JULY 21, 2020

By Narendra Singhvi, Joint Partner, Lakshmikumaran & Sridharan

IN my article titled 'Liquidated Damages - Industry tolerating the dilemma', published on 13th April, 2020, I had discussed the issues concerning ST/GST liability on liquidated damages and relevance of decision of Hon'ble CESTAT in KN Food Industries Private Limited v. Commissioner of CGST, 2019-TIOL-3651-CESTAT-ALL and that of Hon'ble Madras High Court in GE T&D India Limited v. Deputy Commissioner of Central Excise, 2020-TIOL-183-HC-MAD-ST.

One of the related issues is the liability to pay Service Tax on foreclosure charges levied by banks and financial institutions on the foreclosure of loan. Divergent views were expressed on chargeability of Service Tax on these charges by different benches of Hon'ble CESTAT resulting in a reference to the larger bench. In Commissioner of Service Tax v. Repco Home Finance Limited,- 2020-TIOL-1039-CESTAT-MAD-LB, the larger bench has answered the reference in favour of the assessees, closing the doors on levy of Service Tax on foreclosure charges.

In terms of the contractual relationship between the banks/financial institutions, the banks agree to lend loan to the customers subject to the terms and conditions, including those relating to repayment etc. The loan agreements invariably contain a clause providing an option to the borrower for closure of the loan before the agreed period, resulting into loss of interest income for the banks. This is popularly known as foreclosure of loan. Every foreclosure of loan results in loss of interest for the lender. For this reason, the foreclosure of loan is always subject to payment of foreclosure charges, essentially meant to compensate the lender towards the loss of expected interest income. Questions arose about the taxability of the foreclosure charges under the Service Tax regime.

In one set of matters¹, it was held that the foreclosure of loan brings an end to the loan agreement and cannot be treated as consideration for lending. In another decision ², it was held that such charges are received in relation to lending and thus, are chargeable to Service Tax. The conflict in these decisions has now been resolved by the Larger Bench holding that these charges are not consideration for any services but are in nature of liquidated damages identified in the loan agreement itself payable on breach of the agreement by the borrower by closing the loan before the identified period.

The Larger Bench resolving the issue in favour of lenders has considered all the aspects of contractual relationship between the lender and the borrower, and also the different aspects of 'conditions of a contract'. This judgment also lays down certain guiding principles on treatment of payments under agreements as consideration for supply of services.

Though rendered in the context of erstwhile Service Tax law, the judgment has direct and immediate applicability to the transactions under the GST regime also.

The concept of consideration in both ST and GST law is identical, based on the mutual understanding of the parties. Essentially, this has been borrowed from the law of contracts, where consideration, whether monetary or otherwise, should have flown or should flow from the service recipient to the service provider and should accrue to the benefit of the latter. This envisages mutual agreement of both the promisor and the promisee to undertake an activity in return for the agreed consideration. Where the consideration is not at the desire of the promisor, it ceases to be a consideration. The larger bench has held that the lenders would not desire pre-mature termination of the loan advanced by them, resulting in a unilateral act of the borrower in repudiating the contract and consequently breach of the loan agreement.

It has further held that payment of foreclosure charges is not an alternative mode of performance as they are merely intended to compensate the banks for breach by the borrower. That it cannot be understood to mean that the borrower has been given an option to breach the contract in return of payment of foreclosure charges.

These observations have direct relevance in determining the applicability of ST/ GST on the ever-disputed clause of 'agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act'. Payment of liquidated damages agreed under an agreement on breach of such agreement also arise on unilateral act of the party breaching the agreement. Such breach of agreement entitles the party to recover damages from the other party, which are quantified in the agreement itself for the sake of certainty. Nonetheless, the right to recover such liquidated damages arises only upon breach of the agreement.

It has further been explained that there is a difference between conditions of a contract and consideration under a contract and that conditions of a contract are not equivalent to consideration under a contract. In mining/transportation contracts, sometimes diesel is provided free of cost by the recipient to the supplier. In regasification contracts, the recipient may allow expected loss of certain quantity of gas by the supplier. All these disputes now have to be analysed in light of these observations to determine whether these are in nature of conditions of a contract or consideration under a contract. In the context of GST, advance rulings have been issued treating these as consideration for supply in the garb of Section 15(2)(b) of the CGST Act. However, the said provision has rightly been enacted by the Parliament accepting the aforesaid difference between conditions of a contract and consideration under a contract.

This judgment, thus, seeks to answer many of the disputable issues concerning determination of 'consideration for a supply' under both Service Tax and GST law, endorsing the views communicated in the earlier article. I expect the Revenue to accept this judgment and apply the same in GST transactions also, which is a 'Hope against Hope'.

[The views expressed are strictly personal.]

¹Magma Fincorp Ltd v. Commissioner, 2016-TIOL-2014-CESTAT-KOL and Small Industries Development Bank of India v. Commissioner,   2011-TIOL-581-CESTAT-DEL

²Housing & Dev. Corporation Limited v. Commissioner, 2011-TIOL-1606-CESTAT-AHM