Liquidated damages do not incur service tax : CESTAT Hyderabad
The Hyderabad bench of the Customs, Excise and Service Tax Appeal Tribunal (CESTAT) ruled that the service provider’s receipt of damages for breach of the terms of a service agreement would not trigger the service tax.
The bench, consisting of members PK Choudhary (judicial member) and PV Subba Rao (technical member), held that the claim for penalty/damages did not arise from any obligation on the part of the service provider to “tolerate an act or condition’ of the defaulting party, as provided for in section 66E(e) of the Finance Act 1994, so it cannot be considered payment for a service.
The CESTAT ruled that the scope of the service tax cannot be extended to apply to situations where the real activity was non-existent.
The caller M/s. Krishnapatnam Port Company Limited has entered into an agreement to provide “port services” in respect of imports made by M/s. Simhapuri Energy (P) Ltd. The agreement also provided for the payment of damages/“compensation costs” by the recipient of the service in the event of non-compliance with the “guaranteed minimum tonnage”.
The Service Tax Department issued a formal notice to the appellant proposing to recover the service tax on the grounds that the collection of “compensation fees” amounted to consideration for the provision of a taxable service.
The Central Tax Commissioner found that said activity amounted to a “declared service” under Section 66E(e) of the Finance Act 1994. The Commissioner thus passed an order confirming the service tax claim as well as the penalty imposed on the appellant. . Against this order, the appellant M/s. Krishnapatnam Port Company filed an appeal with the CESTAT.
The CESTAT considered that the penalty clause was provided for in the agreement to safeguard the commercial interest of the appellant and to compensate the appellant for financial loss or prejudice in the event of non-fulfilment of the given contractual condition as stipulated . CESTAT added that the penalty clause was added to discourage the recipient of the service from repeatedly violating the terms and conditions of the agreement and that the penalty clause was invoked only in cases where the recipient of the service n did not respect the contractual condition.
CESTAT ruled that according to the Finance Act 1994, the basic element for charging the service tax is the service element, i.e. there should be an activity under the form of “service” or “declared service”. The CESTAT found that “compensation fees” had been collected by the appellant for violation of the terms and conditions of the agreement and not for an activity subject to the service tax. The CESTAT therefore ruled that these “compensation costs” were not covered by the definition of taxable service under the Finance Act 1994 and were therefore not subject to the tax on services.
CESTAT observed that under section 66E(e) of the Finance Act 1994, “declared service” means accepting an obligation to abstain from an act, to tolerate an act or situation , or to do an act.
The CESTAT thus considered that to benefit from the provisions of Article 66E(e), there must be an action, a passive action or a reaction which is declared to be a service. Therefore, CESTAT considered that there should be an obligation to refrain from an act, condone an act or perform an act to invoke the provisions of Article 66E(e), which was missing. in the appellant’s case.
The CESTAT ruled that the appellant’s claim for penalty or damages as contemplated by the agreement arose to repair the financial damages or injuries suffered by the appellant as a result of the non-compliance with the stipulations/ contractual conditions by the beneficiary of the service. The CESTAT added that the claim for penalty/damages did not arise from any obligation on the appellant’s part to “tolerate any act or situation” of the defaulting party and therefore could not be considered as payment for any service.
The CESTAT has retained that the term “service” designates any activity carried out by one person for another for consideration. The CESTAT added that the recovery of damages/penalties from the other party cannot be considered a service in itself, since the appellant did not perform any activity to receive the “compensation costs”. Therefore, the CESTAT ruled that the scope of the service tax cannot be extended to apply to situations where the real activity was non-existent.
Thus, the CESTAT ruled that there must be a link between the amount invoiced and the taxable service.
The CESTAT considered that the compensation received by the appellant to repair the financial damages/losses cannot be considered as “consideration” at all and that it has no connection with a taxable service.
“Any amount invoiced which has no connection with the taxable service and is not consideration for the service provided is not part of the taxable value. In other words, the amount invoiced must necessarily be consideration for the taxable service provided under the finance law In this case, the compensation received to repair the financial damage/loss cannot be considered as a “consideration” at all and has no connection with a taxable service. “
CESTAT considered that there was a distinction between the “conditions of a contract” and the “considerations for the contract”. The CESTAT ruled that a recipient of services may be required to fulfill certain conditions contained in the contract, but this would not necessarily mean that this value would form part of the value of the taxable services that are provided.
Therefore, the CESTAT ruled, the “compensation charges” received by the applicant simply constituted the fulfillment of the condition provided for in the agreement and not the counterpart of the said contract.
Thus, the CESTAT upheld the appellant’s appeal and canceled the order of the Central Tax Commissioner.
Case title: M/s. Krishnapatnam Port Company Limited v Commissioner of Central Excise and Service Tax, Guntur
Date: 25.04.2022 (CESTAT Hyderabad)
Appellant’s representative: Me C. Manickam, lawyer
Representative of the Respondent: Mr. S. Hanuma Prasad, Authorized Representative of the Respondent
Click here to read/download the order