[Opinion] Taxability of liquidated damages, penalties and similar charges

Krishan Arora, Sachin Sharma & Rahul Jhawar – [2022] 141 taxmann.com 403 (Article)

An essential requisite of any contract is a timely discharge of agreed terms and conditions. A failure to do so usually results in payment of damages by one party to another to indemnify against losses. Such damages are referred to as penalty or liquidated damages.

Black Law dictionary defines liquidated damages as “Cash compensation, agreed to by signed, written contract for breach of contract, payable to the aggrieved party.” In simpler terms, the liquidated damage refers to compensation paid by one party to another party for non-performance of any obligation agreed to in the contract. Similarly, there are different types of penalties or compensations imposed for non-fulfilment of terms. For instance, compensation to the employer for not serving the minimum agreed period is known as notice pay, compensation paid for cancelling the intended supply is known as cancellation charges and so on.

Taxability of liquidated damages, penalties, notice pay, etc.

The taxability of payment of damages, penalties, compensation has always been unsettled. Under the erstwhile Service Tax law, Section 66E of the Finance Act 1994 included an entry “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act” as declared service. Similar approach was adopted in the Goods and Service Tax (GST) regime by inserting entry 5(e) in Schedule II of CGST Act, 2017 that classified such transactions as a supply of service.

Basis the above-mentioned legal provisions, the tax authorities have interpreted the liquidated damages, notice pay, cheques dishonour charges, etc. to be taxable. On the other hand, various courts have pronounced contrasting judgements on the taxability of the said transaction.

The following are few of the judicial precedents which held the service to be taxable:

• • In the matter of Maharashtra State Power Generation Company Ltd. In re [2018] 93 taxmann.com 266/13 GSTL 177/68 GST 494 (AAR-Maharashtra), Authority of Advance Ruling (AAR) and Appellate Authority of Advance Ruling (AAAR) of Maharashtra has held that liquidated damages are to be viewed as consideration for an act of tolerance of non-performance, and thus are subject to GST at 18%.
  • In the matter of Bajaj Finance Limited, AAR of Maharashtra held that cheque dishonour charges are the act of delay by one party which is tolerated by the financial institution and would be taxable under entry 5(e) of the Schedule II of the CGST Act 2017. (GST-ARA-25/2020-21/B-05)
  • In Fastrack Deal Comm Pvt. Ltd., In re [2021] 124 taxmann.com 399/[2022] 61 GSTL 125 (AAR – Gujarat) matter, Gujarat AAR held that the GST is leviable on the amount forfeited on account of breach of agreement of sale of land as it is a supply of service as per entry 5(e) of Schedule II.

On the contrary, following judgments by courts posed a different view of the said transaction to not be taxable under the indirect tax laws:

• • The Hon’ble High Court of Madras in the matter of GE T & D India Ltd. v. Dy. CIT [2020] 115 taxmann.com 213/35 GSTL 89 held that notice pay is not taxable under service tax as the employer has not “tolerated” an act of the employee. Rather, employer has permitted a sudden exit upon being compensated by the employee in this regard.
  • In the matter of CST v. Repco Home Finance Ltd. [2020] 117 taxmann.com 755/42 GSTL 104, the larger bench of CESTAT Chennai held that service tax is not levied on the foreclosure charges charged by the bank as it is recovered as compensation for disruption of a service and not towards lending services. Further, it held that no service is sought to have been rendered by the banks to borrowers against the charges.
  • The Hon’ble High Court of Bombay in the matter of Bai Mumbai Trust v. Suchitra [2019] 109 taxmann.com 200/31 GSTL 193 pronounced that the services of Court Receiver are to be considered as services provided by the Court itself and it is specifically excluded from definition of supply as per schedule III. Also, held that compensation paid as damages for violation of a legal obligation was not a supply under GST.

With the contrasting view of the authorities, the matter has always been controversial and problematic for the taxpayers.

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