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Introduction:

Regarding the tax liability of an activity or transaction as the supply of service of consenting to the requirement to refrain from an act, tolerating an act or a condition, or doing an act, concerns have been raised in certain cases/instances.

The scope of the entry at para 5 (e) of Schedule II of the Central Goods and Services Tax Act, 2017 (hereinafter referred to as the "CGST Act"), which applies to payments in the form of liquidated damage, compensation, penalties, cancellation fees, late payment surcharges, etc. arising out of breach of contract or otherwise, has been examined by Central Board of Indirect Taxes and Customs, in its circular dated, 03.08.2022.

Issue:The whole question of tax liability revolves around whether payments in the form of liquidated damage, compensation, penalties, cancellation fees, late payment surcharges, etc. arising out of breach of contract or otherwise,constitute supply of service. As per schedule 2, para 5(e) of the CGST Act, “Agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act”, has been constituted as supply of service. If there is a supply of service for consideration, tax liability arises.

Liquidated Damages: In the case of liquidated damages, the circular opines, loss and damages are suffered by the other party when one party breaches or fails to perform a contract.Therefore, when a contract is broken, the law stipulates in Section 73 of the Contract Act, 1872, that the party who suffers as a result of such breach is entitled to collect compensation from the other party for any loss or damage caused to him by such breach.The payment is simply an occurrence during the performance of that contract, it is not given as consideration for any other independent work. According to Section 74 of the Contract Act, 1872, the aggrieved party is entitled to receive reasonable compensation which does not exceed the money that has been stated or the penalty that has been stipulated in the contract as the amount or penalty to be paid in case of breach. It is asserted that the core of a contract is performance. A compensation received for tolerating a contract breach or non-performance cannot be regarded to represent liquidated damages. Instead, they serve as compensation for refusing to accept the contract's breach. A contract may include a provision for the payment of liquidated damages to assure performance and to thwart non-performance, subpar performance, or delayed performance. A measure of loss and damage that both parties agree would result from a breach of contract is known as liquidated damages. They do not serve as a remedy for the contract violation. The aggrieved party is not given their money back. A contract is supposedly entered into for its execution rather than for its breach. The liquidated damages or penalty are not what the contract intended to happen. The party injured by a breach of contract cannot be deemed to have allowed or condoned the other party's deviation or non-fulfillment of the commitment by accepting the liquidated damages. In light of the above discussion, a reasonable interpretation of the tax liability of liquidated damages is that there is no express or implied agreement by the party receiving the liquidated damages to refrain from, tolerate, or take any action on behalf of the party paying the liquidated damages. Instead, the amount paid as "liquidated damages" is paid only to compensate for injury, loss, or damage suffered by the aggrieved party due to a breach of the contract.These payments don't count as consideration for a supply of service, hence, there is no tax liability.

Compensation: In case of compensation, the circular discussed, compensation on the cancellation of coal blocks, as per the circular, Coal block and mine designations were revoked in 2014 by an order dated September 24th issued by the Hon. Supreme Court. In order to allocate coal mines and grant winning bidders and allottees rights, title, and interests in and over the land and mine infrastructure as well as mining leases, the Coal Mines (Special Provisions) Act, 2015 was enacted. According to section 16 of the aforementioned Act, prior allottees of mines received compensation in 2016 for the transfer of their rights/titles in the land, mine infrastructure, geological reports, consents, and approvals to the new entity in accordance with the Hon'ble Supreme Court's instructions. There was no agreement between the Government and the previous owners of coal blocks that the previous owners would consent to or tolerate the cancellation of the coal blocks granted to them in exchange for compensation. The previous allocators did not make any such commitment or pledge to the government. The only choice left to the allottees was to accept the cancellation. They received the compensation for the cancellation per the terms of the statute and in accordance with the Supreme Court's order, not as part of a contract between the allottees and the government. It would therefore be incorrect to claim that the prior owners of the coal blocks rendered a service to the government by agreeing to accept the cancellation of the allocations that the government had made to them or that the compensation provided by the government for the cancellation in accordance with the Supreme Court's order was a consideration in exchange for the service. As a result, the compensation given for cancelling coal blocks in accordance with the Supreme Court's order in the aforementioned case was not taxable.

Cheque Dishonour/ Penalty: In case of cheque dishonour fine or penalty, the circular opines that No vendor wants a check that has been provided to him to be dishonoured. The vendor will incur additional administrative fees as well as disruptions to his regular activities and income flow. Any seller of goods or services promises to fulfil their obligation to provide their goods or services in exchange for payment within the specified time frame (including the specified time frame for late payments), using a valid instrument. There is never an implied or explicit promise made by the provider that he will accept the deposit of a fraudulent, defective, or unreliable payment instrument in exchange for a fine or penalty for a cheque dishonour. The fine or penalty that the provider or banking applies for the dishonour of a cheque is a punishment or penalty levied for not tolerating, penalizing, and so deterring and discouraging such an act or circumstance, rather than for tolerating the act or condition. As a result, a fine or penalty for cheque dishonour is not a consideration for any service and is not taxable.

Penalties in Violation of Law: In case of penalties in violation of laws, the circular opines that, the punishment imposed for breaking other rules, such as traffic regulations, pollution standards, or other laws, is also not considered payment for the supply received and is not taxable, which is likewise not taxable. The same is true of fines and penalties levied by the mining department of a central, state, or municipal government, or by a local authority, upon learning of mining extra mineral beyond what is allowed or of mining actions that are not permitted by the mining permit.

Such fines for breaking the law cannot be viewed as consideration charged by the government or a local authority for tolerating breaking the law. Laws are not made to tolerate for being broken. They specify penalties that are intended to prevent, punish, and discourage such transgressions rather than accepting them. There is no contract between the government and the offender that states the violation will be permitted or will be permitted in exchange for a fine or penalty. Such an agreement is impossible because breaking the law is never a legal goal or benefit. According to the service tax education guide published in 2012 on the implementation of the negative list regime for services, fines and penalties paid for breaking legal requirements are not considered because no service is provided in exchange for the payment of such fines and penalties. Additionally, it was made clear in Circular No. 192/02/2016-Service Tax, dated 13.04.2016, that fines and penalties assessed by the government or a local authority for breaking a law, ordinance, rule, or regulation are not subject to the service tax. The GST falls under the same category. 

REFERENCES

• https://www.livelaw.in/news-updates/central-board-of-indirect-taxes-and-customs-cbic-gst-breach-of-contract-liquidated-damages-205789

• https://www.livelaw.in/pdf_upload/gst--429083.pdf

• Central Goods and Services Tax Act, 2017

• The Indian Contract Act, 1872