Liquidated Damages For Cancellation Of Contract To Attract 18% GST; Classifiable As ‘Other Services’: AAR [Read Judgment]

The Maharashtra Authority for Advanced Ruling (AAR) has held that GST is applicable on liquidated damages in case of contracts for (i) operation and maintenance and (ii) construction or renovation of power plants entered into by the Maharashtra State Power Generation Company, the applicant in the ruling. The applicant had sought a clarification from the AAR as to whether the recovery of liquidated damages from the invoice of the contractor would amount to supply under the GST Act.

It was contended by the applicant that as damages are being paid towards deficiency of service reducing the original consideration, liquidated damages should be treated as part of the contract and not a separate service under ‘obligation to refrain from an act, or to tolerate an act or a situation, or to do an act’. Rejecting this argument, the AAR held that contract price and the liquidated damages are two different aspects. It was noted that deduction of one from the other was a mere facilitation towards the settlement of the accounts and would not affect the valuation of the supply under the contract. It was observed by the AAR, “In the present case, the agreement provides that the liability of payment of these liquidated damages by the Contractor will be established once the delay in successful completion of trial operation is established on the part of the Contractor. Thus, the act of delayed supply has happened. The same is being tolerated by an additional levy in the nature of liquidated damages. The agreement has provided that the payment by Contractor or deduction by Owner of any sums under the provisions of this clause shall not relieve the contractor from his obligations to complete the works or from his other obligations under the contract. This provision just ensures that the obligations under the contract are fulfilled. The facts are much obvious that the empowerment to levy liquidated damages is for the reason that there has been a delay and the same would be tolerated, but for a price or damages. The impugned income through presented in the form of a deduction from the payments to be made to the Contractor is the income of the applicant and would be a supply of ‘service’ by the applicant in terms of clause (e) of para 5 of Schedule II appended to the GST Act.”

AAR held that levy of liquidated damages would attract GST for supply of services under para 5(e) of Schedule II of the GST Act at the rate of 18% GST as provided for under the HSN Code 9997 for “Other Services”. It may be noted that Para 5(e) of Schedule II lists “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act” as a supply of service. It may be noted that identical provision was found in Section 66E(e) of the Finance Act, 1994.

It was also observed that the facts of each agreement and attending circumstances need to be seen in order to determine the applicability of GST on liquidated damages in case of operation and maintenance activities and construction of new power plants or renovation of old plants or applicable in both cases.

The ruling was given by BV Borhade and Pankaj Kumar, members of AAR. This ruling is significant as till now tax experts had been divided on the applicability of GST to liquidated damages. With this understanding, no service tax for liquidation damages was paid under the erstwhile Section 66E(e) of the Finance Act, 1994 and this trend had continued even after the introduction of the GST Act.