Introduction
In Transmission Corporation of Andhra Pradesh Ltd., In re[i], the Authority of Advance Rulings, Andhra Pradesh (‘AAR’) held that the amount recovered by the Transmission Corporation of Andhra Pradesh Ltd (‘Applicant’) from the contractors/suppliers for breach or non-performance of contract within the stipulated time as liquidated damages in the form of compensation was taxable under Central Goods & Service Tax, 2017 (‘CGST Act’).
Brief Facts
The Applicant, registered under the AP Goods & Service Act, 2017 (‘APGST’), was a licensed distribution company for the supply of electricity. It entered into various contracts and agreements with the successful bidders, i.e., contractors (suppliers), to construct and maintain the transmission network in the state of AP within a time span as fixed in the contract agreement.
The Applicant submitted that as time is, in essence, thus, to address any late delivery or delay in supplies for not adhering to the time frame agreed upon by the contracting parties, the contract provided for a penalty clause, which was in the form of liquidated damages as per s. 74 of the Contract Act, 1872 ('Contract Act').
With respect to the same, the Applicant had filed an application under s. 97 of the CGST Act and APGT to seek an advance ruling on whether the amount collected as liquidated damages from contractors for late delivery was taxable under GST or not.
Further, the Applicant contended that the liquidated damages collected were not a consideration for tolerating the non-performance or breach of contract; instead, these were the amounts recovered to avoid a breach of contract, and hence, they were not taxable under the CGST Act.
Held
The findings of the AAR were as follows:
The AAR observed that liquidated damages, as per the Contract Act, mean the amount of compensation pre-determined in a contract for an estimated loss suffered by one party due to the other party's breach of contract.
Further, the AAR ruled that as per para 5(e) of sch. II of the CGST Act, the liquidated damages received by the non-defaulting party from a defaulting party for tolerating non-performance under a contract are considered as supply of service under s. 7(1A) of the CGST Act.
The AAR ruled that there must be a direct nexus between the consideration agreed upon and the activity of the services. A specific amount agreed upon as quid pro quo for undertaking a particular activity can be established, and thus, consideration will constitute services and be liable for GST.
Further, the AAR ruled that the circular issued by CBIC[ii] (‘circular’) on the levy of GST on liquidated damages, compensation and the penalty is not universal and absolute according to which the payment towards damages is incidental to the principal supply’s taxability if principal supply is exempted then incidental damages will also be exempted from tax.
Furthermore, the AAR ruled that as per s. 7 r/w. definition of consideration under s. 2(31) of the CGST Act, the compensation amount paid by the defaulting party in a contract to the non-defaulting party for tolerating an act of non-performance or breach of contract has to be treated as consideration. Consequently, such an activity is deemed as a supply of services, and thus, liquidated damages in the form of compensation amounts are subject to tax under the CGST Act.
Hence, the AAR, in this ruling, held that the compensation amount recovered by the Applicant as liquidated damages from the contractors (suppliers) for not performing the contractual obligations or breaching the contract within the stipulated time span was taxable under the CGST Act.
Our Analysis
It is important to note that the AAR brushed aside the detailed circular on the levy of GST on liquidated damages in the present ruling. The AAR has referred to a selected paragraph of the circular,[iii] the meaning of which is out of context.
The circular vividly clarifies that when there is an express or implied agreement for or to do an activity and a consideration for non-performance of the same, it will be treated as consideration for tolerating the act of non-performance. But when there is an event that is contingent upon which is an essential condition of the contract itself, then in such a case, the amount recovered as a penalty or liquidated damages will not be taxable.
The circular categorically clarifies the position that nobody enters into an agreement for breach of their contract. Thus, in the present case, recovery of penalty in the form of liquidated damages appeared to have been for an event, i.e., when the person is not performing the contract, and it is not for any other independent activity that was required to be done and not done. Therefore, we do not think the AAR correctly applied the circular.
Thus, the AAR failed to appreciate the nature of the payment, which is contingent upon the happening of an event, that activity which the contractor delays in the contract. The circular clearly states that not every payment flow is liable to tax.
Hence, in the present case, there is no element of quid pro quo, and it is only an event of that particular contract and not a separate independent activity. The AAR has conveniently ignored this crucial reasoning of the circular.
Thus, based on the circular, the AAR's reasoning does not seem very detailed and exhaustive. The contentions of the Applicant have not been considered. The AAR ruled that every payment received under the contract would be leviable under the CGST Act unless the principal supply were exempted. Thus, the ruling deserves reconsideration, and accordingly, it is likely to be challenged before the Appellate Authority.
End Notes
[i] [2024] 164 taxmann.Com 141 (AAR - Andhra Pradesh).
[ii] CBIC, Circular No. 178/10/2022 -GST (03.08.2022).
[iii] Para 7.1.6 of CBIC, Circular No. 178/10/2022 -GST (03.08.2022).
Authored by Purvi Garg, Advocate at Metalegal Advocates. The views expressed are personal and do not constitute legal opinion.