Recently Karanataka Authority for Advance Ruling has decided that GST is leviable on the forefiture of Security Deposit by the Landlord (Copy of the Decision is attached in the end of the Article).
In this article, we will discuss following aspects:
Brief Facts of the Case
The applicant states that they have entered into lease agreement with two different landlords and has obtained two premises for lease. The applicant states that they have sub let the above two premises to M/s Novocura Tech Health Services Pvt. Ltd., [hereinafter referred as Client] vide agreement dated 3rd November 2021 and 11th January 2022;
The Applicant states that their client approached them stating their incapability to continue the above mentioned agreements/contract; that to maintain cordial relationship with the client, they agreed upon for the early termination of the contract subject to payment of damages by the Client.
The applicant states that they have received the amount towards damages by way of forfeiture of interest free security deposit of Rs.1,19,00,000/- and Rs.16,00,000/-. The Client has also paid Rs.50,00,000 from Jul'22 to Jan'23 in various trenches towards damages for foreclosure as one-time settlement.
Now Question Comes, whether GST is leviable on forfeiture of this security deposit.
Key Submissions of the Taxpayer including Circular 178/10/2022
Taxpayer had submitted that:
Entry No 5 (e) in Schedule II of the CGST Act 2017 states that the following activity is to be treated as a deemed supply -
"Agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act" There are 3 legs to this definition:
i. Agreeing to the obligation to refrain from an act
ii. Agreeing to the obligation to tolerate an act or situation
iii. Agreeing to the obligation to do an act
This definition draws a parallel to the definition of contract as per The Indian Contract Act, 1872. Section 2(h) of the Contract Act defines a Contract as "An agreement which is enforceable by Law". There has to be an agreement which is legally valid and consisting a set of promises in exchange for a consideration.
The applicant contends that providing working space as per the rental agreement is the principal essence of the contract to supply. In the event of failure to continue with the supply/ terminate the contract prior to the agreed upon lock-in period, the lessee makes the payment of damages for the contract violation as per the agreement duly agreed upon and the same is not considered as a Supply.
The applicant states that the breach of lock-in period is a breach of contract and Section 73 of the Indian Contract Act, 1872 deals with compensation for loss or damage caused by breach of contract.
The applicant is of the view that Circular No 178/10/2022 is squarely applicable in this case as the lock-in clause arises out of the primary rental contract and is only a compensatory clause.
As per Circular No 178/ 10/2022,
A reasonable view that can be taken with regard to taxability of liquidated damages is that where the amount paid as 'liquidated damages' is an amount paid only to compensate for injury, loss or damage suffered by the aggrieved party due to breach of the contract and there is no agreement, express or implied, by the aggrieved party receiving the liquidated damages, to refrain from or tolerate an act or to do anything for the party paying the liquidated damages, in such cases liquidated damages are mere a flow of money from the party who causes breach of the contract to the party who suffers loss or damage due to such breach. Such payments do not constitute consideration for a supply and are not taxable.
Key Observations of the Authority
It is observed that there is a clause in the agreement which says as below:
3. In the event of early termination the LESSEE shall continue to be liable for the rental that would otherwise be payable for the reminder of the lock-in period, the LESSOR shall refund the security deposit to the LESSEE within 30 days of such termination.
The amount which was received by the applicant from their client, was a part of the terms and condition of the lease agreement signed between the applicant and their client. This means that, while entering into the agreement, the client was aware about the terms and conditions of the contract that, in case of breach of agreement i.e. in case of early termination, they shall be liable to pay the rental till the end of lock-in-period as a settlement for exit from the contract. Thus the Applicant has received money on account of non fulfillment of conditions as stipulated in the lease agreement.
In the impugned case, the Applicant has refrained from taking subsequent action/ tolerated an act of the client, for which consideration has been received by him. The payment of amount is for an act of tolerance in the sense that, when there is breach of the contract, the other party is put to certain hardships, which he tolerates in return of the payment received by his client. The same can be understood as consideration received by the Applicant for "agreeing to the obligation to refrain from an act, or to tolerate an act or a situation" of their client of not completing the lock-in period, which he had agreed in terms of contractual obligations.
As per the contract, the Applicant agrees to refrain or tolerate or to do an act. In case obligation/condition of the contract is not fulfilled, then such act is squarely covered under clause 5(e) of Schedule-II. Therefore, this activity constitutes supply in Section 7(1) of CGST Act, 2017.
Para 7.1.6. of the Circular:
7.1.6 If a payment constitutes a consideration for a supply, then it is taxable irrespective of by what name it is called; it must be remembered that a “consideration” cannot be considered de hors an agreement/contract between two persons wherein one person does something for another and that other pays the first in return. If the payment is merely an event in the course of the performance of the agreement and it does not represent the ‘object’, as such, of the contract then it cannot be considered ‘consideration’. For example, a contract may provide that payment by the recipient of goods or services shall be made before a certain date and failure to make payment by the due date shall attract late fee or penalty. A contract for transport of passengers may stipulate that the ticket amount shall be partly or wholly forfeited if the passenger does not show up. A contract for package tour may stipulate forfeiture of security deposit in the event of cancellation of tour by the customer. Similarly, a contract for lease of movable or immovable property may stipulate that the lessee shall not terminate the lease before a certain period and if he does so he will have to pay certain amount as early termination fee or penalty. Some banks similarly charge pre- payment penalty if the borrower wishes to repay the loan before the maturity of the loan period. Such amounts paid for acceptance of late payment, early termination of lease or for pre-payment of loan or the amounts forfeited on cancellation of service by the customer as contemplated by the contract as part of commercial terms agreed to by the parties, constitute consideration for the supply of a facility, namely, of acceptance of late payment, early termination of a lease agreement, of pre-payment of loan and of making arrangements for the intended supply by the tour operator respectively. Therefore, such payments, even though they may be referred to as fine or penalty, are actually payments that amount to consideration for supply, and are subject to GST, in cases where such supply is taxable. Since these supplies are ancillary to the principal supply for which the contract is signed, they shall be eligible to be assessed as the principal supply, as discussed in detail in the later paragraphs. Naturally, such payments will not be taxable if the principal supply is exempt.
From the above mentioned para of the circular, it is clear that amount paid for termination of lease constitute consideration for the supply of a facility and are subject to GST and they shall be eligible to be assessed as the principal supply. In the impugned case the principal supply is sub letting of a commercial property which is a taxable supply of service as explained supra and is classified under chapter heading 9972 - Real Estate Services. The same is taxable as per entry No.16(iii) of Notification No. 11/2017-Central Tax (Rate) dated 26.06.2017, as amended.
Copy of Judgement
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Disclaimer: We did interpretation of Respected Authority Decision for purely academic purpose. In case, there is any mistake in understanding of the order, we are apologised to the Authority.