India: GST on liquidated damages awarded by the arbitral tribunal
Charanya Lakshmikumaran and Pranav Mundra of Lakshmikumaran & Sridharan analyse the implementation of India’s GST law, which has had a significant impact on damages awarded by arbitral tribunals.
The GST was brought into force by the Indian government on July 1st 2017 with an objective of “one nation, one tax”. The introduction of GST drastically changed the indirect tax regime in India. Various central as well as federal taxes were subsumed into the GST.
Despite continuous efforts of the Indian government, there are multiple areas where jurisprudence under GST law has not yet been settled. One such area is with respect to the applicability of GST on various amounts awarded by arbitral tribunals. One of the amounts typically awarded by an arbitral tribunal is liquidated damages for breach of contract. Service tax authorities, and since July 2017, GST authorities in India, have taken a view that liquidated damages are considerations being paid to tolerate the breach of a contract and hence subject to service tax or GST. This article focuses on the GST implications on liquidated damages awarded by an arbitral tribunal.
‘Liquidated damages’ are a genuine pre-estimated amount of money that would be paid on account of breach of a contract. The purpose behind including clauses for payment of liquidated damages is to ensure timely performance of a contract.
When performance of such contracts is disputed in an arbitral tribunal, the tribunal may award liquidated damages to the aggrieved party for the loss it suffered on account of breach of contract. Therefore, the question is whether such an amount awarded towards liquidated damages is a consideration for the supply of any service and would consequently attract GST.
Under Indian GST law, the taxable event which attracts GST is “supply”, which has been defined widely and includes sales, transfers and disposals, made in the course of business.
The GST law also recognises “the act of tolerance or agreeing to refrain from an act” as ‘supply of service’. The GST authorities were treating the payment of liquidated damages as consideration for tolerating the breach of contract and raised huge demands of tax on liquidated damages awarded or paid to parties. The GST authorities formed this view on the premise that the aggrieved party had contracted to tolerate the non-performance of the contract. Further, an exemption granted to the government or local authority from payment of GST on the liquidated damages they receive, that are put towards the services they provide by way of tolerating non-performance of a contract, amounts to supply of a service according to the GST authorities.
GST is a contract-based levy, and to treat any supply as taxable, it is necessary that parties have had a meeting of minds to provide such a supply. An agreement between parties to either refrain from or tolerate an act needs to be explicitly entered into. Additionally, liquidated damages received for breach of contract cannot be said to be a consideration as defined under Section 2(31) of the Central Goods and Services Tax Act (CGST), as liquidated damages are neither “in respect of” nor “in response to” any identified supply made by the parties. Instead, it is paid to make good the loss/injury suffered by the aggrieved party. Accordingly, it does not qualify as supply and no GST should be applicable on liquidated damages. Further, the mere existence of an exemption entry cannot pre-suppose the existence of levy.
To clear this ongoing debate, the Indian government recently clarified that GST would not be applicable on liquidated damages. This is because the said amount is paid only to compensate for the injury, loss or damage suffered by the aggrieved party on account of breach of contract.
This clarification is also in line with international jurisprudence, which supports that liquidated damages cannot be treated as consideration for supply or tolerance of an act. The Australian ruling, namely GSTR 2001/4 dated 20 June 2001, clarified the position of law on taxability of liquidated damages. As per said ruling, in claims for damages arising out of negligence that cause loss of profits, termination or breach of contract, the aggrieved party will often seek an appropriate compensation or claim for the damage caused. This damage, loss or injury in itself does not constitute a supply under Section 910 of the CGST Act.
Similarly, the UK Court of Appeal in the case of Vehicle Control Services Limited, observed that payment in the form of damages/penalty for parking incorrectly is not a consideration for service as the same arises out of breach of contract with the parking manager. The European Court in the case of Financial & General Print Limited has also observed that liquidated damages are the compensation for loss of earnings and hence are not consideration for supplies and are outside the scope of VAT.
In light of the above, it can be safely concluded that the liquidated damages awarded by the arbitral tribunal on account of breach of contract would not attract the levy of GST.