Beyond Boilerplate: GST Indemnities In Commercial Contracts And Allocation Of Tax Risk

A company has signed a supply contract with a vendor at a fixed price. The vendor raises a tax invoice on which GST is charged. The company pays the entire amount, including GST, and accounts for it in its books. After a few months, on a tax audit or departmental inspection of its records, the company is informed that the vendor has either not remitted the GST collected, has not reported the invoice correctly to the department, or has had issues in its compliance related to the invoice. 

The claim for input tax credit is thus denied to the company, entailing liability for interest and penalty. Meanwhile, the vendor may have become untraceable, insolvent, or commercially unwilling to cooperate. While the initial battle will be with the tax department, the more significant fight is typically between the buyer and the seller under the supply contract - who should ultimately bear this loss? The buyer who had paid in good faith? The vendor who made a default? Or, perhaps, the party that got carried away with a “price inclusive of all taxes” clause? This is the point at which a routine tax clause becomes a serious risk-allocation clause.

Those clauses may sound all fine to you at the time of signing. But under the GST regime, tax exposure is not over on payment of the invoice; it spans across return filing, invoice reporting, ITC matching, RCM, audit, investigation, reassessment, and even demands after termination of the contract from past periods. That is why the GST indemnities are not boilerplate wording anymore but are critical components of commercial risk allocation.

Contractual Nature of GST Risk

Though GST is an indirect tax, its economic incidence normally comes to rest through a contractual arrangement. The economic impact of levy, collection, and compliance falls upon private parties, as defined by law, but this economic burden on individual parties is allocated through contract.

This distinction is important. For example, the GST legislation may impose the obligation to collect and pay the tax upon the supplier. However, a supplier can make good on this obligation by contracting to charge the tax to the buyer and recover the payment. Conversely, though the GST legislation might not allow a recipient to claim the input tax credit if not all statutory requirements are met, the recipient might contract for indemnity from the supplier in case the denial is on account of fault on the part of the supplier. The GST risk therefore exists at two levels: the statutory risk, being between the taxable person and the Revenue authorities, and the risk that operates between parties to the transaction, through a contract. These must be taken care of in any well-drafted commercial contract.

However, the problem is that quite a number of commercial contracts address only the first layer, generally stipulating that taxes will be charged as may be applicable under the law. It, however, fails to address tough questions such as: what if the classification adopted by either party is later questioned by the department? What if the tax rate is changed after entering into a contract?  What if the supplier uploads the invoices at a later date? What if the input tax credit is not allowed due to the supplier's delay in filing returns? What if a penalty and interest are levied for default and notice is received after the transaction is completed or the contract is terminated? These are not farcical situations; they occur regularly under GST.

ITC Denial and Supplier Default: The Buyer's Hardest Problem

It is the most common, and therefore, most important, trigger for careful GST indemnity drafting that the buyer stands to lose input tax credits. Input tax credit lies at the heart of GST. Businesses transact under the assumption that the GST paid on inward supplies is available to them as credit (subject to compliance with legal requirements), which is factored into their pricing, cash flow, margin calculation and commercial negotiations. Should the credit turn out to be inadmissible post-completion of the transaction, the commercial bargain may be disturbed. 

This situation becomes exacerbated when the disallowed ITC is a result of a supplier's non-compliance. 

A buyer may have already received goods or services, paid the invoice consideration, remitted the GST amount to the supplier, and preserved requisite documents, and yet, if the supplier defaults in discharging their own GST duties, the buyer may face issues relating to claiming credit. From a business perspective, this represents a material equity deficit, as a buyer may have no control over the manner in which the supplier files their tax returns, pays their GST obligations, declares sales in invoices or manages their internal compliance processes, but the buyer will bear the financial impact if credit is blocked due to the supplier's non-adherence. It is important not to oversimplify and state a generic clause such as “supplier will comply with tax laws”. The contract must clearly obligate the supplier to pay for loss of ITC, penalty, interest, and all other incidental and direct tax costs arising as a consequence of their breach. 

A well-drafted clause will mandate the supplier to provide the original tax invoices; to report the invoices properly and timely; to remit the GST collected; to fully assist the buyer during audit/ departmental proceedings; and to reimburse the input tax credits which would not be admissible by virtue of the supplier's default.

In other words, without it, he would end up having a tax bill and not much in contract against the seller.

Why “Inclusive of All Taxes” Can Be Dangerous?

“Inclusive of all taxes” is a phrase that is perhaps used the most casually when it comes to commercial contracts. It sounds like a harmless sentence; it can become a serious point of dispute in commercial litigation.

Imagine a situation where two parties enter into a contract based on a certain supply attracting 12% GST; only later, the department assumes the said supply attracts 18% GST. Would it be permissible for the supplier to recover the difference of 6% from the buyer if the supply has been contracted at a price that is inclusive of all taxes? Would the supplier be expected to shoulder the differential tax liability? Would the answer be the same if the rate presumed from the very start was incorrect? What if both the payer and receiver act under this false understanding of the GST rate? Would it be different if the contract were silent on the aspect of a subsequent upward movement of tax? It is for such very eventualities that it could so happen that an inclusive price might not clarify the tax liability regarding the levy of interest, penalty or late payment penalties or demands from the revenue department for post-assessment taxation.

The buyer may argue that in case of any eventuality from the revenue department, the vendor has agreed to the tax. The supplier, in contrast, may argue that while he has consented to a price inclusive of all the taxes he was obligated to supply at the time of levy of taxes, then known to both parties and in accordance with the law applicable at the time of supply. The wording then becomes the centre of the dispute; the best route is not to completely discard inclusive pricing per se; however, it should be drafted with precision.

The agreement should state the taxes, the assumed rate, and their correct classification, whether GST or any other tax. It should also specifically deal with the consequences of alteration in tax, modification in legislation, any future upward movement of tax, the decision of the department to deny credits, the changes in the scope of supply, or change of classification and, critically also, distinguish between taxes, interest, penalties and other incidental costs for any default. It may look appealing and like a way to avoid cumbersome negotiations for a party to insist on an 'all-inclusive' payment clause; nevertheless, the said clause only hides risks which should rather be at the negotiating table between parties and their counsel.

GST Indemnity as a Risk Allocation Tool

An indemnity is no longer just a promise to pay a sum of money; rather, it represents a transfer of risk between parties. In the GST regime, it will now be decided which party should bear the financial consequences of tax risk. A carefully drafted GST indemnity clause should address at least four categories of risk.

The first category pertains to a primary tax demand on account of misclassification, wrong valuation, incorrect exemption/concession claim and/or taking an aggressive tax stance which results in a tax demand. 

Secondly, credit non-availability for the recipient as a consequence of the supplier's act or omission.

The third category relates to procedural non-compliance in the matter of issuing proper invoices, failed uploading of invoices, invoice mismatches, incorrect GSTIN, non-filing of returns, default in depositing collected taxes, non-cooperation during audit/investigation, etc.

Fourthly, it covers Consequential Tax Costs, i.e., apart from paying the primary tax demand, the parties should also clarify whether interest, penalty, litigation costs, legal and professional fees, pre-deposit to be paid by a party on behalf of the other during appeal proceedings, as well as costs arising out of disruption to business should also be borne by the indemnifying party. Needless to say, if such amounts are sought to be excluded, that needs explicit exclusion, rather than implicit. 

And the indemnifying party needs to specify when the same is to be activated – only upon a final determination and payment? Can it be upon issuance of a show cause notice? Can the buyer refuse payment or seek adjustments if the supplier has failed to provide valid invoices and consequently the buyer loses input credit and the same is not reflected in the GST Portal?

Such fine print of an indemnity provision is critically important, lest the indemnity provision itself transform into a brand new dispute, defeating the very purpose for which it was created in the first place.

Change-in-Law Clauses and GST Rate Risk

The GST legislation is dynamic, and changes can arise from alterations in tax rates, removal of exemptions, issuance of clarifications, and judicial pronouncements. What seems to be a tax-neutral arrangement when a document is signed may turn into an expensive one over time. Change-in-law clauses are especially prevalent in lengthy contracts such as construction, infrastructure supply, lease, outsourcing and service agreements.

Such clauses typically seek to first stipulate what can be considered a 'change-in-law'. This can take many forms, including changes to statutes and rules, notifications and circulars issued by regulatory authorities, alterations in tax rates, revocation of exemptions, and even binding interpretations by courts and tribunals. Secondly, the clauses then address the commercial implications. For example, will the contract price be amended; will the buyer be obligated to pay an increased GST amount; will the supplier assume the GST impact; or can the contract be terminated if the changed tax incidence renders the deal commercially unviable for a party?

Without such clauses, companies would have to rely on general contract law provisions in such instances, and this can prove precarious as courts and arbitrators may hesitate to disturb a previously accepted deal simply due to post-contractual shifts in fiscal implications. The focus should be on anticipating the risk, rather than litigating it after the dispute arises.

Gross-Up Clauses and the Preservation of Commercial Bargain

Another important tax-sensitive provision is the gross-up clause. In a gross-up clause, if a party is faced with a tax deduction, withholding, an additional levy or the like, the other party is obliged to pay additional amounts to make good the net amount (i.e., the net commercial benefit) received by the affected party.

In a GST contract, gross-up can be handy where one party is guaranteed a fixed net payment and the changes in taxes do not affect their net consideration. Of course, the clause should be worded meticulously. 

The gross-up wording should also not fall foul of the GST invoicing and valuation, nor the anti-profiteering provisions and should specify to what taxes the clause applies. (All taxes, duties, cess, interest and penalties; or only GST?) If drafted vaguely, a gross-up clause may itself become another source of dispute.

Reverse Charge and the Need for Clarity

Reverse charge is also another source of “silent zones”. When the receiver is liable to pay GST instead of the vendor on a given supply, the RCM becomes applicable. If both parties had not envisaged this at the time of drafting the document, disputes over price and compliance might be triggered. It should clearly indicate in the contract where a particular supply of good or services is under reverse charge. 

The payment or discharge of tax by either party, whether the contracted price has factored this in, and whether the supplier will supply the required documentation to the receiver for compliance, should be included. Where ambiguity exists, the contract should assign the risks arising from a contrary departmental view on such matters.

This becomes even more important where a service or good includes legal services, the transportation of goods, the import of services, the provision of sponsorship, director's services or the rental of any premises, where there's dealing with an unregistered person. Where this is the case, the party with ultimate tax liability may not be the person that you'd expect. Reverse charge risk must therefore be specifically addressed in the contract.

Survival of GST Indemnities After Termination

GST demands sometimes arise well after a transaction date. Although a contract may terminate in 2024, a notice might be received in 2026. If a tax indemnity does not continue to survive termination, it will be challenging for the indemnified party to recover protection. 

Accordingly, GST indemnities should explicitly survive expiry, termination, completion, closure or settlement. This consideration applies, among other things, to share purchase agreements, asset purchase agreements, business transfer agreements, long-term supply contracts and vendor agreements. Where the tax laws permit proceedings to be brought for a period of time, the tax indemnity should not expire before then without careful consideration. It would be undesirable for a party to be liable to the department yet be unable to claim indemnity from the other party.

GST Risk in M&A and Business Transfers

GST indemnities are crucial in merger, acquisition, slump sale and business transfer transactions wherein the buyer may pick up commercial liability which arises on account of some prior transaction, tax notice, blocked credit, unpaid tax liability, disputed Classification, wrong availing of credit or a vendor compliance issue. Tax due diligence could discover one or more tax exposures, but it does not uncover every risk that might exist with GST. Accordingly, transaction agreements usually prescribe comprehensive tax representations, warranties & indemnities. 

In the context of GST, this should ideally encompass the compliance concerning Registration, Returns, Tax Payment, ITC availing, pending audits, investigations, tax notices, refunds, E-way bill compliance, e-invoice, RTPS, as well as related-party transactions. 

A general representation of the fact that the company has complied with all relevant laws is probably not enough. There is a specific structure within GST that addresses compliance, and that is what should be reflected in the agreement.

The Need for Cooperation Clauses

GST claims often necessitate the submission of documents and cooperation by the other party to the contract. For instance, the customer might request copies of tax invoices, e-way bills, tax payment challans, reconciliation statements or copies of GST returns filed by the supplier. Similarly, in case of a GST demand against a supplier, the supplier would require receipt copies, proof of delivery or acknowledgement of goods from the customer. 

To resolve disputes arising between contract parties for payment of taxes/penalties/interests/fines, it would be prudent to include clauses mandating each of the contractual parties to support audit/inspection proceedings, assist in proceedings related to refund claims, in case of summons/notices, etc. 

The parties should also explicitly set out who will have control over the tax proceedings, especially when a payment is due from one party due to the default/actions of the other. This clause should clearly define whether the indemnified party will have a right to participate in such proceedings, whether it can settle such claims without the indemnifying party's consent, etc., besides defining the responsibility for bearing the cost and charges of professional assistance like that of an advocate, a chartered accountant, etc.

Drafting GST Clauses as Business Clauses, Not Tax Formalities

The larger point is clear. GST clauses must be approached as business provisions, not merely tax technicalities.

A well-drafted clause seeks to provide commercial certainty by responding to basic practical questions such as: Which is the accepted tax position? Who is to issue the invoice for GST? Which party will discharge GST to the Revenue authorities? Which party bears any credit loss? Who is liable for interest and penalties in case of a default? What are the consequences of a change in the GST rate? What happens if the department has a different approach on interpretation? What documents are to be provided to each other? What is the position after contract termination? Can any payments be suspended, withheld or adjusted? Which party has control of tax proceedings?

After answering these questions, the commercial aspects of the agreement become robust, and although a dispute over taxes may arise between parties, it will be clear which of the parties will ultimately bear the cost or gain from the differing treatment by the department.

From the foregoing discussion, it is evident that GST indemnities are not merely boilerplate clauses. They have come to be critical commercial tools for risk allocation for tax. The tax, of course, will be recovered from the person on whom it is legally levied, but ultimately the burden between private parties will rest on contract. Hence, vagueness like “taxes as applicable” or “price inclusive of all taxes” would, in effect, mean the loss would fall on either of the parties.

Firstly, GST risk is dual, i.e., statutory and contractual: tax laws define liability, levy and compliance, but contracts determine which party will have to bear the brunt of loss when GST risk materialises. This becomes more imperative where ITC is to be disallowed because the supplier defaulted in reporting his invoice or not depositing tax collected, or providing wrong ITC in his return, or non-cooperation in inquiry or proceedings.

Secondly, Generic tax clause is not enough for modern commercial transaction: a mere clause like the prices is inclusive of all taxes fails to address the questions like who will be the person bearing loss due to change in tax rates in future or due to levy on reverse charge mechanism or liable for payment of interest and penalties or litigation costs or who is to carry any future claims by the tax authorities post completion of the transaction, etc. Such clauses seem so convenient, but might result in endless dispute when a demand notice arrives from tax authorities.

Thirdly, GST indemnities must be drafted specifically: they should include the price and loss of input tax credit, penalties, interest, professional costs and expenditure and even an obligation to cooperate with the tax department and importantly, must survive after termination of the contract, since claims often arrive late.

This is important for me because GST is central to any commercial bargain: the core intention in such commercial transactions is for parties to establish for each of them what will be their cash outflow, credit entitlements, pricing and risk management. If there is a risk concerning the GST amount, it will convert a contractual bargain into a taxation dispute. For instance, a buyer has paid the entire GST to the seller; he should not be left in the lurch if the seller does not deposit the amount or does not report it in time. At the same time, if it has been mutually agreed, the seller cannot be forced to make up any difference in the tax rates later, and it must be borne by the buyer.

GST provisions must be drafted as commercial provisions in the contracts, not mere template which have existed in past. Parties should include specific clauses about the manner in which risk with respect to ITC, non-compliance by suppliers, the reverse charge mechanism, any change in law, grossing-up clauses, cooperation obligations, non-survival, and the survival of indemnities post-termination must be dealt with to prevent further dispute

Conclusion in a nutshell: in the GST regime, the risk travels with the transaction, which needs to be decided by the commercial transaction. It is not the other way round that after the transaction happens we try to deal with the GST risk, the commercial transactions itself needs to determine how, when and who will bear the risk. GST indemnities are therefore not tax clauses but risk-allocation clauses.

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