Liquidated damages in certain cases to draw 18% GST, says AAR

Liquidated damages received by a service receiver from a service provider for not meeting terms of contract would attract 18 per cent goods and services tax (GST) in certain cases, the authority for advance rulings (AAR) in Andhra Pradesh has ruled.

Liquidated damages are the sum that one party receives when the other party fails to meet provisions of a contract between them. 

The ruling was given in an application by Andhra Pradesh Development Company (APPDCL), a special-purpose vehicle set up to implement mega power projects in the state.

The order came despite a circular issued by the government in 2022 that says liquidated damages are a mere flow of money from a party that caused a breach of contract to a party that suffered loss due to such breach. Such payments do not constitute consideration for supply and are not taxable, the circular had said.

However, AAR said the circular was not universal and absolute but only meant to clarify the position of law and shall be applied reasonably having regard to the facts of the case.

APPDCL entered into an agreement with Chettinad Logistics Pvt. Ltd. (CLPL) for supply of services, which included liasoning with MCL, East Coast Railways, Paradip and Adani Krishnapatnam ports for coordination and supervision of coal loading, arranging rakes, transportation of raw coal, and crushing of boulders. 

In the event of failure in performance of job assigned to the service provider, the receiver (APPDCL) will collect ‘liquidated damages’ for increase in moisture of raw coal over the loading end, for increase in ash percentage, penalties for late transportation of coal, and also penalty for short supply of coal, according to the contract signed between the two parties. 

Amit Maheshwari, tax partner at AKM Global, said the ruling of the AAR does not seem to be well reasoned. “The ruling focuses more on the meaning of ‘consideration’ rather than ‘supply’  since consideration would be subservient to supply,” he said.

APPDCL submitted in its application that these liquidated damages arise on mutual acceptance of both parties on account of unintentional occurrence, which both parties tend to avoid. Hence, liquidated damages cannot be a consideration for tolerating the breach or non-performance of contract.

The AAR, however, said the service provider is paying the said amounts only for certain advantages derived or to ward-off any disadvantage incurred. Thus, “It is inconsequential whether the payment is for tolerating the mistake or not tolerating”, it said.

AAR emphasised that the circular cited above has to be understood in the proper context. This meant that the payment towards damages are incidental to the main supply and since the main supply is taxable they shall also be taxable.

If the principal supply is exempt, the incidental shall also be exempt, AAR said.

AAR said liquidated damages in the present case constitutes supply of service and are exigible to 18 per cent GST.