Blog Details

The parties involved in a contract may opt for Arbitration proceedings for various reasons such as failure to fulfill the terms of the contract, the release of withheld funds by either party, the return of a security deposit, compensation for damages incurred due to non-performance of the contract, among others. However, when it comes to tax implications on compensations awarded in such arbitration proceedings, the analysis depends on the reason for granting the award. This includes whether the compensation is awarded for breaching the terms of the contract, carrying out activities beyond the scope of the contract, delayed payment of the agreed consideration, or for work already completed as per the contract entered into by the parties.

Compensation in the form of damages may be awarded to the parties through the arbitral award. The meaning of damages is defined in Sections 73 and 74 of the Indian Contract Act, 1872, which specifically deal with compensation and liquidated damages. These sections state that if a specific sum is mentioned in the contract as payable in the event of a breach, or if there is any other provision in the contract for penalty, such amounts constitute damages. Additionally, Section 2(31) of the CGST Act defines the term 'consideration' in an inclusive manner, which includes any payment (in money or otherwise) or monetary value of any act or forbearance made in respect of, in response to or for the inducement of supply. Therefore, it can be concluded that agreeing to tolerate an act or situation for a consideration is a supply of service and is subject to GST as per Section 7 and Schedule II of the CGST Act.

In regards to the Mining Industry, we can refer to FAQ No. 15 of the FAQs issued by CBIC, which addresses the imposition of GST on liquidated damages or penalties recovered from contractors for not lifting the minimum targeted annual quantity of coal. The FAQ clarifies that such liquidated damages or penalties would be considered as a consideration for the supply of the service of "tolerating an act" mentioned in Sl. No. 5(e) of Schedule II and would be subject to GST. While the FAQ is not legally binding, it represents the Department's understanding or interpretation of taxing such damages or compensation.

Landmark Case:

In re Continental Engineering Corporation (GST AAR Telangana), Decided on October 8, 2021

The applicant sought for Advance Ruling on the following questions-

• Whether GST is applicable on the proposed receipt of money in case of Arbitration claims awarded for works contracts completed in the Pre-GST regime?

• If the answer to the above question is 'Yes' then under what HSN Code and GST rate the liability is to be discharged by the applicant?

The Authority for Advance Ruling considered the submissions made by the applicant. The Authority for Advance Ruling made ruling for each and every component of the claim as discussed above, as below-

Unpaid amounts including escalation of price for works executed in pre-GST period:

The liability to tax under CGST/SGST Acts for works contracts is determined by the time of supply of services in Section 13 read with Section 31 i.e., the provisions pertaining to tax invoice. The time of supply of service according to Section 13(2), is the earliest of the date on which invoice is issued or date of provision of service or date of receipt of payment or date on which the recipient shows the receipt of services in his books. The supply was made prior to the introduction of GST. Therefore it is not covered by Section 13(2) of the CGST/SGST Acts and not taxable.

Refund of excess deductions made:

The refund of excess deductions both statutory and non-statutory made against the bills raised for the works completed in pre-GST period do not constitute consideration for supplies made under GST period. Therefore these amounts are not taxable under CGST/SGST Acts.

Interest on delayed payments of interim payment certificates:

The interest is claimed on delayed payments on the works executed and payment certificates received in pre-GST period. The time of supply is not in the GST period, hence these amounts are not taxable under CGST/SGST Acts.

Cost of Arbitration:

Arbitration as service was supplied independently after the introduction of GST i.e., the tribunal was constituted conclusively on 20.11.2017 and rendered its orders on 09.05.2019 and therefore this supply is taxable on reverse charge basis under GST. The taxable rate is @ 9% each. The service tariff code is 998215.

Liquidated damages:

The damages are - consideration for tolerating an act or a situation arising out of the contractual obligation. The entry in 5(e) of Schedule II to the CGST Act classifies this act of forbearance. Such a toleration of an act or a situation under an agreement constitutes supply of service and the consideration or monetary value is taxable @ 9% CGST + 9% SGST

Interest on Arbitration Amount:

Under Section 15(2)(d) of the CGST/SGST Acts interest for delayed payment against supply is a consideration which is taxable under CGST/SGST Acts. Therefore the interest on amounts eligible to tax under CGST/SGST forms part of the value of taxable supply.

In the matter of Maharashtra State Power Generation Company Limited [Order No. GST-ARA- 15/2017-18/B-30, decided on May 8, 2018], the Hon'ble Maharashtra AAR held that GST at the rate of 18% would be payable on liquidated damages received by the Applicant for delayed supply under a contract and considered liquidated damages to be a consideration for agreeing to the obligation to tolerate an act or a situation that is treated as a supply of service under Para 5(e) of Schedule II of the CGST Act.

Circular No. 178/10/2022-GST dated 3.8.2022

However, in a recent circular (Circular No. 178/10/2022-GST dated 3.8.2022), the CBIC clarified that if damages are paid to compensate for injury, loss or damage incurred by one party due to breach of contract by the other party and there is no agreement, either express or implied, to tolerate or refrain from any act or perform any action in exchange for the payment of liquidated damages, then such payment will not be considered as consideration towards the supply of any goods or services and are not taxable.

In the Matter of Achampet Solar Private Limited (GST AAAR Telangana); Date of Judgment: October 19, 2022: The CBIC issued Circular No. 178/10/2022-GST on 3.8.2022 regarding the application of GST to liquidated damages. According to paragraph 7.1.6 of the circular, when the principal supply is exempt, the ancillary activities to that principal supply are not subject to GST. Because the applicant's primary supply in this case is the production and distribution of electricity, which is exempt from GST payment, the liquidated damages received by the applicant for such supply must be deemed a flow of money without the implication of GST payment. According to the circular, where the amount paid as 'liquidated damages' is an amount paid only to compensate for injury, loss, or damage suffered by the aggrieved party due to breach of the contract and there is no express or implied agreement by the aggrieved party receiving the liquidated damages to do or refrain from doing anything for the party paying the liquidated damages, liquidated damages are simply a flow of money from the party who causes the breach of the contract to the party who suffers loss or damage due to such breach. Such payments are not taxable because they do not constitute consideration for a supply.

Therefore, analyzing the facts and contractual terms of each case is necessary to determine the character of the Arbitral Award. For instance, If the contract stipulates that one of the parties will withhold a specific sum from the contract price due to the other party's non-compliance with the contract's terms. If the Arbitral Tribunal decides that the withheld amount should be released by the withholding party, it's crucial to determine whether the released amount is part of the contract price and falls under the category of consideration or is released as compensation following the contract's termination by the withholding party. If the withheld amount pertains to work that the party had already completed before the contract's termination, the arbitral award may qualify as consideration. 

However in a case, where parties enter into a contract for executing certain works, but one of the parties illegally terminates the contract, causing a loss to the other party. In such circumstances, the Arbitral Tribunal may direct the party responsible for the termination to compensate the affected party with a certain amount. This compensation is not for the supply of goods or services but rather for the party's non-compliance with the contractual terms. Therefore, this amount is considered to be compensation. The parties should carefully review each award amount to determine the tax implications.

References:

https://www.lexology.com/library/detail.aspx?g=15231fd3-9eaf-472f-bc4e-55ab8b7ba7fa

https://www.sbsandco.com/blog/gst-implications-on-issues-arising-from-arbitration-awards/

https://www.taxmanagementindia.com/visitor/detail_article.asp?ArticleID=10073

https://www.a2ztaxcorp.com/gst-payable-on-amount-received-through-arbitration-for-work-executed-in-pre-gst-period/

https://taxguru.in/goods-and-service-tax/gst-payable-liquidated-damages-principal-supply-exempt.html