TAXABILITY OF DAMAGES IN INDIA

The Authority for Advance Rulings (AAR) is a high level quasi judicial body set up in 1993 under the Income Tax Act 1961 for giving binding advance rulings which may indicate the prospective indirect tax liabilities in respect of any activity undertaken under the Customs Act, 1962, or Central Excise Act 1944, or taxable services rendered under Finance Act 1994 by a person.

The AAR has recently on 21.05.2018 ruled that payment of damages in respect of non-performance of contracts, except in certain cases, would attract goods and services tax (GST) in India (Ruling).

In contracts for supply of goods and services, parties generally stipulate that both the service provider and the service recipient would abide by the terms and conditions of the contract. In addition there is a provision of liability which states that if any of the parties breaches the contract for any reason including non-performance of contractual obligations, then such person is liable to pay damages in the form of fine/penalty/damages to the other party.

According to AAR, in such cases, the non-defaulting party is tolerating the non-performance of contract for which consideration in the form of fine or liquidated damages is payable by the defaulting party. The AAR has concluded that tolerating such non-performance of contract is an activity or transaction which is deemed to be a supply of service as they fall under the category of agreeing to the obligation to tolerate an act or a situation under clause 5 of Schedule II of CGST Act 2017. Therefore, the person who has received the damages from the defaulting party is liable to pay GST on such amount.

However, the AAR has clarified that payment of fine or liquidated damages to Government of India or any local authority, in case of non-performance or breach of contracts for supply of goods or services to the Government, violation of laws, bye-laws, rules or regulations, etc would not attract GST. Thus, the consideration received by the Government from any person or supplier for non performance of contract, or violation of laws, etc is exempted from GST.

Earlier, there was no service tax payable on the amount of fine or liquidated damages so received by a person and this position was continued under GST regime until the Ruling was published by AAR.  A number of industry experts have commented negatively on this Ruling stating that for GST to be applicable to an activity or transaction there has to be an element of supply, which is absent in the case of receipt of liquidated damages in the case of non-performance of contract. Moreover, there is a need to set up a mechanism whereby such rulings are well debated before they are published.

It is anticipated that this Ruling can lead to a lot of litigation, particularly in those sectors, such as infrastructure sector, where provisions for liquidated damages are commonly used in contracts.

Harini Daliparthy

Senior Legal Associate

The Indian Lawyer