Parties entering into contractual agreements usually insist on including a clause for liquidated damages to pre-emptively agree upon the amount of reparation that would be payable by either Party on failure to meet its commitment. Generally, such commitments are in the nature of adhering to timelines, fulfilment of conditions, quality of product, etc. The levy of GST on the amount of liquidated damages has faced a series of doubts in the minds of the Industry as a whole. However, Maharashtra Advance Ruling Authorities has viewed liquidated damages as consideration for an act of tolerance or non-performance, thus are eligible to GST.1
In cases where the Applicant is contractually entitled to collect liquidated damages from the supplier in case of deficiency in service or not meeting the timeline as mentioned in the contract, GST would be applicable in terms of Schedule II of the Act.2
Liquidated damages have been treated as an independent levy. The impugned income though presented in the form of a deduction from the payments to be made to the Contractor is the income of the applicant and would be a supply of service by the applicant. It has been held that the reason giving rise to liquidated damages is toleration at the end of the other party. Thus, GST is invariably leviable.
The rate at which the same would be taxable is 18%.3 Further it has been held that the levy of liquidated damages is not when the delay is occurring. As per the contract in question, liquidated damages are to be levied on payment of liability that would define the time of supply.
Liquidated Damages under erstwhile Service Tax regime
The levy of an indirect tax on the amount of liquidated damages has faced a series of challenges under the erstwhile service tax regime. Agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act was deemed to be service under the service tax regime. Where liquidated damages were in the nature of accidental damages caused due to unforeseen actions and not relatable to the provision of service, these were not included in the value of the service, and hence not to be taxed.5
Additionally, it was clarified that security deposits forfeited for damages done by the service receiver in the course of receiving a service were not to be regarded as consideration. Hence, there existed a lack of clarity whether the failure to adhere to timelines was an “act of toleration” or was merely the consequence of breach of contract, i.e. the treatment of liquidated damages.
Notification No. 25/2012 – Service Tax dated June 28, 2012, was amended on April 13, 2016, exempting liquidated damages payable to the Government or local authority from the levy of service tax.6 Post the amendment, show cause notices were issued to taxpayers demanding service tax in the instances where the damages were not payable to the Government or local authority.
The aforesaid issue was still at a preliminary stage at the time of the introduction of the Goods and Service Tax (GST). Entry 5(e) of Schedule II to the Central GST Act, 2017 replicates the entry of the erstwhile service tax regime. Thus, the act of tolerating the failure to adhere to timelines, condition or quality continues to remain a concern.
The matter of liquidated damages has always raised a doubt among the suppliers. In the erstwhile indirect taxation regime, the same was chargeable to tax. However, a grey area still remains as to the claim of ITC on the GST paid for liquidated damages. The recent rulings have not provided any clarity to the issue. However, we are of the view that ITC shall be claimed as there is no specific exclusion as per Section 17(5) of the CGST Act .
The AAR leads to the inference that the contractual terms are relevant for determining whether the payment of liquidated damages could be considered as a consideration for an independent supply of tolerating an act. Such contractual terms are: clauses that reflect the linkage of payment to milestone events; those that include liquidated damages as a variation factor in the price variation/ deduction clause; or general clauses that reflect redetermination of the consideration of supply. Accordingly, companies would need to structure their transactions keeping in mind the aforementioned parameters in order to mitigate GST implications on liquidated damages.
1Maharashtra State Power Generation Company Limited, 2018-TIOL-33-AAR-GST
2Clause e of para 5 of the Schedule II of the CGST Ac,2017
3Notification No. 11/2017- Central Tax (Rate) dated 28.06.2017
4Section 66(e ) of Finance Act, 1994
5Rule 6(2)(vi) of Service Tax (Determination of Value) Rules, 2006
6Notification No 22/2016 – ST, dated April 13, 2016
BT Associates is a premier indirect tax consultant in kolkata, delivering high quality services to client in the area of indirect taxation.GST idea is a unit of BT Associates formed to share knowledge on stakeholders. We cover entire gamut from technical papers to recent development including IT under GST
Chief Executive officer
BT Associates, India
Twenty years of exprience in tax practice, specialist in structuring & planing and tax optimization under indirect tax. Lead eastern India indirect tax practice of Ernst & Young in past.