The Covid pandemic is likely to leave in its wake a proverbial tsunami of litigation on account of breach of contracts. Astronomical claims for damages are likely to flood the courts. India will be no exception to this phenomenon. One suspects that the tax implications with respect to the damages payable may also not be free from doubt in many cases. The idea behind this article is to provide a brief overview of some of the key income tax aspects with respect to the payment of damages for breach of contract.
Broadly speaking, damages may be of two categories: (a) liquidated damages; and (b) unliquidated damages. Typically, when an agreement exists between parties to compensate each other for a predetermined amount upon a breach of contract, such compensation is known as payment of liquidated damages. On the other hand, unliquidated damages are decided by the courts based on an assessment of the loss or injury caused due to breach of contract as parties have not pre-agreed to the compensation.
While computing the taxable income of the business, the provisions of the (Indian) Income Tax Act, 1961 (IT Act) allow for a deduction of all revenue expenditure that is incurred wholly and exclusively for the purpose of business. Thus, expenditure incurred by way of payment for damages for breach of contract maybe allowed as a deduction. For instance, in PCIT vs. Mazda Ltd. a company was engaged in the business of manufacturing, trading of machinery/ machinery parts and production of drink concentrates, paid damages for delay in delivery or late completion of terms and conditions of an order. The Gujarat High Court held that the deduction claimed on account of liquidated damages was allowable as revenue expenditure. The court noted that damages for such delay was an inbuilt feature and inherent part of business and cannot be disassociated from taxpayer’s normal business activities.
Similarly, in the case of Huber Suhner Electronics, the Delhi ITAT held that if a company was under an obligation to deliver goods to a purchaser within a fixed period and the company failed to meet its obligation within the stipulated period, any liquidated damages paid by the company to the purchaser should be allowable as revenue expenditure.
However, it is pertinent to note that deductions cannot be claimed with respect to capital expenditures. Therefore, damages of a capital nature may not be allowed as a deduction for tax purposes. In the case of New Central Jute Mills Ltd vs. CIT the Calcutta High Court held that where the taxpayer who received an advance for sale of its land (held as a capital asset) that was pledged with the government, refunded the advance along with liquidated damages upon failure to get the land released from the government, the expenditure on damages cannot be treated as revenue expenditure as the transaction was not in the normal course of the taxpayer’s business.
Thus, in order for a payment of damages to be deductible it is imperative that it must qualify as a revenue expense, and it is this determination which inevitably leads to litigation.
Another issue that often arises pertains to the year in which a tax deduction may be allowed. Judicial precedents suggest that in the case of unliquidated damages, the liability to pay damages accrues only on passing of award by the court and not on the date of breach of contract. On the other hand, in the case of liquidated damages, a deduction may be allowed in the year in which provision for damages is made i.e. the year in which the liability is crystallised, if the taxpayer proves that (a) the company has an obligation as a result of the past event; (b) it is probable that an outflow of resources will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation. In a case where the determination of amount for liquidated damages is under dispute and is to be determined by courts, then the liability for damages will crystallise only when the decision is finalised by the courts and deduction may be claimed in the year in which decision is passed.
The amount received by an aggrieved party as liquidated or unliquidated damages may be treated as a revenue receipt or a capital receipt, and it is this classification which in turn impacts the taxability of the receipt. The Supreme Court has held that the receipt of damages which is connected with the source of income or profit making apparatus rather than a receipt in the course of profit earning process i.e. receipt relating to a normal business activity, is treated as capital receipt. In this case, the court held that where a company engaged in manufacturing business, entered into an agreement with a supplier for purchase of machinery for certain consideration, received damages as per the terms of the contract for delay caused in delivery of machinery, the compensation so received is for delay in coming into existence of the profit-making apparatus and thus would be a considered as capital receipt not subject to tax.
Damages of a revenue nature would however form part of the taxable income of the business. In the case of ACIT vs. India Gelatine & Chemicals Ltd, the Ahmedabad ITAT held that the damages paid by a company to a supplier for termination of contract were revenue in nature.
The tribunal’s rationale was that the termination led to a loss of profit, but since the supplier continued to remain in business, the source of income was not paralysed, and thus the damages received would be considered to be revenue in nature.
It is well settled that the right to receive unliquidated damages arises when damages are ascertained by the court. The receipt of unliquidated damages will accordingly be taxed in the hands of the aggrieved party in the year in which the liability is ascertained by the court. Whereas, the right to receive liquidated damages arises upon breach of contract. However, if liquidated damages is in the form of a judgement debt then tax liability will arise in the year when decision is finalised.
Another issue that often arises is as to whether damages may be considered as revenue in the hands of one party and capital in the hands of the other. It is pertinent to note that where a receipt in hands of recipient is treated as revenue receipt, it is not necessary that it should be considered as a revenue expenditure in hands of the payer i.e. it is not necessary that in all cases a receipt will have the same character as it is in the hands of the person who has made the payment.
In case of contracts between resident company and foreign companies, damages paid by a resident company to a foreign company may be subject to withholding taxes in India. The receipt of damages by a foreign company from a source in India is taxable as ‘business income’. In the absence of a permanent establishment (PE) of the foreign company in India, these receipts may be taxable as ‘income from other sources’. The compensation for damages may become exempt from tax if the foreign company does not have a PE in India and the applicable tax treaty does not provide for its taxation under the head of residual income i.e. ‘other income’. In the case of Glencore International AG v. Dalmia Cement (Bharat) Limited, the Delhi High Court has held that the damages received by a non-resident under an arbitration award would not be subject to withholding tax in India in terms of Article 22 of the India – Swiss tax treaty relating to ‘other income’. The said clause only taxes incomes received from lotteries, crossword puzzles, etc. in India and therefore, compensation towards breach of contract would not fall within its ambit. Notwithstanding the tax treaty benefit, one may argue that no withholding of taxes be made on the principle that only those adjustments and deductions that are permissible under the Code of Civil Procedure, 1908 can be made in case of a judgement debt.
The aforementioned Dalmia judgement, may not however provide a “one size fits all” kind of answer. It should be noted that as per the provisions of other tax treaties entered into by India, a payment for damages may fall within the ambit of taxable residual income i.e. ‘other income’. Thus, a tax liability in India may arise on the damages received by a non-resident even in the absence of a PE.
The tax treatment of a payment of damages is a complex issue, and a straight jacketed formula may not always apply. An in-depth factual analysis would almost certainly be called for before any definitive conclusions can be reached. The spectre of litigation on the subject looms large and may very well be one of the many legal challenges that businesses will have to deal with in the post Covid era.
  [TS-5893-HC-2017(GUJARAT)-O] (Gujarat)
 Huber Suhner Electronics Pvt. Ltd. Vs. Deputy Commissioner of Income Tax  (Delhi – Trib.)
  [TS-5787-HC-1981(CALCUTTA)-O] (Cal.)
 CIT vs. Ganesh Stores (Madhya Pradesh HC)  [TS-5373-HC-1986(MADHYA PRADESH)-O] (Madhya Pradesh); Asuma Cashew Co. vs CIT (Kerala HC)  [TS-5143-HC-1989(KERALA)-O] (KER)
 FFE Minerals India (P.) Ltd vs. Joint Commissioner of Income Tax
 CIT vs. Saurashtra Cement Ltd ,  [TS-5026-SC-2010-O] (SC)
  (Ahmedabad)
 EX.P. 75/2015 & EX.APPL.(OS) Nos.1216-17/2015
 All India Reporter Ltd., Nagpur vs Ramachandra Dhondo Datar 1961 AIR 943, 1961 SCR (2) 773; Islamic Investment Company vs Union Of India (Uoi) And Anr 2002 (4) BomCR 685, (2003) 1 BOMLR 583, 2002 (3) MhLj 555
Contributed by: Abhay Sharma, Parter; Priyanka Jain, Associate
This is intended for general information purposes only. The views and opinions expressed in this article are those of the author/authors and does not necessarily reflect the views of the firm.
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