Service Tax on Liquidated Damages - When not Leviable?

Regional Bench of Chennai CESTAT in the case of SAIL vs. Commissioner of GST & Central Excise, Salem ( [2021] 128 taxmann.com 400 (Chennai - CESTAT)[26-07-2021] set aside the order of Commissioner (Appeals) after rejecting the contentions advanced on behalf of the Department that penalty amount, forfeiture of earnest money deposit and liquidated damages had been received by the said appellant towards "consideration" for "tolerating an act" leviable to service tax under section 66E(e) of the Finance Act.

Summary of the case

Facts: As per the contract of SAIL with suppliers, it had in the cases where the suppliers defaulted in adhering to the time schedule prescribed by the SAIL recovered (i) liquidated damages @1%. SAIL also sells goods through Online Forward Auction (OFV). (ii)The Bidders who intend to purchase goods through OFV, has to pay EMD as prescribed in the notice. A permanent customer, as well as a temporary customer, is required to pay a certain amount as EMD for every auction they intend to participate. The successful bidder has to pay 10% of the bid value towards Additional Security Deposit (ASD) and Full Sale Value (FSV) as per sale order. In the event of failure on the part of the successful bidder to make ASD/FSV payments within the due date as stipulated in the Sale Order, the EMD shall forfeited.

The Assistant Commissioner issued SCN and adjudicated the case against the appellants. The appellants filed an appeal with the Commissioner(Appeals) who upheld the order of the Assistant Commissioner. Now SAIL is in CESTAT challenging the order of Commissioner(Appeals).

Arguments of the Department

The department contended that the amount recovered by the appellant for non-fulfilment of obligation in terms of the agreement from their suppliers and buyers (bidders) are nothing but consideration for tolerating an act of their customers or a situation and hence the activity is a 'declared service' as stated under Section 66E(e) of the Finance Act, 1994 and therefore liable to pay service tax.

Arguments of the Appellants

They argued that no service tax is payable on the amount collected towards liquidated damages as this issue has been decided by the Tribunal in favour of the appellant in South Eastern Coalfields. They also placed reliance on the decision of the Tribunal M.P. Poorva Kshetra Vidyut Vitran Co. Ltd. v. Principal Commissioner CGST & Central Excise Bhopal 2021 (2) TMI 821 - CESTAT NEW DELHI, in support of the contention that the amount of liquidated damages/penalty collected for non-compliance of the terms of the contracts cannot be subjected to levy of service tax.

Observations by the CESTAT

CESTAT emphasized on the relevant portions of the order in the case of South Eastern Coalfields which is reproduced below-

"25. It is in the light of what has been stated above that the provisions of section 66E(e) have to be analyzed. Section 65B(44) defines service to mean any activity carried out by a person for another for consideration and includes a declared service. One of the declared services contemplated under section 66E is a service contemplated under clause (e) which service is agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act. There has, therefore, to be a flow of consideration from one person to another when one person agrees to the obligation to refrain from an act, or to tolerate an act, or a situation, or to do an act. In other words, the agreement should not only specify the activity to be carried out by a person for another person but should specify the:

(i) consideration for agreeing to the obligation to refrain from an act; or
(ii) consideration for agreeing to tolerate an act or a situation; or
(iii) consideration to do an act.

26. Thus, a service conceived in an agreement where one person, for a consideration, agrees to an obligation to refrain from an act, would be a 'declared service' under section 66E(e) read with section 65B (44) and would be taxable under section 68 at the rate specified in section 66B. Likewise, there can be services conceived in agreements in relation to the other two activities referred to in section 66E(e).

27. It is trite that an agreement has to be read as a whole so as to gather the intention of the parties. The intention of the appellant and the parties was for supply of coal; for supply of goods; and for availing various types of services. The consideration contemplated under the agreements was for such supply of coal, materials or for availing various types of services. The intention of the parties certainly was not for flouting the terms of the agreement so that the penal clauses get attracted. The penal clauses are in the nature of providing a safeguard to the commercial interest of the appellant and it cannot, by any stretch of imagination, be said that recovering any sum by invoking the penalty clauses is the reason behind the execution of the contract for an agreed consideration. It is not the intention of the appellant to impose any penalty upon the other party nor is it the intention of the other party to get penalized.

28. It also needs to be noted that section 65B(44) defines "service" to mean any activity carried out by a person for another for consideration. Explanation (a) to section 67 provides that "consideration" includes any amount that is payable for the taxable services provided or to be provided. The recovery of liquidated damages/penalty from other party cannot be said to be towards any service per se, since neither the appellant is carrying on any activity to receive compensation nor can there be any intention of the other party to breach or violate the contract and suffer a loss. The purpose of imposing compensation or penalty is to ensure that the defaulting act is not undertaken or repeated and the same cannot be said to be towards toleration of the defaulting party. The expectation of the appellant is that the other party complies with the terms of the contract and a penalty is imposed only if there is non-compliance.

29. The situation would have been different if the party purchasing coal had an option to purchase coal from 'A' or from 'B' and if in such a situation 'A' and 'B' enter into an agreement that 'A' would not supply coal to the appellant provided 'B' paid some amount to it, then in such a case, it can be said that the activity may result in a deemed service contemplated under section 66E (e).

30. The activities, therefore, that are contemplated under section 66E (e), when one party agrees to refrain from an act, or to tolerate an act or a situation, or to do an act, are activities where the agreement specifically refers to such an activity and there is a flow of consideration for this activity."

Order of CESTAT

The CESTAT relying on the ratio of the above order allowed the appeal and set aside the order and demand.

Our Comments

It is important to note that the penalty and liquidated damages can be subjected to service tax where there is express agreement between the parties to refrain from an act, or to tolerate an act or a situation, or to do an act and there is consideration agreed for such activity. The example in para 29 above illustrates it. This would hold good in GST law as well.