Treatment of Liquidated damages collected on Capital contract

[ROHIT GOEL]

Sirs,

Our client had entered into a contract for commissioning of a capital asset and as per contract, delay in commissioning attracted liquidated damages @10%.

The supplier executed the work with considerable delay and now raised invoice for entire contracted price. The client now intends to deduct LD of 10% and make balance payment. As per our opinion, the LD deducted by the client would be taxable@18% under Schedule II.

We had following queries on which discussion is welcomed:

a) Whether the client has to raise separate invoice for the same?

b) Whether ITC can be claimed on entire invoice amount raised by vendor as LD will become a separate transaction?

c) Since client will be making payment after deducting LD+GST, whether it would mean a violation of condition of payment within 180 days or whether since that balance amount will be reduced from LD income, no ITC disallowance would be required?

d) Whether LD amount should be reduced from value of asset (like a capital receipt) or considered as separate income liable to tax?

[Shilpi Jain]

a) Whether the client has to raise separate invoice for the same? - LD may not be liable at all to GST. Another view which can be taken is that LD indicates deficiency in supply and should be adjusted by way of a credit note. Though it is not a view which the department would appreciate.

b) Whether ITC can be claimed on entire invoice amount raised by vendor as LD will become a separate transaction? - If tax is paid ITC should be eligible

c) Since client will be making payment after deducting LD+GST, whether it would mean a violation of condition of payment within 180 days or whether since that balance amount will be reduced from LD income, no ITC disallowance would be required? - Payment would include book adjustment also. So 180 days condition cannot be considered to be violated.

d) Whether LD amount should be reduced from value of asset (like a capital receipt) or considered as separate income liable to tax? - To be checked with your IT auditor.

[Ganeshan Kalyani]

There is deficiency of service which can be affected by way of credit note. But there is another view which considers the same as 'tolerating an act...' which is a separate supply. If the taxpayer is considering it as tolerating an act then it becomes an income and accordingly need to account as an income. If deficiency of service then credit note to be accepted from vendor. This credit note then would be adjusted from capital asset. The impact of ITC reduction or availment in both the method is same.

[KASTURI SETHI]

I agree with both experts. Nicely explained by both experts.

[YAGAY andSUN]

To charge the GST on LD, it is pretty necessary to know the differentiation between Liquidated Damages and unliquidated Damages, such knowing the difference will only trigger the applicability of GST on such scenarios.

In a judgement of the Bombay High Court in Bai Mamubai Trust and others v Suchitra - 2019 (9) TMI 929 - BOMBAY HIGH COURT. Here, the Bombay High Court held that violation of a legal right, and compensation to make right such violation of a legal right, was not a ‘supply’ under Section 7 of the CGST Act. Payment made in the nature of damages and the doctrine of ‘supply’ did not encompass wrongful unilateral acts that resulted in the payment of damages. An order to direct payment / damages was to balance equities between parties and there were no enforceable reciprocal obligations which were essential to make it a supply under GST. In the latter half of 2019, a series of judgements were delivered by CESTAT(s) across the country. In Amit Metaliks Limited v Commissioner CGST, Bolpur - 2019 (11) TMI 183 - CESTAT KOLKATA, the Tribunal held that payments received towards the compensation for non-performance of contract would not be within the definition of Section 66 E (e) of the Taxation of Liquidated Damages – Is it Time to Have a Re-Look at the Law? Date: May 13,2020 Page 1 of 3 taxsutra All rights reserved(Finance) Act, and hence not exigible to Service tax. The CESAT, further placing reliance on the Supreme Court judgement(s) of Keshoram Industries [1965 (11) TMI 41 - SUPREME COURT] and Sunrise Associates v Govt. of NCT of Delhi [2006 (4) TMI 118 - SUPREME COURT]went on to hold that the compensation that was received by the appellant was more of an actionable claim.

A look at international statutes and rulings can be perused as guidance.

In the United Kingdom, Her Majesty’s Revenue and Customs in VAT Notice 708, clearly specify that LD(s) are not be treated as payment for a supply and no VAT is due on that amount. Such amounts, collected as liquidated damages, cannot be considered as consideration for an obligation of tolerance and hence cannot be characterized as a supply of service. The Australian Tax Office in its rulings GSTR 2001/4 and GSTR 2003/11 has also clarified that damage or loss or injury does not constitute a supply under the provision of Australian GST and payments in respect of damages will not constitute consideration for a supply exigible to tax. Other international rulings also uphold the same general principles.

AI Summary

Exploring Liquidated Damages in Capital Contracts: Separate Invoicing, ITC Impact, and GST Tax Classification Debate. A discussion on the treatment of liquidated damages (LD) in capital contracts under GST regulations explores whether LD should be invoiced separately, its impact on Input Tax Credit (ITC), and its classification as income. One view suggests LD indicates a deficiency in service, which could be adjusted via a credit note, while another considers it as tolerating an act, making it taxable income. Legal precedents and international rulings indicate that LD may not be considered a supply under GST, thus not subject to tax. Participants agree on the complexity and suggest consulting tax auditors for clarity.