Liquidated damages (“LD”) mean a fixed or pre-determined sum that is required to be paid upon breach of a contract, which may arise due to non-fulfilment of the obligations, delay in fulfilling the obligations or abandonment or termination etc. Hence, LD damages are directly connected to the actual injury and losses incurred by a party due to failure or delay in performance of obligations under the contract by either party. These LD clauses/ obligations are prevalent in construction contracts where the provisions relating to timely and milestone performance of the project are incorporated. For instance, EPC onshore/ offshore sub-contracts have milestone-based implementation, hence any delay in execution / completion of the same causes huge losses to the project owners. LDs cover this contingency.
Commercially, the LDs are considered to be a measure of compensation for a pre-determined loss arising out of breach of contract. However, in a recent matter of In re Maharashtra State Power Generation Company Limited dated May 18, 2018, the Authority for Advance Ruling, Maharashtra (“Authority”) under GST ruled that the amount of LD deducted from the payments made to the contractor/ vendors would amount to supply of service by the project owner / Taxpayer. The said ruling along with the factual background is discussed hereunder:
The Taxpayer approached the Authority under Section 97 of the Central Goods and Services Tax Act, 2017 (“CGST Act”) seeking an advance ruling on levy of GST on the amount of LD deducted from the contract price agreed with the contractors/ vendors. The main issue for this ruling was as to: (i) whether the LD would be treated as ‘sale’; and (ii) whether this would be liable to GST as separate from the contract value/ price. The Taxpayer relied upon the ruling in GSTR 2003/11 issued by the Australian Tax Office under the Australian Goods and Services Tax Act, 1999, wherein the deduction from the contract price was held to be towards deficiency in the provision of services, and therefore the same would not attract GST. Also, reliance was placed in the matter of Commissioner of C. Ex., Chandigarh-I v. H.F.C.L. (Wireless Division) reported as 2015 (11) TMI 893 – CESTAT- New Delhi, wherein it was held that if a taxpayer is liable to pay a lesser amount than the generically agreed price as a result of a clause stipulating variation in the price, on account of liability to ‘liquidated damages’ on account of delay in delivery of manufactured goods then such resultant price would be the ‘transaction value’. Further, the Taxpayer submitted before the Authority that the provision of such a clause in the contract is to ensure that the completion of the project does not get delayed.
Observations of Authority
The Authority observed that contract price and LD are two distinct aspects of the contract, and deduction of LD from the contract price merely facilitates the settlement of accounts. The Taxpayer contended that LD helps in mitigating the impact of higher costs in form of interest during construction and administrative charges. Taxpayer further contended that it was never its intention to get supplies/ project delayed nor did the contractors want to make delay and thereby causing it to tolerate. Therefore, LD could not be termed as service provided to the contractor. However, the Authority observed that the provision of LD in the contract is squarely covered by the clause (e) of the Para 5 of the Schedule II annexed to the CGST Act. The said entry provides that ‘agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act’, shall be treated as supply of services. The Authority ruled that the amount of LD deducted from the payments made to the contractor/ vendors is income in the hands of the Taxpayer and would amount to supply of service by the Taxpayer. Accordingly, the Authority held this would be classified under Heading 9997, and GST at the rate of 18 percent would be levied on the amount of LD deducted from the contract price.
While the said ruling is binding on the Taxpayer and the Revenue in respect of the particular issue in question, the same may have a persuasive precedential value. Also, it may have a bearing on how the clauses relating to LD is negotiated in contracts in the future.