MAY 30, 2024

By Somesh Jain, Advocate

GST is leviable on all supplies of goods or services made for a consideration by a person in the course or furtherance of business. There was an ongoing debate on whether damages paid for breach of contract should be regarded as consideration for a supply.

The Board issued Circular No. 178/10/2022-GST dated 3.8.2022 clarifying that where the amount paid as 'liquidated damages' is only to compensate for injury, loss or damage suffered by the aggrieved party due to breach of the contract and there is no agreement to refrain from or tolerate an act or to do an act, such payments are not consideration for a supply and are not be taxable.

However, whether a sum of money paid in lieu of default in primary obligation is, in fact, a payment of liquidated damages is a question of interpretation of the contract. It is possible that in some cases, the clause may specify an alternative performance of the contract by way of monetary payment rather than liquidated damages. The GST implication will substantially differ in such cases.

Before discussing the issue of alternative performance, it is imperative to first understand the legal basis on which the damages for breach of contract are not held to be taxable under the GST law.

The liability to pay damages arises from law and not from the agreement of the parties.

A contract is entered into for execution, and not for its breach. A mere mention of a sum to be payable as damages on breach of contract does not imply that there is an agreement between the parties to tolerate the breach.

It is the law, and not the agreement of the parties, which imposes a liability for payment of damages. In the case of Hydraulic Engineering Company, Limited v. McHaffie, Goslett, & Co. (1878) 4 Q.B.D. 670 before the United Kingdom Court of Appeal, Bramwell L.J. held that:

"It cannot be said that damages are granted because it is a part of the contract that they shall be paid; it is the law which imposes or implies the term that upon breach of contract damages must be paid."

The Hon'ble Supreme Court in the case of Union of India v. Raman Iron Foundry, (1974) 2 SCC 231 held that in case of a breach, the party complaining of the breach does not become entitled to a debt from the other party until the damages are assessed and decreed by the court. The only right which the party aggrieved gets is the right to sue for damages. The relevant extract of the said decision is as under:

"It, therefore makes no difference in the present case that the claim of the appellant is for liquidated damages. It stands on the same footing as a claim for unliquidated damages. Now the law is well settled that a claim for unliquidated damages does not give rise to a debt until the liability is adjudicated and damages assessed by a decree or order of a Court or other adjudicatory authority. When there is a breach of contract, the party who commits the breach does not eo instanti incur any pecuniary obligation, nor does the party complaining of the breach becomes entitled to a debt due from the other party. The only right which the party aggrieved by the breach of the contract has is the right to sue for damages."

Under the service tax regime also, the above issue was decided in favour of the assessee by the CESTAT ¹ and the department has accepted the decision and decided not to file/pursue the appeal before Supreme Court.²

What is an alternative performance clause?

The concept of alternative performance has been explained by the Hon'ble Supreme Court in the case of ML Devender Singh v. Syed Khaja, (1973) 2 SCC 515. The Hon'ble Supreme Court was concerned with a case where the vendor defaulted in its obligation to transfer the ownership of immovable property to the buyer and sold it to another person at a higher price. The agreement provided that in case of default by the buyer, the vendor will forfeit the security deposit and in case of default by the vendor, the security deposit will be refunded and the vendor will pay an amount equal to the security deposit to the buyer as damages.

In a suit filed by the buyer for specific performance, the vendor inter alia contended that the sum named in the agreement is not liquidated damages but an option to pay the money in lieu of specific performance (alternative performance). This distinction has been statutorily recognized in Section 23 of Specific Relief Act, 1963, which provides as under:

"23. Liquidation of damages not a bar to specific performance.

(1) A contract, otherwise proper to be specifically enforced, may be so enforced, though a sum be named in it as the amount to be paid in case of its breach and the party in default is willing to pay the same, if the court, having regard to the terms of the contract and other attending circumstances, is satisfied that the sum was named only for the purpose of securing performance of the contract and not for the purpose of giving to the party in default an option of paying money in lieu of specific performance.

(2) When enforcing specific performance under this section, the court shall not also decree payment of the sum so named in the contract.

Construing the above section, the Hon'ble Court held that where payment is alternative to carrying out the other terms of the contract, it would exclude, by the terms of the contract itself, specific performance of the contract to convey a property. However, on facts, the Hon'ble Court came to the conclusion that the clause is a liquidated damages clause and not one providing for alternate performance.

The Hon'ble Court in the above case, cited extract from Sir Edward Fry's "Treatise on the Specific Performance of Contracts" (Sixth Edn. at p. 65) which very aptly explains the distinction between liquidated damages and alterative performance. The relevant extract is as under:

"The question always is: What is the contract? Is it that one certain act shall be done, with a sum annexed, whether by way of penalty or damages, to secure the performance of this very act? Or, is it that one of the two things shall be done at the election of the party who has to perform the contract, namely, the performance of the act or the payment of the sum of money? If the former, the fact of the penal or other like sum being annexed will not prevent the court's enforcing performance of the very act, and thus carrying into execution the intention of the parties: if the latter, the contract is satisfied by the payment of a sum of money, and there is no ground for proceeding against the party having the election to compel the performance of the other alternative.

Another significant case on the concept of alternative performance is the California Court of Appeal's case in the matter of McGuire v. More-Gas Investments, LLC (2013)³. In this case, the plaintiff entered into an agreement with the defendant to purchase two lots. The terms of the agreement required the defendant to amend the covenants, conditions, and restrictions on the lots, ensuring that owners of three nearby lots could not build or install structures within 900 feet of the access road adjoining the plaintiff's property. Failure to do so would obligate the defendant to refund ,000 to the plaintiff. When the defendant did not meet this requirement, the plaintiff filed a lawsuit seeking damages, including the stipulated refund. The trial court sided with the defendant, ruling that the provision was an unenforceable penalty, as no research had been conducted to determine the extent of the potential harm to the plaintiff. However, the Court of Appeal later reversing the decision of trial court held that the provision constituted an alternative performance clause rather than a liquidated damages clause. The Court held that:

"[A] provision in a contract that appears at first glance to be either a liquidated damages clause or an unenforceable penalty provision may instead merely be a provision that permissibly calls for alternative performance by the obligor."

Thus, the Court concluded that there were two obligations under the contract, first either to ensure that the nearby lots do not build or install structures or in alternative, pay a sum of money of ,000. Accordingly, the plaintiff was awarded the sum and was not required to prove any loss or injury.

Why will the parties to a contract want to interpret the clause as an alternative performance as against liquidated damages?

In a contractual dispute, as seen above, where a party fails to perform its part of the promise, the aggrieved party only gets the right to sue for damages. Further, the Constitution Bench of the Hon'ble Supreme Court in the case of Fateh Chand v. Balkishan Dass, (1964) 1 SCR 515, held that Section 74 of the Contract Act does not confer a special benefit upon any party; it merely declares the law that notwithstanding any term in the contract predetermining damages or penalty, the court will award to the party aggrieved only reasonable compensation not exceeding the amount named or penalty stipulated.

Thus, the aggrieved party must prove legal injury as also reasonable compensation for such injury. However, if the clause is interpreted as alternative performance clause, the aggrieved party may receive the full amount without proving any injury or damage, as there is no breach of contract.

An example of a situation where the aggrieved party would want to interpret the clause as one for alternative performance to do away with the proof of damage and injury is the case of McGuire v. More-Gas Investments, LLC (2013) (supra).

In some cases, even a party at fault would want to interpret the clause as an alternative performance particularly when it does not want to specifically perform the other obligation under the contract. This was the fact case in the case of ML Devender Singh v. Syed Khaja, discussed supra.

GST implication on sum payable as alternative performance.

The rationale for non-levy of GST on liquidated damages is based on the absence of an agreement between the parties for breach of the contract. The parties agree to perform the contract, not to breach it. Further, the liability to pay liquidated damages arise from the law, not from the agreement of the parties.

However, if the contract provides for payment of a sum as an alternative to performing the obligation under the contract, such payment itself constitutes performance of the contract. Such contracts are inherently designed to be fulfilled by performing one of the several specified acts as intended by the parties. Thus, alternative performance is, in fact, execution of the agreement and not a payment for breach of contract. There is, in fact, no breach of contract in such cases. Consequently, the non-taxability argument for liquidated damages does not apply to payments made as alternative performance. The applicability of GST in such cases is required to be assessed independently.

A dichotomy thus arises in the position the parties want to adopt in case of contractual dispute as against a taxation dispute.

Therefore, it is not prudent to always assume that any payment made for failure to fulfill a primary obligation will automatically be considered as liquidated damages and exempted from GST. A thorough analysis of the contractual terms and the parties' intentions is crucial to determine whether the clause specifies alternative performance or liquidated damages, which will, in turn, affect the GST implications of the payment.

[The views expressed are strictly personal.]

¹ M/s. South Eastern Coal Fields Ltd. [2021 (55) G.S.T.L. 549 (Tri. - Del.)], M/s. Western Coalfields Ltd. [(2023) 4 Centax 271 (Tri.-Bom)], M/s. Neyveli Lignite Corporation Ltd. [2021 (53) G.S.T.L. 401 (Tri. - Chennai)].