GST Applicability on Liquidated Damages, Compensation and Penalty

In a circular dated August 3, 2022, the Central Board of Indirect Taxes and Customs (CBIC) clarified the application of the GST to various taxes, fines, and penalties resulting from contract violations and other situations. The circular has examined a wide range of situations when one party recovers a charge, fee, or penalty from another due to a violation of the contract in great detail.
In this article, we’ll discuss GST On Liquidated Damages.

Key Abstract

In this article, our GST specialists at Legal Window provide a summary of recent Circulars from the Central Board of Indirect Taxes and Customs (CBIC) that address the taxability of various goods and services as well as the applicability of the Goods and Services Tax (GST) on liquidated damages, compensation, and penalties for violations of contractual or other legal obligations.

Liquidated damages are frequently assessed in situations of contract violation, failure to fulfill goods, etc. We will talk about the effect and rates of GST that apply to liquidated damages in this write-up.

Let us first discuss Liquidated Damages so that we can easily understand the notification released by the Central Board of Indirect Taxes and Customs (CBIC).

Meaning of Liquidated Damages

Liquidated damages are an amount specified in a contract to represent an estimate of the actual losses sustained by one party as a result of a particular violation by the other party. Liquidated damages are simply recompensed for contract violations, to put it simply.

Where there has been an intangible loss, liquidated damages are often determined. The amount of compensation required for breach of the contract will be outlined in a provision in the agreement.

For instance, if a seller delays supplying raw materials, causing a manufacturer to lose income, the seller is responsible for paying 0.5% of the revenue lost for each week of delay, up until delivery is made.

GST on Liquidated Damages

The scope of the entry in paragraph 5(e) of Schedule II of the Central Goods and Services Tax Act, 2017, and the application of GST to payments made in the form of liquidated damages, compensation, penalties, cancellation fees, late payment surcharges, etc. resulting from contract violations or other circumstances.

According to the circular from August 3, 2022, “Agreeing to the obligation to refrain from an act, to tolerate an act or a situation, or to perform an act” has been specifically declared to be a supply of service in paragraph 5 (e) of Schedule II of the CGST Act if the same constitutes a “supply” within the meaning of the Act.

According to the circular, “forfeiture of earnest money by a seller in case of breach of ‘an agreement to sell an immovable property by the buyer, or such forfeiture by Government or local authority in the event of a successful bidder failing to act after winning the bid for allotment of natural resources, is a mere flow of money, as the buyer or successful bidder receives nothing in return for such forfeiture of earnest money.” In such circumstances, the forfeiture of earnest money is provided not as consideration for accepting the breach of contract, but as recompense for losses incurred and as a deterrent for discouraging non-serious purchasers or bids. Such payments, as a flow of money, are not a consideration for any supply and are thus not taxed.”

It went on to say that “the amount forfeited in the case of a non-refundable air travel ticket or a security deposit or earnest money forfeited in the event of the customer failing to avail the travel, tour operator, or hotel accommodation service or such other intended supplies should be assessed at the same rate as applicable to the service contract, say air transport or tour operator service, or other such services.”

GST coverage for Liquidated Damages

According to Section 7(1) (d) of the Central Goods and Services Tax (CGST) Act, 2017, Schedule II activities are included in the definition of the term “scope of supply.” According to Schedule II Paragraph (5) (e) above, the definition of supply of services includes “agreeing to the requirement to refrain from an act, or to tolerate an act or a condition, or to do an act.”

Given that the party that has been wronged has put up with the other party’s failure to comply with the contract, it might be assumed that liquidated damages are taxable under GST.

Liquidated damages will be subject to taxation as a service under the GST Act since GST is applicable to the sale of both commodities and services. According to the terms of the contract, the breach would occur at the moment of supply. When a contractor, for instance, fails to finish a building by a certain date and the delay is documented, that is the period of supply.

Input tax credit (ITC) availability and raising the GST invoice for Liquidated Damages

GST paid on liquidated damages can be used as an input tax credit to offset any future tax payment, subject to GST law’s limits and requirements.

The party receiving liquidated damages is required to generate a separate GST invoice for the same.

Key Clarifications regarding the notice on GST on Liquidated Damages

The clarifications regarding the GST on Liquidated Damages are as follows:

• Liquidated damages cannot be regarded as payment made in exchange for tolerating a contract’s violation or non-performance. They are more like compensation for not tolerating the contract violation. Such payments are not taxed since they do not qualify as consideration for a supply.
• A fine for a dishonored check, a fine for breaking the law, the loss of pay, or the recovery of a bond’s value, are not considerations for services and are thus not taxable.
• A facility offered by the supplier that comes naturally with the primary supply is the ability to accept late payments with interest or a charge, close a loan before it is due, and permit the cancellation of an anticipated supply in exchange for a fee. The same should thus be evaluated as the major supply.
• There have been requests for clarity about the taxability of certain commodities and services. As a result, the GST Council’s suggested issue-by-issue explanations have also been given.

The circular no. 178/10/2022-GST, issued August 3, 2022, gives a comprehensive knowledge of numerous such payments. The following is a summary of the same –

Exemption of GST on Liquidated Damages in various cases

• In view of the preceding circular, it has been clarified that GST would not be imposed in the following cases:
• Damages in Liquidation
• Compensation for coal-block cancellation
• Fine/penalty for cheque dishonor
• The penalty imposed for breaking the law
• Pay recovery notice
• Compensation for failure to collect tolls
• Surcharge or fee not paid on time (should be assessed at the same rate as Principal supply)
• Power fixed capacity charges
• Cancellation fees (depends upon nature of supply) 

Case study on the application of GST to Liquidated Damages

Mr. X is a senior partner in the Mumbai-based law firm XYZ and Co. He signed a non-compete agreement with XYZ and Co. that said that when his employment with XYZ and Co. was terminated, he would not establish his own business or join any other rival firm in Mumbai for a period of 12 months. If Mr.X violates this non-compete agreement, he must pay liquidated damages to XYZ and Co.
On January 12, 2021, he chose to leave XYZ and Co. Mr. X joined ABC and Associates, one of XYZ and Co.’s main competitors, on March 3, 2021. As a result, because Mr.X violated the non-compete provision, he is obligated to pay liquidated damages to XYZ and Co., as specified in the agreement.
The violation, which is characterized as a provision of service under Section 7(1) (d) of the CGST Act, Schedule II Para 5 has been allowed by XYZ and Co. (e). As a result, XYZ & Co. must issue a GST invoice to Mr. X for the liquidated damages at the current rate.

Endnote

CBIC clarifications strive to resolve the ambiguity on the taxability of numerous products and services and are anticipated to eliminate needless litigation to a considerable extent. Given the department’s reliance on Circulars, the industry may need to identify concerns where procedures have been commenced by the adjudicating body or where matters are currently in appeal to appellate forums in order to determine the best course of action.

While the circular clarifies the taxability of cancellation costs, it does not appear to have addressed the conditions in which such charges might be viewed as liquidated damages/compensation or payment for the supply of a facility. This might be crucial because of the varied tax treatment in both circumstances.

While the Circular considers early contract termination to be a facility offered and thus a service, a judgment by a larger bench of the Chennai Tribunal concluded that foreclosure charges were in the nature of liquidated damages and hence not subject to service tax. Taxpayers may need to assess the impact of the Circular on the handling of employee recoveries for loss or physical damage to the employer’s assets.

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