Written by Manish Mishra & Shareen Gupta
As the world deals with the challenges posed by the COVID-19 pandemic, India Inc. struggles to overcome the economic slowdown triggered by the consequent lockdown. The shutdown of businesses, slowdown in demand, and complete disruption in the supply-chain have triggered a severe liquidity crisis in the economy.
Businesses will find it increasingly difficult to meet their contractual obligations, which may result in non-performance of agreed obligations or delayed performances/deliveries. These defaults could cause a surge in claims for contractual or liquidated damages, especially in cases where the plea of force majeure is untenable.
Levying of taxes on ‘contractual damages’ remains one of the most debated issues under the Goods and Services (GST) laws, and may soon become litigious, with an increase in claims for damages.
At the core of this issue is a stipulation in Schedule II of the Central GST Act, whereby “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act” is specifically declared as a supply of service. Tax authorities are interpreting this clause to apply to payments for contractual damages as “consideration” towards supply of service for “tolerating an act” of non-performance, and hence, seek to levy GST on the same. The concern is amplified due to certain Advance Rulings that affirm this analogy and deem that payment of such damages would be subject to GST.
In this regard, one may appreciate that the claim for damages does not arise out of an obligation of the injured party to tolerate a default or non-performance but is more in the nature of financial compensation for the loss suffered on account of such non-performance. An interpretation to the contrary is uncalled for, as the contracts are not entered into for tolerating an act of non-performance by the contractor and the damages ought to be considered as penal or compensatory for the respective default or breach of contract.
It is also possible to argue, by way of invoking such damages, that the customer in no way tolerates or accepts non-performance of contractual commitments. In fact, the breach is not tolerated, which is why the injured party imposes the penalty or damages. The penalties merely aim to compensate the customer in a manner as if the default not occurred.
Further, a contract must be read in its entirety, to ensure specific clauses are not read independently to distort the essence. In other words, clauses pertaining to damages must not be read in isolation to infer that the contract is entered to render a service of tolerating or accepting a breach of a contract.
Courts have analysed the taxability of such payments in the pre-GST regime, and held that such penalties/ damages should not be subject to tax, as they do not form a consideration towards rendering service. The view emerging from these Rulings is that such damages are meant to compensate the injured party for injuries or losses suffered on account of the default and have no connection with the supplies agreed between the parties. Inferences may also be derived from these Rulings, setting aside tax demands on recovery of the notice period, salaries from employees for not serving the full notice period, post-resignation. The courts have viewed such recoveries as breach of contract, not liable to tax.
Contractual or liquidated damages are not subject to Value-Added Tax (VAT)/GST globally as well. VAT laws in the United Kingdom specifically prescribe that liquidated damages are agreed, pre-estimated sums, to be paid in the event of a breach of contract, either as a set figure or determined by a formula. They are not paid for supply and no VAT is due on such an amount.
However, there could be instances of short upliftment of goods by the purchaser, for which the price must be paid in full for the pre-agreed quantity, without any adjustment. In terms of valuation provisions in GST laws, GST needs to be paid on the full value charged by the supplier, without any adjustment for such short supplies. Therefore, each situation must be independently assessed to determine the GST exposure on this account.
It is vital that the government provides suitable clarification to settle this issue to avoid unnecessary litigation and tax administration costs for assessees and the government.
(The article is co-authored by Manish Mishra and Shareen Gupta, Partners with J. Sagar Associates, with inputs from Sr. Consultant Shikha Parmar. Views are personal and do not reflect the official opinion of the firm.)
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