Understanding GST Implications on Liquidated Damages in India
This article explores the Goods and Services Tax (GST) implications on liquidated damages in India, clarifying their definition and the conditions under which they attract GST. It details insights from Ministry of Finance Circular No. 178/10/2022-GST, distinguishing between taxable and non-taxable scenarios. Additionally, it outlines applicable GST rates, invoicing responsibilities, and the availability of Input Tax Credit for such payments.
Liquidated damages are typically imposed when a contract is breached, supplies are not delivered, or performance fails. A common query among Indian businesses is whether Goods and Services Tax (GST) applies to such payments, including penalties and compensations. To address this, the Ministry of Finance issued Circular No. 178/10/2022-GST on August 3, 2022. This article clarifies the definition of liquidated damages, their GST applicability, the impact of the GST Circular, and the relevant GST rates.
What Constitutes Liquidated Damages?
Liquidated damages refer to a predetermined sum outlined in a contract. This amount is an estimate of the actual loss one party incurs due to a specific breach by the other party. Essentially, these damages serve as compensation for contractual non-compliance. They are commonly determined in situations where the exact financial loss is difficult to quantify. A contract clause usually specifies the payment required in case of a failure to perform contractual obligations.
For instance, if a seller delays raw material delivery, causing revenue loss for a manufacturer, the contract might stipulate that the seller must pay 0.5% of the lost revenue for each week of delay until delivery is complete.
GST Applicability on Liquidated Damages
Under Section 7(1)(d) of the Central Goods and Services Tax (CGST) Act, the scope of supply includes activities mentioned in Schedule II. Specifically, Paragraph 5(e) of Schedule II states that "agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act" falls under the definition of service supply.
Therefore, it can be inferred that liquidated damages might be taxable under GST, particularly if the aggrieved party is deemed to have tolerated the other party's non-performance as per the contract. Since GST applies to the supply of goods and services, liquidated damages can be treated as a service under GST law. The time of supply would be the moment the breach occurs, as defined in the contract. For example, if a contractor fails to complete construction by a specified deadline, the time of supply is established once the delay is confirmed.
Understanding the GST Circular on Liquidated Damages?
On August 3, 2022, the Ministry of Finance issued Circular No. 178/10/2022-GST. This circular aimed to clarify various industry concerns regarding the taxability of fines or penalties, such as those for cheque dishonor, liquidated damages due to contract breaches, late payment charges, penalties for violating laws, and notice period recovery.
The Circular provides the following clarifications:
- A "supply of service" under Paragraph 5(e) of Schedule II of the CGST Act encompasses three scenarios:
- Agreeing to the obligation to refrain from an act.
- Agreeing to the obligation to tolerate an act or a situation.
- Agreeing to the obligation to do an act.
- All three activities must be established by an "agreement" or "contract," whether express or implied.
- Furthermore, a "consideration" must flow from the other party in return for this contract/agreement.
- GST applicability for specific situations is clarified in the table below:
| Type of Payment | GST Applicable? | Reasoning |
|---|---|---|
| Liquidated damages | Depends | Under Section 74 of the Indian Contract Act, 1872, such damages must be reasonable and not exceed the stipulated amount. These payments are meant to deter breaches and ensure performance, not to compensate for tolerating an act. Generally, they are not taxable if they solely compensate for loss without any underlying supply. However, if the payment acts as consideration for tolerating or enabling an act (e.g., late fees or early termination charges), it is taxable as a supply under GST. |
| Cheque dishonor penalty or fine | No | This penalty is not considered a payment for any service, hence it is not taxable. |
| Penalty for violating laws | No | Laws are not created to allow their violation. Similar to service tax law, fines or penalties for legal violations are not taxable under GST. |
| Late payment/surcharge/fee | Yes | This is naturally bundled with the primary supply, and GST applies at the rate of the principal supply. |
| Cancellation charges/late payment with interest or fee | Yes | This is naturally bundled with the primary supply, and GST applies at the rate of the principal supply. |
| Forfeiture of earnest money | No | Forfeiture of earnest money compensates for the loss suffered due to contract breach and is not for tolerating the breach itself. |
GST Rate on Liquidated Damages?
Liquidated damages are subject to GST as follows:
| Chapter Heading | Description | Rate |
|---|---|---|
| 9997 | Other services | 18% |
| 9991 or 9997 | Services provided by the Central Government, state government, Union Territory, or local authority for tolerating the non-performance of a contract, where consideration in the form of fines or liquidated damages is paid to them under such contract | Nil |
Who Should Issue the GST Invoice for Liquidated Damages?
The party receiving the liquidated damages is responsible for issuing a separate GST invoice for the amount.
Input Tax Credit (ITC) Availability on Liquidated Damages?
GST paid on liquidated damages can be utilized as input tax credit to offset future tax liabilities, provided it adheres to the restrictions and conditions specified under GST law.
Case Study: GST on Liquidated Damages Example?
Consider Mr. X, a senior lawyer at XYZ and Co., a Mumbai-based legal firm. Upon termination of his employment, he entered a non-compete agreement with XYZ and Co., stipulating that he would not establish his own firm or join a competitor in Mumbai for 12 months. Should Mr. X breach this agreement, he would be liable to pay liquidated damages to XYZ and Co.
Mr. X resigned from XYZ and Co. on January 12, 2021. On March 3, 2021, he joined ABC and Associates, a major competitor of XYZ and Co. By breaching the non-compete clause, Mr. X became obligated to pay liquidated damages as per the agreement. Since XYZ and Co. tolerated this breach, which is categorized as a supply of service under Section 7(1)(d) of the CGST Act, Schedule II, Paragraph 5(e), XYZ and Co. must issue a GST invoice to Mr. X for the liquidated damages at the prevailing applicable rate.