Taxability of Liquidated Damages under GST

As and when there is any breach of contract, the suffering party would be paid the amount in the form of liquidated damage or compensation, penalty or cancellation charges, etc. Notably, there prevailed a lot of confusion in the trade and industry concerning the applicability of GST on such liquidated damage or compensation or penalty or cancellation charges vis-à-vis entry at para 5(e) of Schedule II of the Central Goods and Services Tax Act, 2017. In a view to providing clarification on the above issue, the Ministry of Finance issued a circular no. 178/10/2022-GST dated 3^rd August 2022. The present article briefly covers the taxability of liquidated damages under GST.

What is Liquidated Damages under GST?

Liquidated damages under GST refer to the compensation paid for a breach of contract, such as delays in project completion or non-fulfillment of contractual obligations. As per GST law, these damages are considered a supply of service and are subject to GST under the "agreeing to the obligation to refrain from an act or to tolerate an act" category. The applicable GST rate depends on the nature of the transaction. However, whether GST applies depends on factors such as the contractual agreement and the specific case facts.

Understanding the scope of entry at para 5(e) of Schedule II –

As per para 5(e) of Schedule II, the following supply is specifically declared as a supply of service –

1. Agreeing to the obligation to refrain from an act –

Some of the relevant examples are –

• Non-compete agreement,
• An industry refraining from carrying out the manufacturing activity per certain specified hours

2. Agreeing to the obligation to tolerate an act/ a situation –

One of the relevant examples is –

• A hawker can operate in front of the shop on payment of a monthly amount to the shopkeeper.

3. You are agreeing to the obligation to do an act.

Going through the above examples, it would be somewhat clear that the intention was to cover such services within the ambit of para 5(e) of Schedule II. However, taking the recourse of para 5(e) of Schedule II, demands were being raised on –

• Amount of charges i.e., fine/ penalty levied on dishonor of the Cheque,
• Liquidated damages paid on account of breach of contract,
• Late payment charges collected by the service provider on account of late payment of bills,
• The penalty levied for violation of any law,
• Notice pay recovery, etc.

Clarification provided on the taxability of liquidated damages and GST on Liquidated damages –

General clarification was given vide circular no. 178/10/2022-GST dated 3^rd August 2022 regarding the GST on liquidated damages, is that –

• An agreement to do/ refrain from an act/ situation should not be imagined/ presumed to exist.
• In order to bring the payment within the ambit of GST, there should be an express/ implied promise done on the part of the recipient of the money to either agree to do or abstain from doing something against the money so paid to him.
• It is specifically clarified that the following payments are not a consideration for tolerating an act/ situation –
  • Liquidation damages for breach of contract;
  • Penalty for the dishonor of Cheque;
  • Forfeiture of salary/ payment of the amount on the basis of the employment bond for leaving employment before the minimum agreed period;
  • The penalty levied under the mining act on account of excess stock found with the mining company; etc.
• Importantly, such payment will not be considered as ‘consideration’ and accordingly will not be considered as ‘supply’ unless –
  • Payment is made for an independent activity of tolerating an act; and
  • Payment is made under an independent agreement entered for the such activity of tolerating act.

The said circular no. 178/10/2022-GST dated 3^rd August 2022 provides a broad understanding of various such payments. The briefing of the same is tabulated hereunder –

Payments	Taxability under GST	Reason
Liquidated damages	It is not taxable under GST.	Liquidated damages are not considered received towards tolerating the non-performance/ breach of contract. In fact, it is a payment for not tolerating the breach of contract.
Cheque dishonor penalty/ fine	It is not taxable under GST.	Cheque dishonor penalty/ fine is not a consideration towards any service and hence the same is not taxable.
The penalty imposed for violation of laws	It is not taxable under GST.	Laws are not being framed for tolerating their violation. In service tax, it was clarified, vide circular no. 192/02/2016- Service Tax dated 13th April 2016 that fines/ penalty imposed for violation of statute/ laws are not leviable to service tax. The same is applicable under GST and hence the same is not taxable under GST.
Late payment/ surcharge/ fee	Taxable under GST	The same is naturally bundled with the principal supply and hence should be assessed on the bases of the rates of the principal supply.
Cancellation charges / late payment with interest or fee	Taxable under GST	The same is naturally bundled with the principal supply and hence should be assessed on the bases of the rates of the principal supply.
Forfeiture of earnest money	It is not taxable under GST	Forfeiture of earnest money is not considered received towards tolerating the breach of contract. In fact, it is compensation paid towards the loss suffered.

FAQs

1. What is the GST applicability on liquidated damages?

GST on liquidated damages depends on whether the payment is for tolerating an act or for compensating a breach of contract. As per Circular No. 178/10/2022-GST, this specified damages are generally not considered a taxable supply under GST.

2. How is GST on liquidated damages determined?

GST on liquidated damages is applicable only if the payment is made for an independent activity of tolerating an act under a separate agreement. Otherwise, it is not subject to GST as it is compensation for breach of contract.

3. What is the basis for calculating liquidated damages under GST?

Calculating liquidated damages under GST involves assessing whether the amount paid is for tolerating a breach or an independent service. If it falls under the former, it is not taxable; otherwise, GST may apply based on the contractual terms. This is how the calculating liquidated damages works.

4. Are penalties for contract breaches considered a supply under GST?

No, penalties and liquidated damages for contract breaches are not considered a supply under GST. They are compensatory payments and do not involve an obligation to tolerate an act or situation.

5. Does GST apply to late payment charges and surcharges?

Yes, GST applies to late payment charges and surcharges as they are linked to the principal supply and are considered taxable under GST law.

6. How does the government clarify liquidated damages GST?

The government issued Circular No. 178/10/2022-GST, clarifying that liquidated damages are not taxable under GST unless there is a separate agreement to tolerate an act in return for a payment.