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2022 (66) G.S.T.L. J44

2022 (66) G.S.T.L. J44 (Article)

GST on washout charges or liquidated damages
By

M.S. VENU GOPAL

M.Com., MBA (Finance), LLB, ADCA

What is Washout charge?

"A sum equivalent to difference between the settlement rate (market rate) and the rate as agreed in contract".
It's discretionary upon the both parties of the contract to settle/close/washout the unexecuted contract at the rate fixed by
it. In this regard, on mutual agreement, the rates which contracts settles is usually the market rate. In case of 'Closure' or
'washout' of aforesaid contracts, the party to the contract which opts for such closure is required to pay the other party a
sum of equivalent to difference between the settlement rate (market rate) and the rate as agreed in contract.

What is Liquidated Damages?

'Liquidated Damages' means a compensation specified under the contract agreed between the parties for an
estimated loss and which is required to be paid upon failure of either party to perform its obligations.
Section 7 Schedule II Para 5(e) reproduced here under.

Schedule II, Section 7 :- Activities to be treated as supply of goods or supply of services.

"As per the provisions laid down under Section 7 of the CGST Act, the expression "supply" includes all forms of
supply of goods/services for a consideration by a person in the course and furtherance of business.
Para 5 (e) :- Agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act; and

Perusal of the aforesaid Schedule II entry makes it amply clear that in order to invoke the above taxable activity, there
needs to be an agreement to tolerate a situation. This is not the case of washout such as contractual penalties, liquidated
damages/cancellation fee etc.

The understanding of the learned adjudicating authority seems contradictory to the commercial understanding because -
These washout charges arise on mutual acceptance of both parties on account of an 'unintentional occurrence' which
both parties actually intend to avoid.

Damages/cancellation charges/washout charges are provided for with an intent to ensure due performance of an
agreement or to further obedience of the law.

It is an expression of dissatisfaction or a form of penalty resulting from unsatisfactory performance or breach of the
contract.

Such washouts are not the desired result or intended to be a source of revenue for the receiving party but are incurred to
compensate for loss suffered by one party upon the occurrence of an unintended event.

Washout charges/damages are measures of compensation for breach/non-execution of contract due to conditions not
under one's control, but not a fee for agreeing to tolerate an act or situation.

Washout charges result from failure to perform as per agreed terms.

The very purpose of agreeing to payment of washout Charges is to ensure performance and not for tolerating non-
performance.

A contract is never entered into with an intent of non-performance or to tolerate non-performance.

Washout Charges are not the desired income or Expense or result of contract but are compensation for the loss suffered
by receiving party.

A contract can never be read as agreeing to breach of the contract.

Before, determining any person as supplier, the activity or transaction of goods or services carried out by such person
should be covered within the scope of "supply". The scope of "supply" is denoted in Section 7 of the CGST Act which is
reproduced as under :

Section 7. Scope of supply. —

(1) For the purposes of this Act, the expression ― "supply" includes ––
(a) all forms of supply of goods or services or both such as sale, transfer, barter, exchange, licence,
rental, lease or disposal made or agreed to be made for a consideration by a person in the course or
furtherance of business;
(b) import of services for a consideration whether or not in the course or furtherance of business; and
(c) the activities specified in Schedule I, made or agreed to be made without a consideration;
(d) xx xx xx.
(1A) where certain activities or transactions constitute a supply in accordance with the provisions of sub-section
(1), they shall be treated either as supply of goods or supply of services as referred to in Schedule II.
(2) Notwithstanding anything contained in sub-section (1),––
(a) activities or transactions specified in Schedule III; or
(b) such activities or transactions undertaken by the Central Government, a State Government or any
local authority in which they are engaged as public authorities, as may be notified by the
Government on the recommendations of the Council, shall be treated neither as a supply of goods
nor a supply of services.
Thus, as per Section 7 of the CGST Act, any transaction should pass through the following tests as in order to be
qualified as a "supply",
 (a) agreement for transaction or activity i.e. the transaction or activity should be made or agreed to be made;
(b) transaction or activity should be relating to goods/services;
(c) an element of consideration should be present in transaction or activity;
(d) transaction or activity should be carried out in the course and furtherance of business;
(e) activities specified in Schedule I, made or agreed to be made even though without a consideration;
(f) the transaction should not be specified in Schedule III.
Absence of consideration : The term consideration is defined in clause (31) in section 2 of the CGST Act, which is
reproduced as under :

(31) "consideration" in relation to the supply of goods or services or both includes –

(a) & (b) xx xx xx

In the above definition of "consideration", the words "in relation to" are used. In the case of 'Doypack Systems (P.) Ltd. v.
Union of India - AIR 1988 SC 782, the Apex Court has categorically held that the phrase "in relation to" is equivalent to
the phrases "concerning with" and "pertaining to". Therefore, the phrase "In relation to" used in the definition of the
term "consideration" suggests a connection with the act of supply. Therefore, it can be deduced that any consideration
should have a direct nexus to the voluntary act of supply.

In order to understand a clear intention of the legislature reliance is drawn towards Schedule II 5(e) of the GST Act
2017. It will be convenient if the above entry is split into its components for a clear and easy understanding :

Agreeing to the obligation –

• to refrain from an act, or

• to tolerate an act or a situation, or
• to do an act
In order to invoke the above clause, there needs to be consensus or a clear agreement to tolerate or to enter into a
contract agreeing to tolerate a situation.

Schedule II of the CGST Act is confined to define as to what constitute supply of goods or supply of services and does
not defines supply per se. Schedule II of the CGST Act has to be read along with section 7 of the CGST Act, which
means if an activity does not constitute a "supply" in itself as per section 7(1) of the CGST Act, mere coverage of the
same under the entry Schedule II cannot make it liable to GST. Further, there is no positive act of supply of services
between the parties and there is no agreement between the parties to cause loss or damage by breaching terms and
conditions of an agreement for a consideration.

The expression 'to tolerate an act' relates to situations where a person commissions another person to do or commit a
particular act for a consideration. The payment of damages is a condition of contract and not a consideration for any
service in nature of tolerating an act.

In recent times, the Bombay High Court, in the case of Bai Mamubai Trust v. Suchitra - 2019 (31) G.S.T.L. 193 (Bom.)
has held that GST is not payable on damages/compensation paid for a legal injury.

The principle laid down by the Court is that such payment does not have the necessary quality of reciprocity to make it a
'supply' and, therefore, GST is not payable on such amount.

In this case, there was a dispute between the landlord and an occupant of premises, and a court receiver was appointed
by the High Court for maintenance of the property and to collect rent from the defendant. The plaintiff claimed that in
case his right over the property is proved in Court and the royalty amount is paid to him, then the same will be an
income earned by him for letting out the premises and will be a taxable income under GST. The plaintiff moved an
application to the Court to direct the defendant to pay royalty along with GST. Although in the ruling, the Court did not
discuss at length on the issue of whether the damages paid would fall under clause 5(e) of Schedule II of the CGST Act.

However, it is to be noted that according to the amendment in the scope of 'supply' under Section 7 of the CGST Act, all
activities which are specified in Schedule II would have to first qualify as a supply in terms of Section 7(1A) of CGST
Act.

Therefore, the reference to clause 5(e) of Schedule II will not be relevant in cases where supply is absent.

Thus, the principles laid down by the Bombay High Court in the above case will squarely applicable to our present issue
" Washout Charges" where the supply or service is not qualify hence GST is not attracted.

Provision in clause 5(e) of the Schedule II of the CGST Act is similar to the earlier Service Tax law i.e. Section 66E(e)
of the Finance Act, 1994. With reference to the said earlier Act.

Very Recent judgments of CESTAT held that Penalty/Liquidated Damages/Compensation Charges are not treated as
services. Hence it is not liable for service tax. Rulings are as under.

Krishnapatnam Port Company v. CCE & ST - CESTAT Hyderabad. ST appeal No. 30227 of 2016, dated 25-4-2022

Brahmaputra Cracker & Polymer Ltd. v. Commissioner of CGST& Excise - CESTAT Kolkata. [ST Appeal No. 75209 of
2019, dated 4-5-2022]

South Eastern Coalfields v. CCCE & ST - 2021 (55) G.S.T.L. 549 (Tri. - Del.)

The very essence of the contract is tolerating of act or situation and not to recover any damages where as in performance
based contracts, performance is the very essence of contract and not non-performance or tolerating non-performance,
therefore the amount of damages so received cannot be said to be the consideration for tolerating non-performance. Per
say, the liquidated damages will not fall under the ambit of 'SUPPLY/SERVICES' and hence will not be subject to GST.

1. The view of not considering Washout Charges/Liquidated Damages as supply/services for tolerating an act
has also been supported by various International Jurisprudence.
Ruling GSTR 2001/4 (GSTR 2003/11 issued by the Australian Tax Office, where it has been clarified that
damage or loss or injury does not constitute a supply under the provisions of Australian GST.
2. The European Court of Justice in the case of Societe Thermale v. Ministere de l'Economie [2007] S.T.I.
1866, Celex No. 650J0277 has held that where the client exercises the cancellation option available to him as
compensation for the loss suffered and which has no direct connection with the supply of any service for
consideration, it is not subject to tax.
3. The Court of Appeal (UK) in case of Vehicle Control Services Ltd. - (2013) EWCA Civ 186, has said that
payment in the form of damages/penalty for parking wrong places/wrong manner is not a consideration for
services as the same arises out of breach of contract with the parking manager.
Hence we conclude that washout charges are not covered under the definition of "supply" or "service". Hence GST is not
attracted on this issue.

Further, there is no obligation under the subject contracts for refraining from an act or to tolerate an act or a situation or
to do any specific act. Thus, the present transaction does not qualify as a service as provided in para 5(e) of Schedule II.

The CBIC has issued circular to provide clarifications on several contentious issues such as GST applicability on
liquidated damages, notice pay recovery, compensation for non-collecting roll charges etc. vide Circular No
178/10/2022-GST, dated 3rd August, 2022 [2022 (63) G.S.T.L. C29].
With the above circular the following advance rulings are lost their essence.

1. Telangana State AAR in case of Singareni Collieries Co. Ltd., In re TSAAR order No. 13/2021 A.R.Com.
18/2020, dated 8-10-2021
2. Punjab Advance ruling in case of Louis Dreyfus Co. India (P.) Ltd., In re 2018 (18) G.S.T.L. 377 (A.A.R. -
GST)
In respect to taxability of liquidated damages, the CBIC has clarified that where the amount paid as 'liquidated damages'
is an amount paid only to compensate for injury, loss or damage suffered by the aggrieved party due to breach of the
contract and there is no agreement, express or implied, by the aggrieved party receiving the liquidated damages, to
refrain from or tolerate an act or to do anything for the party paying the liquidated damages, in such cases liquidated
damages are mere a flow of money due to such breach. Such payments do not constitute consideration for a supply and
are not taxable.

Para number 7.1 to 7.1.6 of the above said circular is reproduced here under for your ready reference.
7.1 Breach or non-performance of contract by one party results in loss and damages to the other party. Therefore,
the law provides in Section 73 of the Contract Act, 1972 that when a contract has been broken, the party which
suffers by such breach is entitled to receive from the other party compensation for any loss or damage caused to
him by such breach. The compensation is not by way of consideration for any other independent activity; it is just
an event in the course of performance of that contract.
7.1.1 It is common for the parties entering into a contract, to specify in the contract itself, the compensation that
would be payable in the event of the breach of the contract. Such compensation specified in a written contract for
breach of non-performance of the contract or parties of the contract is referred to as liquidated damages. Black's
Law Dictionary defines 'Liquidated Damages' as cash compensation agreed to by a signed, written contract for
breach of contract, payable to the aggrieved party.
7.1.2 Section 74 of the Contract Act, 1972 provides that when a contract is broken, if a sum has been named or a
penalty stipulated in the contract as the amount or penalty to be paid in case of breach, the aggrieved party shall be
entitled to receive reasonable compensation not exceeding the amount so named or the penalty so stipulated.
7.1.3 It is argued that performance is the essence of a contract. Liquidated damages cannot be said to be a
consideration received for tolerating the breach or non-performance of contract. They are rather payments for not
tolerating the breach of contract. Payment of liquidated damages is stipulated in a contract to ensure performance
and to deter non-performance, unsatisfactory performance or delayed performance. Liquidated damages are a
measure of loss and damage that the parties agree would arise due to breach of contract. They do not act as a
remedy for the breach of contract. They do not restitute the aggrieved person. It is further argued that a contract is
entered into for execution and not for its breach. The liquidated damages or penalty are not the desired outcome of
the contract. By accepting the liquidated damages, the party aggrieved by breach of contract cannot be said to have
permitted or tolerated the deviation or non-fulfilment of the promise by the other party.
7.1.4 In this background a reasonable view that can be taken with regard to taxability of liquidated damages is that
where the amount paid as 'liquidated damages' is an amount paid only to compensate for injury, loss or damage
suffered by the aggrieved party due to breach of the contract and there is no agreement, express or implied, by the
aggrieved party receiving the liquidated damages, to refrain from or tolerate an act or to do anything for the party
paying the liquidated damages, in such cases liquidated damages are mere a flow of money from the party who
causes breach of the contract to the party who suffers loss or damage due to such breach. Such payments do not
constitute consideration for a supply and are not taxable.
7.1.5 Examples of such cases are damages resulting from damage to property, negligence, piracy, unauthorized use
of trade name, copyright, etc. Other examples that may be covered here are the penalty stipulated in a contract for
delayed construction of houses. It is a penalty paid by the builder to the buyers to compensate them for the loss that
they suffer due to such delayed construction and not for getting anything in return from the buyers. Similarly,
forfeiture of earnest money by a seller in case of breach of 'an agreement to sell' an immovable property by the
buyer or by Government or local authority in the event of a successful bidder failing to act after winning the bid,
for allotment of natural resources, is a mere flow of money, as the buyer or the successful bidder does not get
anything in return for such forfeiture of earnest money. Forfeiture of Earnest money is stipulated in such cases not
 as a consideration for tolerating the breach of contract but as a compensation for the losses suffered and as a
penalty for discouraging the non-serious buyers or bidders. Such payments being merely flow of money are not a
consideration for any supply and are not taxable. The key in such cases is to consider whether the impugned
payments constitute consideration for another independent contract envisaging tolerating an act or situation or
refraining from doing any act or situation or simply doing an act. If the answer is yes, then it constitutes a 'supply'
within the meaning of the Act, otherwise it is not a "supply".
7.1.6 If a payment constitutes a consideration for a supply, then it is taxable irrespective of by what name it is
called; it must be remembered that a "consideration" cannot be considered de hors an agreement/contract between
two persons wherein one person does something for another and that other pays the first in return. If the payment is
merely an event in the course of the performance of the agreement and it does not represent the 'object', as such, of
the contract then it cannot be considered 'consideration'. For example, a contract may provide that payment by the
recipient of goods or services shall be made before a certain date and failure to make payment by the due date shall
attract late fee or penalty. A contract for transport of passengers may stipulate that the ticket amount shall be partly
or wholly forfeited if the passenger does not show up. A contract for package tour may stipulate forfeiture of
security deposit in the event of cancellation of tour by the customer. Similarly, a contract for lease of movable or
immovable property may stipulate that the lessee shall not terminate the lease before a certain period and if he does
so he will have to pay certain amount as early termination fee or penalty. Some banks similarly charge pre-
payment penalty if the borrower wishes to repay the loan before the maturity of the loan period. Such amounts paid
for acceptance of late payment, early termination of lease or for pre-payment of loan or the amounts forfeited on
cancellation of service by the customer as contemplated by the contract as part of commercial terms agreed to by
the parties, constitute consideration for the supply of a facility, namely, of acceptance of late payment, early
termination of a lease agreement, of pre-payment of loan and of making arrangements for the intended supply by
the tour operator respectively. Therefore, such payments, even though they may be referred to as fine or penalty, are
actually payments that amount to consideration for supply, and are subject to GST, in cases where such supply is
taxable. Since these supplies are ancillary to the principal supply for which the contract is signed, they shall be
eligible to be assessed as the principal supply, as discussed in detail in the later paragraphs. Naturally, such
payments will not be taxable if the principal supply is exempt.
Further the circular clarified the below Points where GST Will not be applicable in Below cases :

1. Liquidated Damages compensation for cancellation of coal Blocks.

2. Cheques Dishonour
3. Fines/Penalties imposed for violation of law
4. Notice pay recovery
5. Compensation for not collecting toll charges
6. Late Payment surcharge fee (Should Be assessed at the same rate as Principle Supply).
7. Fixed Capacity Charges for Power Cancellation Charges (Depends up on Nature of Supply).
Hence with the above detailed explanation and C.B.I. & C. Circular No. 178/10/2022-GST, dated 3-8-2022 [2022 (63)
G.S.T.L. C29] the Washout charges/Liquidated Damages are not covered under Para No. 5(e) of Schedule II of Section 7
of CGST Act and not chargeable to GST.

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