2024 (1) TMI 676 - AT - Service Tax

Liquidated damages for delayed supply/work execution not liable for service tax under Finance Act 1994

Madhya Pradesh Power Generating Co. Ltd Versus Commissioner, Central GST, Central Excise & Customs, Jabalpur

CESTAT NEW DELHI allowed the appeal regarding service tax demand on liquidated damages deducted from vendors for delayed supply/work execution. For the ... Levy of service tax - amount deducted by the appellant from the vendors towards liquidated damages - failure to supply the goods/execute the work within the stipulated time - demand of service tax both for the period prior to 01.07.2012 and post 01.07.2012 - HELD THAT:- For the period prior to 01.07.2012 collection of amount towards liquidated damages was not included in any of the specified taxable services under any of the clauses of sub-section (105) of section 65 of the Finance Act, 1994 [the Finance Act]. Thus, no service tax could have been levied on the amount of liquidated damages so collected - For the period w.e.f. 01.07.2012, the impugned order has observed that as the appellant received the amount as consideration for the failure on the part of the contractors to honor the terms of the contract or violating the conditions of the contract, it would be taxable under clause (e) of section 66E of the Finance Act. In M/S SOUTH EASTERN COALFIELDS LTD. VERSUS COMMISSIONER OF CENTRAL EXCISE AND SERVICE TAX, RAIPUR [2020 (12) TMI 912 - CESTAT NEW DELHI], the Tribunal held that liquidated damages recovered on account of breach or non-performance of contract are not consideration in view of any service but are in the nature of deterrent imposed so that such a breach or non-performance is not repeated. It is, therefore, not possible to sustain the demand - The order dated 16.11.2018 passed by the Commissioner, therefore, deserves to be set aside - Appeal allowed. ISSUES PRESENTED AND CONSIDERED 1. Whether amounts recovered as liquidated damages deducted by the recipient from vendors/contractors constitute 'consideration' for a service and are taxable under the Finance Act for the period prior to 01.07.2012. 2. Whether amounts recovered as liquidated damages deducted by the recipient from vendors/contractors constitute 'consideration' for a service and are taxable under clause (e) of section 66E (agreeing to refrain from an act, to tolerate an act or a situation, or to do an act) of the Finance Act with effect from 01.07.2012. 3. Whether the Tribunal's earlier decision holding that liquidated damages are not consideration for a service (and related precedents and administrative circulars) applies and governs the present matter. ISSUE-WISE DETAILED ANALYSIS Issue 1 - Taxability of liquidated damages for period prior to 01.07.2012 Legal framework: Prior to 01.07.2012, service tax applied only to activities falling within the specified taxable services enumerated under section 65(105) (as then numbered) of the Finance Act; the statutory charging provisions did not include recovery of liquidated damages as any specified service. Precedent Treatment: The Tribunal relied on its earlier decisional approach that penal recoveries/ liquidated damages are not consideration for any taxable service. Interpretation and reasoning: Liquidated damages are imposed as a deterrent for breach or non-performance of contract and do not reflect a quid pro quo for any activity performed by the recipient; the contract's consideration was for supply or performance, not for being penalized. Recovery on account of breach does not evidence an activity carried out by the recipient for another for consideration within the meaning of service. Ratio vs. Obiter: Ratio - where statutory schedule does not include penal recoveries as a taxable service, liquidated damages cannot be taxed. Obiter - factual distinctions where a penalty might form part of an independently bargained-for arrangement are noted (see Issue 2). Conclusion: Service tax could not be levied on liquidated damages for the period prior to 01.07.2012; the demand for that period cannot be sustained. Issue 2 - Taxability of liquidated damages w.e.f. 01.07.2012 under section 66E(e) Legal framework: Section 66E(e) contemplates a deemed service where one party agrees to refrain from an act, to tolerate an act or a situation, or to do an act, for consideration. Section 65B(44)/definition of service requires an activity carried out by a person for another for consideration; Explanation (a) to section 67 provides that consideration includes amounts payable for taxable services. Precedent Treatment: The Tribunal in prior decisions (reproduced reasoning) held that activities caught by section 66E(e) require an independent contractual arrangement expressly creating an obligation to do/abstain/tolerate and a concomitant flow of consideration for that specific agreement; administrative Circular (CBIC) corroborates this approach and directs reliance on the evolved jurisprudence. Interpretation and reasoning: The Court/Tribunal reasoned that ordinary penal/liquidated damage clauses in contracts do not constitute an agreement by the recipient to refrain from or tolerate an act in the sense envisaged by section 66E(e). The penal clause is a safeguard/condition of the primary contract and is not the consideration for an independent contract to tolerate or do an act. There must be a 'necessary and sufficient nexus' between the agreed-for activity (to do/abstain/tolerate) and the consideration; mere recovery for breach lacks that nexus and intention. The Tribunal also explained a fact-specific hypothetical where a payment to refrain from supplying (i.e., an exclusivity-type arrangement) would fall within section 66E(e) because the agreement explicitly contemplates abstention in return for consideration. Ratio vs. Obiter: Ratio - where the contract does not create an independent agreement to do/abstain/tolerate in return for consideration, liquidated damages recovered for breach of the primary contract are not taxable under section 66E(e). Obiter - illustrative scenarios where a payment would constitute a taxable deemed service (e.g., explicit agreement to refrain from supplying in return for payment) are explanatory and not decided facts of the present appeal. Conclusion: For the post-01.07.2012 period, liquidated damages deducted on account of breach/non-performance do not amount to consideration for a service under section 66E(e) absent a distinct contractual agreement and flow of consideration for abstention/toleration/act; therefore, the demand under section 66E(e) cannot be sustained. Issue 3 - Application of Tribunal precedent and administrative guidance Legal framework: Judicial decisions interpreting the scope of 'service' and section 66E(e) bind the analysis of taxability; administrative circulars inform departmental stance and enforcement priorities. Precedent Treatment: The Tribunal applied its prior decision holding liquidated damages are not consideration and referred to the Circular of the Board dated 28.02.2023 which (i) restates the need for an independent contractual arrangement and nexus between the specific agreement and consideration, and (ii) records the Board's decision not to pursue certain appellate/civil avenues on this point. Interpretation and reasoning: The Tribunal treated the precedent and the Circular as persuasive and determinative of the correct legal approach: distinguishing penal recoveries from payments for an agreed-for obligation to refrain/tolerate/do an act. The Circular's guidance that taxability is fact-dependent but that the jurisprudential principles should be followed reinforces the Tribunal's conclusion. Ratio vs. Obiter: Ratio - reliance on the prior Tribunal ruling and the Circular to hold that liquidated damages are not taxable in the absence of an independent agreement. Obiter - commentary on the Board's litigation stance and examples in the Circular that illustrate potential taxable scenarios. Conclusion: The Tribunal followed established jurisprudence and administrative guidance, applying them to the facts and holding that the departmental demand is unsustainable. Overall Conclusion and Disposition The demand for service tax, interest and penalty based on amounts recovered as liquidated damages (both for the period prior to 01.07.2012 and w.e.f. 01.07.2012 under section 66E(e)) cannot be sustained because such recoveries are penal/deterrent in nature and do not constitute consideration for a service absent an independent contractual obligation with a direct flow of consideration; the impugned recovery order is therefore set aside.