Performance is the essence of a contract and hence parties to contract generally incorporate their expectation in terms of damage caused by failure of either party to perform its obligations completely or as per the agreed terms.
The contract may prescribe damages for deficiency in the performance of contract known as ‘liquidated damages’. It is to dissuade unsatisfactory performance or non-performance. For instance, contracts state that time is the essence of contract, and any delay invites say, 1% of the value of the contract for every week of delay and the like. Similarly, it is common to forfeit earnest money deposit (EMD) from a bidder in case he wins the bid but fails to act thereafter. This forfeiture clause is a deterrent for non-serious bidders entering the fray. Other examples may be rent for delay in lifting goods; agreeing to shoulder testing charges for samples to meet standards; cost of removing rejected goods, etc.
Payment of damages or the forfeiture of deposit does not restitute the person to whom loss or damage is caused. Liquidated damages are in nature of a measure of damages to which parties agree, rather than a remedy. By charging damages or forfeiture, one party does not accept or permit the deviation of the other party. It is an expression of displeasure. Liquidated damages cannot be said to be the desired income or result of the contract.
However, there is a view that liquidated damages and forfeiture are consideration for the non-performance/delayed performance. This view is based on the provisions under the erstwhile Service Tax Law, “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act” was a declared service under Section 66E(e) of Finance Act, 1994. Similar provision has been incorporated in Central Goods and Services Tax Act, 2017 (CGST Act) also under Schedule II. Under GST law, the taxable event is supply which has been defined widely and includes all forms of supply for a consideration which is made in course of or in furtherance of business. The act of tolerance or agreeing to refrain from an act is treated as supply of service under the CGST Act. As per these provisions there should be an agreement between the parties to either refrain from doing an act, or to tolerate an act/situation or to do an act.
However, liquidated damages may hardly satisfy the essentials of supply or service. As discussed above the purpose of agreeing to payment of liquidated damages is to ensure performance. It cannot be said to be a consideration for tolerating non-performance. The provisions of law cited above thus cannot be applied to situations where the contract does not want delay in performance rather says that time is the essence of the contract. When the aggrieved party receives damages from the defaulting party it cannot be said that the aggrieved party is tolerating the non-performance or delayed performance.
The view supporting Service Tax liability on liquidated damages and forfeiture was based on the premise that the party had ‘tolerated’ the non-performance. A contract cannot be read to be agreeing to a breach of a contract. A breach of contract is not tolerated and that is why an amount is imposed to deter breach. The contract is for execution and not for the breach.
An argument taken was that payment of liquidated damages and forfeiture of EMD would amount to consideration liable to tax and on that assumption, it exemption was / has been granted from Service Tax / GST in case of Government departments, municipalities, panchayats, etc. [Notification 22/2016-ST & Notification 12/2017-Centre Tax (Rate) refer.] It is settled law [See End note 1] that an exemption entry cannot presuppose the levy itself.
International jurisprudence also supports the view that liquidated damages cannot be a consideration for supply/tolerance of an act. We may refer to Ruling GSTR 2001/4 (GSTR) & GSTR 2003/11 issued by the Australian Tax Office, where it has been clarified that damage or loss or injury does not constitute a supply under the provision of Australian GST. The European Court of Justice in the case of Societe Thermale v. Ministere de l’Economie  S.T.I 1866, Celex No. 605J0277 has held that where the client exercises the cancellation option available to him as compensation for the loss suffered and which has no direct connection with the supply of any service for consideration, it is not subject to tax. The Court of Appeal (UK) in case of Vehicle Control Services Limited (2013) EWCA Civ 186, has said that payment in the form of damages/penalty for parking in wrong places/wrong manner is not a consideration for service as the same arises out of breach of contract with the parking manager.
It is time that the Government clarifies the issue with an illustrative list of what constitutes tolerance of an act. This would be of great help to the taxpayers.
[The authors are respectively Senior Associate and Joint Partner, Lakshmikumaran & Sridharan, Chennai]
Commissioner of C. Ex. & Cus., Kerala v. Larsen & Toubro Ltd., reported at 2015 (39) S.T.R. 913 (S.C.)