MAY 23, 2018

By Vijay Kumar

Damages Liquidated?

YOU buy a Railway ticket, you pay GST. When you cancel that ticket, the Railways charge you a cancellation fee. Are you supposed to pay GST on the cancellation fee? If yes, will the GST paid on the ticket in the beginning be refunded? You book a marriage hall and later better sense prevailed and you cancelled the marriage and the consequent hall. You enter into an agreement with a contractor to get some work done with a clause that if the work is not done within a stipulated time, you will collect liquidated damages. Are you supposed to pay GST on the liquidated damages?

Yes, according to a recent decision of the Maharashtra AAR reported in - 2018-TIOL-33-AAR-GST. The details are:

Maharashtra State Power Generation Company Limited (Mahagenco) is a State Power Utility engaged in generation of power with objective to make Power available to all at affordable rates.

In various contracts entered into by the company, there is a clause to deduct Liquidated damages (LD) in case of default by the contractor/ vendor to complete the work in time. The LD is deducted in two cases.

Type 1 : Operation & Maintenance activities.

Type 2 : Construction of new power plants or renovation of old plants.

Normally the contract is awarded to vendors to build the plant on Turnkey basis. The contracts are awarded in three parts, Supply of materials, Erection & commissioning and Civil work. As per terms and conditions, the period of completing the contract is fixed. When plant construction is completed, the actual time taken for completion of contract is calculated. If there is delay in completing the contract, the assessment regarding party responsible for delay is made. If the delay is on account of contractor, then Liquidated damages (LD) are calculated as per contract terms and levied upon the contractor.

In accounting, the LD imposed is reduced from the total project cost while capitalizing the asset. Because of delay in the execution of work, the cost of project increases on account of Interest During Construction (IDC) and other administrative overheads. In such situation, LD helps in mitigating the impact of higher costs in form of IDC and administrative charges. Moreover, the contract entered into is for the purpose of construction of plant. There is no explicit agreement between the company and the contractor wherein the company is intending to supply service of tolerance of delay. The delay is neither desired by the company nor by the contractor but to impress upon the contractor to adhere to the timelines, LD clauses are inserted. However, if the delay occurs on account of vendors/ contractors, LD is levied upon them. Since, it was never the intention of the company to get its supplies/project delayed nor the contractors want to make delay and thereby causing company to tolerate it, the position of terming the LD as a consideration towards a service provided by the company to the contractor requires clarification.

And so, they approached the Authority for Advance Ruling. Their questions and the AAR's Rulings are as given below:

Question 1:

Whether GST is applicable on Liquidated Damages in case of

Type 1 i.e. Operation & Maintenance activities

Type 2 i.e. Construction of new power plants or renovation of old plants

Or is applicable in both cases?

The Ruling: We have not been provided with separate agreements in respect of the situations posed above. The facts of each agreement and the attending circumstances would have to be seen to provide an answer. We can only answer in terms of the agreement between Maharashtra State Power Generation Company Limited (Owner) and Bharat Heavy Electricals Limited (Contractor) for Erection & Commissioning of Main Plant Package at Chandrapur T.P.S. Expansion Project 2 x 500 MW that has been provided for our perusal. In terms of the aforesaid agreement, GST would be applicable on the Liquidated Damages.

Question 2

If GST is applicable, kindly clarify the following related aspects also

Ruling: We would be constrained to restrict the answer to this question in terms of only the agreement placed before us. We have observed above that the impugned levy of liquidated damages would be covered by clause (e) of para 5 of Schedule II appended to the GST Act.

To answer the question as regards the schedule entry and the tax rate applicable, we find that there is no specific schedule entry in the Notification no.11/2017 - Central/State Tax (Rate) [as amended from time to time] for taxable services and the Notification no.12/2017 - Central/State Tax (Rate) [as amended from time to time] for services exempt from GST. A reference to the Annexure about Scheme of Classification of Services as appended to the Notification no.11/2017 - Central/State Tax (Rate) [as amended from time to time] reveals thus -

In view of the above, following schedule entry under the Notification no.11/2017 - Central/State Tax (Rate) [as amended from time to time] for taxable services would cover the impugned levy of liquidated damages -

b) Liquidated Damages is determined and imposed upon the contractor after in-depth study. In such case, what will be construed as the time of supply. Will it be the period in which delay is occurring or it is the time when decision to impose Liquidated Damages is taken?

Ruling: We would be constrained to restrict the answer to this question in terms of only the agreement placed before us. The Agreement expressly provides that liability of payment of these liquidated damages by the Contractor will be established once the delay in successful completion of trial operation is established on the part of the Contractor. This would define the time of supply.

c) If some part of delay has occurred before GST roll-out and some part of delay has occurred after GST roll-out, whether GST will be applicable to the Liquidated Damages imposed for entire period of delay or to the period falling after GST roll-out? In case when GST is to be imposed for period after date of GST rollout but due to maximum capping of LD, the amount of LD is calculated at given percentage instead of being period-based, then how GST needs to be levied.

Ruling: The question is based on some incorrect presumption owing to which the applicant seems to have adopted some method of deduction of liquidated damages from the payments to be made to the contractor. We are afraid that no such strategy of deducting or of capping can be inferred from the agreement clauses. We would be constrained to restrict the answer to this question in terms of only the agreement placed before us. Sub-section (1) of section 13 of the GST Act provides that the liability to pay tax on services shall arise at the time of supply. If the Contractor fails to achieve the Trial Operation of the unit within a specified time period which falls under the GST regime then levy of liquidated damages would be attracted and this levy would attract the GST levy. In view thereof, as discussed in the answer to the Q.2(b), the agreement clauses would have to be referred to. Since no precise facts are before us, the section 14 of the GST Act would have to be referred to by the applicant. Further in respect of the liquidated damages if any collected/ received under the previously applicable service tax regime before coming into effect of GST, would be dealt with in accordance with the then existant (sic) provisions under applicable laws and we do not offer any view with regard to the previous service tax regime being out of the scope of present authority.

d. Whether the contractor/ vendor will be able to utilize the amount of LD imposed over him as Input Tax Credit subject to satisfying all other conditions?

Ruling: The above question is not answered as the proper person to ask the above question would be the contractor /Vendor and not applicant.

It is marvelous that the assessees and officers have so much in-depth knowledge of the tax laws that they cannot come to any precise conclusion. After such scholarly rulings, the AAR refuses to answer a simple question from the applicant as to whether his contractor will get Input Tax Credit, because according to the AAR, that question has to be asked by the proper person and that proper person is the contractor and not the applicant.

As per Section 97(1) of the GST Act,

An applicant desirous of obtaining an advance ruling under this Chapter may make an application in such form and manner and accompanied by such fee ……

As per Section 95(c), "applicant" means any person registered or desirous of obtaining registration under this Act; So virtually, any person can apply to the AAR and the AAR has no option to decide whether the applicant is a proper person to ask a question.

The applicant was stating the hard truth and not indulging in wry humour when he stated:

- There is no explicit agreement between the company and the contractor wherein the company is intending to supply service of tolerance of delay.

-  The delay is neither desired by the company nor by the contractor but to impress upon the contractor to adhere to the timelines, LD clauses are inserted.

- Since, it was never the intention of the company to get its supplies/project delayed nor the contractors want to make delay and thereby causing company to tolerate it, the position of terming the LD as a consideration towards a service provided by the company to the contractor requires clarification.

Anyway, this is not really a new confusion; we had it in Service Tax. Under Section 66E(e) of the Finance Act, 1994, 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. In fact, there was an exemption notification in Service Tax for Government liquidated damages and there is one in GST too.

If you think our tax litigation is too complicated, a similar issue was decided by the Australian Tax Office in 2001. In a long order running into 156 paras, the Australian Commissioner wisely ruled, "The most common form of remedy is a claim for damages arising out of the termination or breach of a contract or for some wrong or injury suffered. This damage, loss or injury, being the substance of the dispute, cannot in itself be characterized as a supply made by the aggrieved party.  This is because the damage, loss, or injury, in itself does not constitute a supply under the GST Act." You can read the ruling here. The ruling is so popular in the world of GST that it is still discussed and incisive analytical articles are written even after 17 years.

I have only admiration for all those who understand these complications. Taxation can neither be good nor be simple - in any country.