Contractual Liquidated Damages not Taxable under Indian Service Tax Laws
CESTAT decision on liquidated damages impacts tax obligations for businesses
In a significant ruling, the Kolkata Bench of the Customs, Excise, and Service Tax Appellate Tribunal clarified that the recovery of liquidated damages from suppliers for breach of contract does not fall under the category of “declared services” and, as such, is not liable to service tax. This decision is crucial for businesses engaged in contractual relationships and provides clarity on the taxability of liquidated damages under the Indian Service Tax regime.
Background of the Case
The case revolves around Eastern Coalfields Limited, a public sector mining company, which had imposed deductions on suppliers who failed to meet the terms of their contractual agreements. Specifically, ECL deducted liquidated damages from invoices as compensation for non-performance. However, the tax department sought to treat these deductions as consideration for the “tolerating an act” of non-performance under Section 66E(e) of the Finance Act, 1994. This provision deals with the taxation of certain declared services, and the department argued that the recovery of liquidated damages amounted to the supplier tolerating the act of breach, thereby making it taxable under service tax laws.
A show-cause notice was issued for the period between 2013-14 and 2015-16, demanding service tax on the liquidated damages collected by ECL. Despite the objections raised by the appellant, the adjudicating authority confirmed the demand, a stance later upheld by the Commissioner (Appeals). ECL then approached the tribunal for relief.
Appellant’s Argument: Liquidated Damages as Compensation
ECL’s counsel strongly contested the demand, arguing that liquidated damages are compensatory in nature and arise from a breach of contract. They clarified that such damages are not a payment for a service rendered, but a remedy to compensate for the non-performance or failure of the supplier to meet the contractual obligations.
The appellant referred to several earlier tribunal decisions, including South Eastern Coalfields Ltd. v. CCE, Raipur and Mahanadi Coalfields Ltd. v. CCE, Rourkela, which had already ruled that liquidated damages, penalties, and forfeitures of earnest money are not taxable under Section 66E(e). Additionally, the appellant cited the CBIC Circular No. 214/1/2023-ST, dated 28th February 2023, which explicitly clarified that recoveries in the form of liquidated damages do not constitute “declared services” and thus do not attract service tax.
Revenue’s Argument: Liquidated Damages as Payment for Tolerating Non-Performance
On the other hand, the revenue’s counsel contended that the deductions made by ECL represented consideration for the act of tolerating the supplier’s failure to perform. The revenue argued that, under the provisions of Section 66E(e), the recovery for breach of contract could be considered as payment for tolerating an act of non-performance, making it subject to service tax.
CESTAT’s Ruling: Liquidated Damages Are Not Taxable
The two-member bench of CESTAT, comprising R. Muralidhar, Judicial Member and K. Anpazhakan, Technical Member, rejected the revenue’s arguments. The tribunal observed that the issue had been settled in favour of the appellants in earlier rulings, such as those mentioned above. Furthermore, the tribunal emphasized that for a transaction to be taxed under Section 66E(e), there must be an express agreement to tolerate an act for consideration. In the present case, there was no agreement between ECL and the suppliers to tolerate any act of non-performance in exchange for payment.
Instead, the tribunal noted that the deduction of liquidated damages was merely a contractual remedy for breach, rather than consideration for a taxable service. As per the established principles, liquidated damages serve as a form of compensation for the supplier’s failure to fulfil the terms of the contract, and not a service for which service tax would apply.
The tribunal also took note of the clarifications issued by the Central Board of Indirect Taxes and Customs, which further supported the appellant’s position. With these considerations in mind, the tribunal set aside the demand for service tax and ruled in favour of Eastern Coalfields Limited, allowing the appeal and granting consequential relief to the appellant.
Implications of the Decision
This ruling brings much-needed clarity to businesses that deal with liquidated damages in their contracts. The tribunal’s decision reaffirms the principle that liquidated damages are a contractual remedy and not a service under the Service Tax regime. Companies that recover such damages from suppliers or contractors will now have greater certainty regarding their tax liabilities in this area.
The judgment also aligns with previous tribunal decisions, emphasizing that not all payments or penalties resulting from a breach of contract qualify as taxable services. By upholding the legal position that liquidated damages are compensation, and not service fees, the ruling ensures that businesses are not subjected to unnecessary tax burdens in situations that are purely contractual in nature.
The CESTAT’s ruling in the case of Eastern Coalfields Limited serves as a crucial reminder that liquidated damages, penalties, and other contractual remedies should not be automatically classified as taxable services. This judgment reinforces the distinction between compensation for breach and consideration for service, offering clarity for businesses involved in contractual agreements where such deductions are made. The case serves as a significant precedent in ensuring that business transactions are not overburdened with unwarranted service tax obligations.
This ruling is expected to be beneficial not only for coal mining companies like Eastern Coalfields Limited but also for all businesses that engage in contracts involving liquidated damages, penalties, or similar provisions for non-performance. The decision is a reaffirmation of the fundamental principles of contract law and service tax law, providing businesses with much-needed respite from ambiguous taxation practices.