CESTAT Rules Liquidated Damages Are Compensatory, Not Taxable as Service

CESTAT Rules Liquidated Damages Are Compensatory, Not Taxable as Service

Introduction

The New Delhi Bench of the Customs, Excise and Service Tax Appellate Tribunal (CESTAT) has set aside a service tax demand of ₹2.10 crore, holding that liquidated damages recovered for delayed supply and short payments under power purchase agreements are compensatory in nature and not taxable as a “declared service” under Section 66E(e) of the Finance Act, 1994.

Factual Background

The assessee, Madhya Pradesh Poorva Kshetra Vidyut Vitran Co. Ltd., a State Government company, recovered sums from contractors as liquidated damages for delayed supply and short performance. The Department issued a Show Cause Notice (SCN) demanding ₹2,10,11,500, treating these recoveries as consideration for "tolerating an act," taxable as a declared service under Section 66E(e).

Procedural History

The adjudicating authority confirmed the demand along with interest and penalty, holding that liquidated damages fell within the scope of declared services. The authority also invoked the extended period of limitation under Section 73(1) of the Finance Act, 1994. The assessee challenged this order before the Tribunal.

Contentions

• Assessee’s Contention: The assessee argued that liquidated damages are compensatory in nature and not consideration for any service, hence outside the scope of service tax. It was also contended that all transactions were duly reflected in the books of accounts and available for verification, thereby ruling out any suppression or intent to evade.
• Department’s Contention: The Department maintained that such liquidated damages constitute consideration for tolerating an act, squarely falling under the ambit of declared service under Section 66E(e).

Tribunal’s Reasoning

The Bench comprising Dr. Rachna Gupta (Judicial Member) and Hemambika R. Priya (Technical Member) held that liquidated damages under contractual clauses are not consideration but compensation for non-performance or breach of contract. The Tribunal emphasized that mere breach of contract and recovery of damages cannot be equated with a taxable service.

It further observed that the Department had failed to establish suppression or intent to evade tax, and that mere non-payment cannot justify invocation of the extended limitation under Section 73(1).

Outcome

The Tribunal:

• Allowed the appeal filed by the assessee.
• Set aside the service tax demand of ₹2.10 crore, along with interest and penalty, holding both the classification of liquidated damages as declared service and the invocation of extended limitation unsustainable.

Significance

This ruling clarifies that liquidated damages are compensatory in nature and not subject to service tax. It also reinforces that the extended limitation period under Section 73(1) can only be invoked in cases of fraud, suppression, or intent to evade, and not for mere contractual recoveries.

Representation

In this case the appellant was represented by Mr. Rajeev Agarwal, Advocate. Meanwhile the respondent was represented by Mr. Rajeev Kapoor & Mr. Aejaz Ahmed, Advocates.