Damages paid for cancellation contract to attract 18% GST

NEW DELHI: The Authority for Advance Rulings (AAR) has ruled that payments in respect to nonperformance of a contract would be liable to goods and services tax (GST). This has made multinational companies, especially those executing infrastructure projects, and the mining sector jittery, and it could have implications on mergers and acquisitions, franchise arrangements too.

Liquidated damages are payments in lieu of non-performance of a contract.

The Contract Act envisages these damaged under a contract as genuine pre-estimate so as to avoid hassles of computation of damages and possible contractual disputes, or litigations, in case of non-performance.


The Maharashtra Authority for Advance Ruling (AAR) has stated that liquidated damages paid on operation & maintenance and erection & commissioning contracts, entered by the applicant --Maharashtra State Power Generation Company -- shall be taxable under GST at 18%.

The Authority has concluded liquidated damages to be a deemed service, covered under the phrase ‘agreeing to tolerate an act or situation’, under Para 5 of Schedule II of GST Acts.

Tax experts are divided on the same, and expect the ruling to be challenged.

Typically, the industry was not paying any service tax on these and has continued to adopt the same position under GST.

“The main argument for not paying GST is that for an activity to be taxable under GST, requirement of ‘supply’ and the consequent ‘consumption’ should be met. The said requirement remains unmet in case of liquidated damages and hence the same should not be taxable”, said Harpreet Singh, Partner, KPMG.

“There has to be a distinction between amount payable for breach of contractual terms, or delay in performance, and something specifically agreed upon for forbearance or tolerance of an act like a non compete fees,” said Pratik Jain, indirect tax leader, PwC. He said the ruling can lead to lot of litigation, particularly in the infrastructure sector, where liquidated damages are common.

“The GST Council needs to set up amechanism wherein some of these advance rulings are adequately debated before issuance to ensure consistency, and also to see the wider ramifications, which could be unintended at times," he said.

AAR is a quasi-judicial body that allows companies to get a guidance on their potential tax liabilities relating to any transaction beforehand.

Though rulings by the AAR are case-specific, they have a persuasive impact on tax assessment in cases of other firms under similar circumstances.