A very frequent question being faced under GST is taxability of Liquidity damages, cancellation charges, late payment charges etc. arising out of breach of contract. Question arises because of Para No. 5(e) of Schedule II of Central Goods and Service Tax Act, 2017 which states “Agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act” is a supply of service if the same constitutes a “supply” within the meaning of the Act.
So, to clear chaos, the department has issued clarification on application of GST on such charges vide Circular No. 178/10/2022-GST dated 3rd August, 2022.
Details analysis of such circular is as follows:
1. Analysis of Para 5(e) of Schedule II of CGST Act
This entry has 3 limbs namely:
- Agreeing to the obligation to refrain from an act: Certain examples of this service is
- 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
- 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 neighboring 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 neighboring school, which wants to avoid noise during those hours
- Agreeing to the obligation to tolerate an act or a situation: Certain example of this service is
- shopkeeper allowing a hawker to operate from the common pavement in front of his shop against a monthly payment by the hawker.
- 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.
- Agreeing to the obligation to do an act: It would include
- an industrial unit agrees to install equipment for zero emission/discharge at the behest of the RWA of a neighboring 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.
2. Services so far covered under Para 5(e) by department
Intention of Para 5(e) was to cover the services described above. However, over the years various other services are tried to be covered under these categories. Service Tax/GST demand has issued on following mattes:
- Liquidated damages for breach of contract.
- Compensation given to previous allottees of coal blocks for cancellation of their licenses pursuant to Supreme Court Order.
- Cheque dishonor fine/penalty charged by a power distribution company from the customers.
- Penalty paid by a mining company to State Government for unaccounted stock of river bed material.
- Bond amount recovered from an employee leaving the employment before the agreed period.
- Late payment charges are collected by any service provider for late payment of bills.
- Fixed charges collected by a power generating company from State Electricity Boards (SEBs) or by SEBs/DISCOMs from individual customer for supply of electricity.
- Cancellation charges recovered by railways for cancellation of tickets, etc.
Even in some of these cases, tax authorities have initiated investigation and in some advance ruling authorities have upheld taxability.
3. Essence of services covered under Para 5(e)
- In Service Tax law, ‘Service’ means any activity carried out by a person for another for consideration. The concept ‘activity for a consideration’ involves an element of contractual relationship wherein the person doing an activity does so at the desire of the other person for a consideration.
- Therefore, An activity done without such a relationship i.e., without the express or implied contractual reciprocity of a consideration would not be an ‘activity for consideration’.
- The element of contractual relationship, where one supplies goods or services at the desire or another, is an essential element of supply.
- All the services described above are similar to the definition of contract in the Contract Act, 1872.
- As per Contract Act, ‘Contract’ is a set of promises, forming consideration for each other. ‘Promise’ has been defined as the willingness of the ‘promisor’ to do or to abstain from doing anything. ‘Consideration’ has been defined in the Contract Act as what the ‘promisee’ does or abstains from doing for the promises made to him.
- Therefore, all these services of agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act is nothing but a contractual agreement.There must be a necessary and sufficient nexus between the supply (i.e. agreement to do or to abstain from doing something) and the consideration.
- Accordingly, activities covered under Para 5(e) must be performed under an agreement/ contract wherein any of these activity is performed for a consideration. Such a contractual arrangement must be an independent arrangement. Such arrangement or agreement can take the form of an independent stand- alone contract or may form part of another contract.
4. Agreement to do or refrain from doing an act can’t be presumed to be exist
- There has to be an express or implied agreement whether written or oral to do or abstain from doing something for a consideration to form a taxable supply.
- An agreement cannot be presumed to exist just because there is a flow of money from one party to another unless there is an express or implied promise that recipient shall do or abstain from doing something in return for the money.
- Therefore, liquidated damages for breach of contract, penalties under various acts, forfeiture of salary or payment of amount as per the employment bond for leaving the employment before the minimum agreed period, penalty for cheque dishonour etc. are not a consideration for tolerating an act or situation.
- These amounts are for preventing breach of contract or non-performance and are thus mere ‘events’ in a contract.
- As discussed above, unless payment is made for an independent activity of tolerating an act under an independent arrangement entered into for such activity of tolerating an act, , such payments will not constitute ‘consideration’ and hence such activities will not constitute “supply” within the meaning of the Act.
Taxability on various similar transactions is discussed in greater detail in the following paragraphs.
5. Liquidated Damages
- ‘Liquidated Damages’ are cash compensation agreed to by a signed, written contract for breach of contract, payable to the aggrieved party.
- Breach or non-performance of contract by one party results in loss and damages to the other party. The compensation is not a consideration for any other independent activity; it is just an event in the course of performance of that contract.
- 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 the contract.
- ‘liquidated damages’ is a compensate for injury, loss or damage suffered by the aggrieved party due to breach of the contract. Liquidity 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.
- Examples of such cases are damages resulting from damage to property, negligence, piracy, unauthorized use of trade name, copyright, etc.
6. Compensation of cancellation of Coal Blocks
- In the year 2014, coal block/mine allocations were cancelled by the Hon’ble Supreme Court. Subsequently, Coal Mines (Special Provisions) Act, 2015 was enacted. In accordance with such Act, prior (old) allottee of mines were given compensation towards the transfer of their rights/ titles in the land, mine infrastructure, etc. to the new entity (successful bidder) as per the directions of Hon’ble Supreme Court.
- There was no agreement between the prior allottees and the Government that the previous allottees shall agree to or tolerate cancellation of the coal blocks allocated to them if the Government pays compensation to them.
- No such promise or offer was made by the prior allottees to the Government. The allottees had no option but to accept the cancellation.
- The compensation was given to them for such cancellation, not under a contract but under the provisions of the statute and in pursuance of the Supreme Court Order.
- Therefore, prior allottees did not supply any service to the Government by tolerating cancellation of the allocations made to them by the Government.
- The compensation paid for cancellation of coal blocks pursuant to the order of the Supreme Court in the above case was not taxable.
7. Cheque dishonor Fine/Penalty
- The fine or penalty that the supplier or a banker imposes, for dishonor of a cheque, is a penalty imposed not for tolerating the act or situation.
- Whereas, such fine or penalty is imposed for not tolerating, or penalizing such Act.
- Therefore, cheque dishonor fine or penalty is not a consideration for any service and not taxable.
8. Penalty imposed for violation of laws
- Penalties imposed for violation of laws such as traffic rules, are not considered for any supply received.
- There is no agreement between the Government and the violator specifying that violation would be allowed or permitted against payment of fine or penalty. There cannot be such an agreement as violation of law is never a lawful object or consideration.
- As clarified earlier also vide Circular No. 192/02/2016-Service Tax, dated 13.04.2016, that fines and penalty chargeable by Government or a local authority imposed for violation of a statute, bye-laws, rules or regulations are not leviable to Service Tax. The same holds true for GST also.
9. Forfeiture of salary or payment of bond amount for not serving minimum period of employment
- The provisions for forfeiture of salary or recovery of bond amount for not serving minimum agreed period are incorporated in the employment contract to discourage non-serious candidates from taking up employment.
- The said amounts are recovered by the employer not as a consideration for tolerating the act of such premature quitting of employment but as penalties for dissuading the non-serious employees from taking up employment and to discourage and deter such a situation.
- The employee does not get anything in return from the employer against payment of such amounts.
- Therefore, such amounts recovered by the employer are not taxable as consideration for the service of agreeing to tolerate an act or a situation.
10. Compensation for not collecting toll charges
- In the wake of demonetization, NHAI directed the toll operators to allow free access of toll roads to the users. Loss of toll charge was paid as compensation by NHAI as per the instructions of Ministry of Road Transportation and Highways.
- It has been clarified vide Circular No. 212/2/2019-ST dated 21.05.2019 that the service that is provided by toll operators is that of access to a road or bridge, toll charges being merely a consideration for that service.
- The service of access to a road or bridge continued to be provided without collection of toll from users. Consideration came from the project authority.
- The fact that for this period, for the same service, consideration came from a person other than the actual user of the service does not mean that the service has changed.
11. Late payment surcharge or fee
- The facility of accepting late payments with interest or late payment fee, fine or penalty is a facility granted by a supplier naturally bundled with the main supply. It is not uncommon or unnatural for customers to sometimes miss the last date of payment of electricity, water, telecommunication services etc.
- Since it is ancillary to and naturally bundled with the principal supply such as of electricity, water, telecommunication, cooking gas, insurance etc. it should be assessed at the same rate as the principal supply. However, the same cannot be said of cheque dishonor fine or penaty.
12. Fixed Capacity charges for Power
- The price charged for electricity by the power generating companies from the State Electricity Boards (SEBs)/DISCOMS or by SEBs/DISCOMs from individual customers has two components, namely, a minimum fixed charge (or capacity charge) and variable per unit charge.
- The minimum fixed charges have to be paid by the SEBs/DISCOMS/individual customers irrespective of the quantity of electricity scheduled or purchased by them during a month.
- They take care of the fixed cost of generating/ supplying electricity. The variable charges are charged per unit of electricity purchased and increase or decrease every month depending on the quantity of electricity consumed.
- Both the components of the price, the minimum fixed charges/capacity charges and the variable/energy charges are charged for sale of electricity and are thus not taxable as electricity is exempt from GST.
13. Cancellation charges
- In case the customer does not show up for availing the service, the supplier may retain or forfeit part of the consideration or security deposit or earnest money paid by the customer for the intended supply.
- The Facilitation Supply of allowing cancellation of an intended supply against payment of cancellation fee or retention or forfeiture of a part or whole of the consideration or security deposit in such cases should be assessed as the principal supply.
- The amount forfeited in the case of non-refundable ticket for air travel or security deposit or earnest money forfeited in case of the customer failing to avail the travel, tour operator or hotel accommodation service or such other intended supplies should be assessed at the same rate as applicable to the service contract, say air transport or tour operator service, or other such services.
- For example, cancellation charges of railway tickets would attract GST at the same rate as applicable to the class of travel (i.e., 5% GST on first class or air-conditioned coach ticket and nil for other classes such as second sleeper class). Same is the case for air travel.