Compensation amounts paid for non-performance or breaches do constitute a supply of service under the GST

Facts of the Case:- In this case, The Applicant was engaged in the manufacturing of edible oils and has its state-of the-art manufacturing facility. Further, when the customers fails to lift the material as agreed, the applicant collects compensation amounts such as Liquidated damages/ Trade settlement from the customer for breach/non-performing of the contract. The compensation amounts such as liquidated damages / trade settlement will be calculated based on the difference between the rate agreed with the customer and the market rate on the date of settlement as agreed.

The applicant has discharged GST liability till the tax period Aug/2022 under the entry heading 9997-Agreeing to tolerate an act. After issuance of Circular by CBIC vide Circular No. 178/10/2022-GST dated. 03/08/2022 to clarify the taxability of Liquidate Damages etc., the applicant discontinued collecting any GST on the compensation / liquidated damages/trade settlement amounts received from the customers as the activity do not satisfy the definition of “Supply” specified under Section 7 of CGST/APGST Act, 2017.

This practice was scrutinized under the GST laws to determine if such compensation constitutes a taxable supply. For this, the Applicant sought Advance Rulings as to whether GST is leviable on compensation amounts such as liquidated damages/trade settlement/damages collected from the customers for non-performing of contractual obligations or breach of the contract.

Contention of the Applicant:- The Applicant Stated that there was a prior agreement between the Applicant and its customer regarding damages or compensation in case of breach of contract. However, as per Section 7 of the CGST Act, no supply of goods or services occurred. This means that the amount customer paid to the Applicant as compensation is purely consequential and doesn't meet the criteria for consideration as defined under GST. Further, submitted that Neither the applicant is carrying on any activity to receive compensation nor can there be any presumption of the intention of the other party to breach or violate the contract and suffer losses. Hence, there is not at all a service/supply element, the amount forfeited or recovered is only compensation due to breach of agreement for the sale of edible oil contract which was not a positive intention.

Ruling of AAR:-

The AAR, stated as under:

• Businesses engaged in contractual agreements where penalties or compensations for breaches are common. It clarifies that such compensation amounts are subject to GST, thereby impacting the way businesses draft their contracts and manage their GST liabilities.
• CBIC Circular No. 178/10/2022-GST Dtd. 03/08/2022 with regard to give a clarity on applicability of GST is applicable on liquidated damages, compensation and penalty arising out of breach of contract or other provisions of law,  is only meant to clarify the position of law and shall be applied reasonably having regard to the facts of the case. 
• Para 7.1.6 of the aforesaid Circular clearly states that. ” Therefore, such payments, even though they may be referred to as fine or penalty, are actually payments that amount to consideration for supply, and are subject to GST, in cases where such supply is taxable. Since these supplies are ancillary to the principal supply for which the contract is signed, they shall be eligible to be assessed as the principal supply.”
• Thus the circular had said payment towards damages are incidental to the main supply and if the main supply is taxable they shall also be taxable and if the principal supply is exempt then the incidental shall also be exempt. Thus the circular shall be understood in the proper context.
• In the light of section 7 read with definition of consideration u/s 2(31)7 compensation amounts paid by defaulting party to the non-defaulting party for tolerating the act of non performance or breach of contract have to be treated as consideration for tolerating of an act or a situation under an agreement and hence such an activity constitutes supply of service and the compensation amounts such as liquidity damages are exigible to tax under CGST @ 9% and SGST @9% each under the chapter head 9997 at serial no. 35 of Notification No. 11/2017- Central/State tax rate.

To read the judgement 2023 Taxo.online 1584