Liquidated damages are means of compensation for the breach of a contract. In literal sense, ‘Liquidate’ implies the winding up of affairs of a business and on the other hand the word ‘Damages’ denotes a sum of money claimed or awarded in compensation for a loss or an inquiry.
Example: There is a forfeiture clause to deterrent non-serious bidders to enter the auction& therefore if the bid winner fails to act thereafter his Earnest Money Deposit (EMD) might be forfeited.
|View under the erstwhile Service Tax Law, “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 under Section 66E(e) of Finance Act, 1994.
Based on above, liquidated damages and forfeiture are consideration for the non-performance/delayed performance.
Similar provision has been incorporated in CGST Act also under Schedule II.
Under GST law, the taxable event is supply which has been defined widely and includes all forms of supply for a consideration which is made in course of or in furtherance of business. The act of tolerance or agreeing to refrain from an act is treated as supply of service under the CGST Act.
As per these provisions there should be an agreement between the parties to either refrain from doing an act, or to tolerate an act/situation or to do an act.
There is no specific schedule entry for tax or for exemption for liquidated damages.Another view prevailed in the experts, according to which ‘liquidated damages’ may hardly satisfy the essentials of supply or service. As the purpose of agreeing to payment of liquidated damages is to ensure performance. It cannot be said to be a consideration for tolerating non-performance.
A clarification is vital from the government on the taxability of subject discussed supra.
For this, references can be drawn from an AAR-ANDHRA PRADESH, of RashtriyaIspat Nigam Ltd.  dated 11thJan, 2019, regarding applicability of GST on Liquidated damages and other penalties.
Facts of the Case
The company had entered various contracts, with a clause in them to deduct liquidated damages (LD) in case of default by the contractor/vendor to complete the work/supply on time.
Whether “Liquidated damages” and other penalties like milestone penalties levied on suppliers/contractors in the nature of making good the damages for any delays in the supply of services or goods in supply & maintenance and project construction contracts are chargeable to GST?
AAR observed that in accounting LD is treated as an income in books of accounts. LD is levied by the reason of an act which has been tolerated for a price.
Liquidated damages and other penalties like milestone penalties levied on suppliers/contractors in the nature of making good the damages for any delays in the supply of services or goods in supply & maintenance and project construction contracts will be chargeable to GST at 18%.
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