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Published on:

October 30, 2024

Alankar Mishra

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Basics of GST

GST on Liquidated Damages

In the scope of business contracts, it is common practice to refer to liquidated damages whenever one side defaults on the fulfilment of obligations under the contractual agreement. These damages are amounts explicitly decided by both sides to cover all possible instalments of a breach of the agreement. Within the setting of the introduction of the Goods and Services Tax (GST) in India, a pertinent issue arises as to whether liquidated damages are subjected to GST and what is their treatment under the law. In this article, we attempt to explore the various aspects of GST application, specifically its application on liquidated damages, the concepts of its liability, its history of court cases, and the regulatory issues businesses are required to know.

What Are Liquidated Damages?

Liquidated damages are in essence a fixed amount of money which is to be paid by one party to another if that party causes a breach of the terms set by the contract. This could involve the late performance of works, the failure to meet defined service level agreements, SLAs, or the late delivery of goods. Liquidated damages are the projected amount set in advance as compensation for the expected loss sustained due to failure to perform various duties.

Example: Suppose a contractor gets a contract for completion of a construction project within a specified duration of time. Such a contractor, if he is unable to meet the deadlines stipulated in the contract, may be required on the contract terms to bear the cost of non-performance and settle liquidated damages to the project owner.

Taxability of Liquidated Damages under GST

The main challenge for businesses now is to determine whether the liquidated damages are taxable under the scope of GST. The law under the GST Act clearly states that any consideration which is paid in respect of the supply of either goods or services becomes taxable. The fundamental question here is whether liquidated damages should be regarded as a supply of service.

In most cases, the breach of a contractual obligation gives rise to an award of damages, also referred to as liquidated damages. Even though they are not directly related to the supply of goods or services, the government has made it evident that liquidated damages are subject to tax under GST, for the same are treated as a service as per the definition in the law.

Notification and Legal Clarifications

The Central Board of Indirect Taxes and Customs (CBIC) made things clear in Circular No. 178/10/2022-GST by saying that for breach of contract liquidated damages are taxable under G.S.T. because they are treated as a supply of services. As per the circular, section 7(1)(d) of the CGST Act of 2017, liquidated damages are like a supply of service.

Such clarification was further supported by various rulings of the Authority for Advance Rulings (AAR) where it was held in an unbroken line that liquidated damages may be construed as being subject to GST.

Applicable GST Rate on Liquidated Damages

The applicable GST on liquidated damages has the same rate as applied to ordinary services, namely, 18%. This rate is applicable without concern for the type of agreement and the type of transaction involved.

Example: In case a company has entered into an agreement to pay liquidated damages of ₹1,00,000 for failure to complete the project within the agreed duration, GST payable would be ₹18,000 (equal to 18 per cent of ₹1,00,000 ).

Input Tax Credit (ITC) on Liquidated Damages

One relevant question that comes up is whether the party incurring such a cost in the form of liquidated damages is entitled to an Input Tax Credit (ITC) on the GST paid. The response varies according to the case and the type of transaction involved. Where the payment by way of liquidated damages can be characterized as a business cost and incurred wholly and exclusively for the business, the payer of GST on liquidated damages can claim ITC on tax paid on such damages.

But it must be emphasized that in claiming ITC, there will be some provisions under the GST act that must be adhered to and there has to be appropriate evidence of the transaction being recorded in the company’s books of accounts.

‍GST on Liquidated Damages: Key Judgements

Liquidated damages, over the last few years, have attained some tax clarity, especially in four recent pertinent rulings. One of the more prominent rulings was the legal case of Bai Mamubai Trust vs. Suchitra Commercial Developers Pvt. Ltd. where it was held that liquidated damages are countervailing as they are a consideration for tolerating an act, by the service definition in GST law.

Furthermore, the Maharashtra AAR in the case of Maharashtra State Power Generation Company Ltd. (MSPGCL) passed an order that GST is also applicable on liquidated damages as the recipient of the service (in this case, the contractor or service provider) is making a payment in consideration of not performing contractual obligations which is a case of “Agreeing to Tolerate an Act” under GST. These judgments have cemented the position that liquidated damages are taxable under GST.

Compliance Requirements for GST on Liquidated Damages

There are some compliance requirements that apply to businesses concerning the GST on liquidated damages, such as:

Issuing of Invoices: The service provider, being the recipient of the liquidated damages, is obliged to issue an invoice for the same under GST regulations as it is deemed to be a taxable supply of service.

Maintenance of Records: In circumstances that warrant examination or audit, it is necessary to keep and provide written evidence to show the contents of a contract, the amount of the liquidated damages, and the GST applicable to such amount.

Reverse Charge Mechanism (RCM): Uniformly, certain situations appending some kind of parties involved (for instance, registered and unregistered parties) could suit RCM applicability. Specifically, liability to pay GST shifts to the recipient of the service (the party incurring the liquidated damages) under RCM.

ITC Procedure: On the other hand, if the party who pays the liquidated damages expects a refund by way of Input Tax Credit (ITC), then this credit must be made within the time guidelines set and relies on correct invoices and other supporting documents.

Exemptions and Exceptions

Though most liquidated damages are subject to GST, some may be excluded depending on the type of transaction or the party agreements. For instance, if the liquidated damages are simply repayment for real costs incurred by any party, such remuneration cannot be considered as a supply of a service and thus most probably will be free of GST.

In the same manner, certain sectors may be provided with certain exemptions under the GST law. Business firms are advised to approach tax advisors or GST practitioners to ascertain whether the liquidated damages attract any exemptions.

Impact of GST on Business Contracts

The treatment of liquidated damages as a taxable event under GST has huge consequences for business agreements. Here are some of the ways it impacts businesses:

Cost of Breach: The applicability of GST on liquidated damages means increased costs for the breach. The liability of settling liquidated damages is increased by the fact that GST is payable.

Contract-Related Issues: When such a business contract is being negotiated, the parties will have to consider this burden: the possibility of GST on liquidated damages. It may be wise to add a clause that concerns the payment of GST on any liquidated damages paid.

Cash Flow Management: Because liquidated damages are subject to GST, businesses must consider this when developing their cash flow strategies. They may even have to coordinate with the other party to present a refund of the GST figure.

Conclusion

Liquidated damages under GST are termed as a service and bear a 18% GST rate. Liquidated damages under GST is a new feature which needs to ensure compliance so that penalties and legal issues do not arise for the businesses. Proper documentation, ensuring invoices are issued on time and making sure GST returns are filed according to the timelines are important in the management of liquidated damages under the GST regime.

Whether you are a contractor, service provider or client, understanding how liquidated damages invite GST is important for business functioning. The complexity and tangle of GST regulations can easily be dealt with by tax consultants or GST practitioners.

FAQs

1. Are liquidated damages subject to GST?

Liquidated damages, as specified in the GST Act, fall within the category of taxable service supply and as such are subject to GST.

2. What is the GST rate applicable on liquidated damages?

The GST on liquidated damages is 18% which is the standard rate for any service.

‍3. Can a business claim an Input Tax Credit (ITC) on GST paid for liquidated damages?

Indeed, businesses are entitled to claim Input Tax Credit (ITC) of the GST paid for liquidated damages if it is incurred in the course of their business activities and is not against the law governing the GST.

4. What is the reverse charge mechanism (RCM) on liquidated damages?

The reverse charge mechanism (RCM) can be considered for liquidated damages based on the characteristics of the relevant parties. Under the RCM, the responsibility of remitting VAT moves to the service-availing party (the one who pays the damages).

5. Do all liquidated damages attract GST?

Generally, GST applies to liquidated damages. But there could be exemptions. In such cases, businesses are advised to seek a tax consultant.

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