in 2016 Taxo.online 61, the Hon'ble Supreme Court had reiterated that where facts and law in a subsequent assessment year are the same, no authority whether quasi-judicial or judicial can generally be permitted to take a different view.
Conclusion
7. Based on the analysis of the legal position of the present case along with the case laws & Circular cited supra, the Appellant submits that the forfeiture of such amounts will not attract the provisions of GST tax in absence of any ‘service’ or ‘supply’ against which the alleged sum is so forfeited.
8. Thereby, It is kindly submitted before the office of your goodself to drop the proceedings upon the Noticee.
