09-Nov-2023 ITC reversal on Retention – Is it a tension ?

The GST law is still in an evolving stage and various issues have started cropping up in the recent wave of GST department audits and issuance of show cause notices. One such issue which is surfacing, is the issue whether reversal on input tax credit is required where the recipient of supplies has retained certain amounts payable by him to the supplier. 

Such kind of retentions are common in the construction and infrastructure related industry and in contracts involving supply goods as well as services. Retention is generally a percentage ( often 5% to 10%) of the amount certified as due to the contractor upon fulfillment of certain conditions during or after completion of the contract. Sometimes the retention amounts are released after 2 to 5 years of completion of the contract to ensure that the work completed has enduring effect over a period of time. The purpose of retention is to ensure that the contractor properly completes the activities required of them under the contract. Retention can also be applied to nominated sub-contractors, and the main contractor may also apply retention to sub-contractors appointed by him for execution whole/part of the main contract.

The provisions of GST law are triggered in case of Retentions due to second proviso to section 16(2) of the CGST Act,2017. The said proviso is extracted hereinbelow : 

Provided further that where a recipient fails to pay to the supplier of goods or services or both, other than the supplies on which tax is payable on reverse charge basis, the amount towards the value of supply along with tax payable thereon within a period of one hundred and eighty days from the date of issue of invoice by the supplier, an amount equal to the input tax credit availed by the recipient shall be 77[paid by him along with interest payable under section 50], in such manner as may be prescribed:

Provided also that the recipient shall be entitled to avail of the credit of input tax on payment made by him 78[to the supplier] of the amount towards the value of supply of goods or services or both along with tax payable thereon.

77. Substituted for "added to his output tax liability, along with interest thereon" by the Finance Act, 2023, w.e.f. 1-10-2023.

78. Inserted by the Finance Act, 2023, w.e.f. 1-10-2023.

Rule 37 of the CGST rules,2017 prescribes the manner in which the reversal is required to be done.

37.68a[(1) A registered person, who has availed of input tax credit on any inward supply of goods or services or both, other than the supplies on which tax is payable on reverse charge basis, but fails to pay to the supplier thereof, the amount towards the value of such supply68b[, whether wholly or partly,] along with the tax payable thereon, within the time limit specified in the second proviso to sub-section (2) of section 16, shall pay68b[or reverse] an amount equal to the input tax credit availed in respect of such supply68b[, proportionate to the amount not paid to the supplier,] along with interest payable thereon under section 50, while furnishing the return in FORM GSTR-3B for the tax period immediately following the period of one hundred and eighty days from the date of the issue of the invoice:

68a. Substituted by the Central Goods and Services Tax (Second Amendment) Rules, 2022, w.e.f. 1-10-2022.

68b. Inserted by the Central Goods and Services Tax (Fifth Amendment) Rules, 2022, w.r.e.f. 1-10-2022.

It may kindly be noted that the other aspects of Sec 16(2) and Rule 37 have not been considered in this article except the ‘failure to pay’ issue.

The main issue that is arising due to the 2nd proviso to section 16(2) is that the payment to the supplier is made beyond 180 days from the date of issue of invoice in cases where retention is made for more than 180 days. Moreover the Rule 37(1) states that the recipient of the supplies shall reverse an amount equal to the ITC availed in respect of such supply proportionate to the amount not paid to the supplier, along with interest payable thereon under section 50, while furnishing the return in FORM GSTR-3B for the tax period immediately following the period of 180 days from the date of the issue of the invoice.

Lets take an example where A Ltd. has issued an invoice to B Ltd, wherein retention of 10% is applicable for two years as per the terms of contract agreed between them : 

Invoice date             :     01-10-2022   

(Invoice date is the date on which the completion of work is certified by the Chartered Engineer)

Basic Taxable Value :    Rs. 10,00,000

GST @ 18%               :    Rs.  1,80,000 

Invoice Value            :   Rs. 11,80,000

IT TDS @ 2%             :    Rs.     20,000

Retention @ 10%.   :   Rs.    1,00,000 ( to be paid after 2 years from Invoice Date)

Balance Paid             :    Rs. 10,60,000

Payment date           :   31-12-2022

A plain reading of the above transactions indicates that B Ltd. would have taken ITC of Rs.1,80,000  on receipt of invoice in Oct’22 and  B it would have to reverse ITC amounting to Rs.18,000 which is proportionate to the amount of Retention (10%) since the retention amount is not paid/payable within 180 days but is payable at the end of two years from the date of invoice, subject to fulfillment of certain conditions as per the terms of contract.

But the issue is that whether the second proviso to sec.16(2) has actually triggered or not in such case. The said proviso mentions that   ‘……where a recipient fails to pay to the supplier of goods or services or both….’, then the reversal shall apply. In this case,  B Ltd. is not failing to pay within 180 days, but has appropriated the amount payable to the supplier in a separate Retention account as per the agreed terms of contract between them. Thus there is no failure to pay the balance 10% amount by B Ltd. to A Ltd. Nor will A Ltd. follow up with B Ltd. to make the impugned payment, since the due date for making payment has not arisen at all, nor the time period for fulfilment of conditions by A Ltd has been completed. Thus the amount has been duly and rightfully retained by B Ltd in pursuance of the agreed terms of contract.

The question is whether the provisions of the GST Act  can override the terms of contract between the contracting parties and deny ITC on such peculiar transactions ? 

The Allahabad High Court in the case of Badri Prasad v. District Judge, Gonda [1983 All LJ 41 at 42] held that the parties can be said to have 'failed to pay ' only if it can be said that they neglected to do something which they were expected to do, or they left some possible or expected action unperformed. Further, several High Courts have analyzed the meaning of  failure in various cases-

Failure means that there is an omission on the part of the person to do something which it is possible for him to do" – held by High Court of Karnataka in the case of Thattessara Subbaraya v. Chinne Gowda & Ors.[AIR 1972 Kant 213]

The word 'failure' means non-fulfillment of an obligation imposed"- held by High Court of Calcutta in the case of Royal Calcutta Turf Club Vs. Wealth Tax Officer[1985] 22 Taxman 438 (Calcutta

Failure means not doing something that one is expected to do"- held by High Court of Kerala in the case of Kavungal Kooppakkattu Zeenath v. Mundakkattu Sulfiker Ali [LQ 2007 HC 7225

By virtue of the above interpretations provided for the term ‘failure’, it is possible to contend that a failure can occur only in the presence of an obligation to do or perform an act. Accordingly, since the words used in the proviso are 'fails to pa ', it is possible to contend that the above provision would only be triggered when contractually there is an obligation on the recipient to pay the amount within 180 days and the recipient subsequently fails to pay the amount within 180 days. In case of payment terms beyond 180 days, it can be said that the proviso doesn't apply, and ideally there is no requirement of reversal in such cases. 

Let’s also analyse related provisions and views taken in AAR and AAAR in case of financial credit notes issued, wherein payment of full amount of consideration is not done to the supplier.

The AAR, Tamil Nadu in the case of MRF Ltd., In re [2019] 103 taxmann.com 278/73 GST 485/2019 (23) GSTL 193 by placing reliance on the second proviso to section 16(2)(d) and not considering Cir. No. 92/11/2019 dtd. 07.03.2018, stated that non-payment of the differential amount (Amount of postsales discount) constituted to be 'failure to pay the amount towards the value of supply'. The Authority observed that since the deduction of discount was not permissible, the value of supply remained prediscounted value. Thus, non-payment of value to the extent of post-sales discount is covered by the said proviso triggering a reversal of ITC at the Applicant's end.

The AAAR, Tamil Nadu set aside the ruling of original authority and held that a proportionate reversal of the credit is not required to be done by them in case of a post purchase discount given by the supplier to them through the C2FO platform, as these discount offered through the transactions on the said platform is settled through commercial credit notes only. It is further held that the appellant M/s MRF Ltd can avail the Input Tax Credit of the full GST charged on the undiscounted supply invoice of goods/ services by their suppliers . 

Even in erstwhile regime, it is worthwhile to note that in the Circular No. 122/03/2010-ST dated April 30, 2010, issued in respect of Rule 4(7) of the Cenvat Credit Rules, 2004 CBIC clarified that full credit will be available even if the service receiver pays the discounted amount to the supplier of services. 

In erstwhile regime, another prominent Circular No.877/I5/2OO8-Cx dated 17th November 2008, regarding reversal of CENVAT Credit in case of trade discount was issued wherein it was clarified that in such cases, the entire amount of duty paid by the manufacturer, as shown in the invoice would. be available as credit irrespective of the fact that subsequent to clearance of the goods, the price is reduced by way of discount or otherwise. However, if the duty paid is also reduced, along with the reduction in price, the reduced excise duty would only be available as credit. It may further be confirmed that the supplier, who has paid duty, has not filed/ claimed the refund on account of reduction in price. 

While Circulars that are issued in the context of another act are not necessarily binding; however, they can still hold persuasive value. Furthermore, as per Circular no. 92/11/2019-GST dated 7-3-2019, if post-sales discounts are excluded from the value of supply by the supplier due to non-compliance with the provisions of Section 15(3), then no Input Tax Credit (ITC) needs to be reversed by recipient. The same analogy should apply to Retention amounts.

An analogy can also be drawn from Cir. No. 178/10/2022 dtd. 03.08.2022 issued in respect of Liquidated damages and issues related to agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act as mentioned in para 5 (e) of Schedule II of CGST Act.

The description of the declared service in question, namely, agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act in para 5 (e) of Schedule II of CGST Act is strikingly similar to the definition of contract in the Contract Act, 1872. The Contract Act defines 'Contract' as a set of promises, forming consideration for each other. 'Promise' has been defined as willingness of the 'promisor' to do or to abstain from doing anything. 'Consideration' has been defined in the Contract Act as what the 'promisee' does or abstains from doing for the promises made to him.

This goes to show that the service of agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act is nothing but a contractual agreement. A contract to do something or to abstain from doing something cannot be said to have taken place unless there are two parties, one of which expressly or impliedly agrees to do or abstain from doing something and the other agrees to pay consideration to the first party for doing or abstaining from such an act. There must be a necessary and sufficient nexus between the supply (i.e. agreement to do or to abstain from doing something) and the consideration.

Liquidated damages cannot be said to be a consideration received for tolerating the breach or non-performance of contract. They are rather payments for not tolerating the breach of contract. Payment of Liquidated damages is stipulated in a contract to ensure performance and to deter non-performance, unsatisfactory performance or delayed performance.

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.

As an analogy to the concept of liquidated damages, Retention Amount is flowing from the terms of the contract and there is no failure to pay to the supplier, in case the retention amount is paid beyond 180 days by the recipient as per the terms of the contract.

Considering all the above aspects , it can be concluded that there is no tension in claiming full ITC in the contracts where retention is made by the recipient as per the agreed terms of contract with the supplier. 

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