Following up on our earlier report detailing the introduction of Goods and Services Tax (“GST”) in India and the importance of distributors working with entities in India to acknowledge the said changes by amending the present agreements and pricing of products, there has been another specific development which should alert entities engaged in distribution in India to reevaluate liquidated damage clauses in the distribution agreements.
Application of GST on liquidated damages has been acknowledged and discussed through a special court in India. This article provides a brief run through of the development.
The Maharashtra Authority for Advanced Ruling (“AAR”), a court constituted for Advanced Rulings under the Goods and Services Tax Act (“GST”), recently provided an advance ruling stating that GST would be applicable on liquidated damaged imposed on delayed performance or non – performance of contracts executed in relation to certain services such as operation and maintenance activities. As per the ruling, liquidated damages would attract GST for supply of services under para 5(e) of Schedule II of the GST Act at the rate of 18% (eighteen) GST as provided for under the HSN Code 9997 as “Other Services”.
The GST Act allows for a person to obtain an advance ruling from the relevant authorities on one or more questions in relation to the supply of goods or services (or both) being undertaken or proposed to be undertaken by such applicant. The said Advanced Ruling court was constituted on the application of the Maharashtra State Power Generation Company Limited, seeking an advance ruling on the specific question of applicability of GST on Operation and Maintenance activities. Hence, the applicant had sought specific clarification whether such recovery of liquidated damaged from a third party contractor would be considered as “supply” of goods and services under the GST Act and hence, attract applicable GST.
It was contended by the applicant that as damages are being paid towards deficiency of services reducing the original consideration, liquidated damages should be treated as part of the contract, and not a separate service under “obligation to refrain from an act, or to tolerate an act or a situation, or to do an act”. The AAR observed that the contract price and the liquidate damages are two different aspects, where deduction of one from the other is a mere facilitation towards settlement of the accounts.
The AAR also observed that the facts and circumstances of each agreement and attending circumstances need to be seen in order to determine the applicability of GST on liquidated damages. The said decision is remarkable as since the introduction of GST in India last year, there have been numerous debates among the tax experts who, up till now, were divided on the applicability of GST on liquidated damages.
There have always been debates in India regarding damages falling under the ambit of service tax or not and there has never been legal acknowledgement/clarification or judicial precedent regarding this up till now. The AAR ruling increases the risk of GST scrutiny for entities such as foreign distributors enforcing liquidated damages clauses for breach of contract.
Even though the AAR ruling is specific to the matter at hand and would only apply to the applicant in the instance, such rulings are often considered as having a persuasive precedential value. Therefore, in light of this ruling, foreign distributors should take these circumstances into account while preparing a liquidated damages clause and should consider revisiting their earlier distribution agreements with Indian entities so as to clearly provide for reduction in contract price or value by the liquidated damage amount and to clearly state that payment of liquidated damages is not a separate event in the contact. Further, entities wishing to evaluate business in India should also consider inserting preemptive protections from the burden of GST in the distribution agreements through mandating that the defaulting party must bear all the GST, if any, levied on liquidated damages.
Srijoy DAS, IDI agency & distribution country expert for India and Harsahib Chadha, lawyer at Archer & Angel