Clarification on GST applicability on liquidated damages, compensation and penalty arising out of breach of contract or other provisions of law
The Central Board of Indirect Taxes and Customs (CBIC) has issued Circular No 178/2022 dated 3rd August 2022, clarifying the applicability of GST on certain charges/fees/penalty arising out of breach of contract and other cases. The circular has extensively dealt with various scenarios where certain charges/fee/penalty are recovered by one party from another on account of breach of terms of contract.
The term supply includes ”Agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act”. Circular has given examples of activities covered under this –
1. Agreeing to the obligation to refrain from an act – This would include non-compete agreements, where one party agrees not to compete with the other party in a
product, service or geographical area against a consideration paid by the other party. Another examples is activities would be a builder refraining from constructing more
than a certain number of floors, even though permitted to do so by the municipal authorities, against a compensation paid by the neighbouring housing project, which wants to protect its sunlight.
2. Agreeing to the obligation to tolerate an act or a situation – This would include a shopkeeper allowing a hawker to operate from the common pavement in front of his shop against a monthly payment by the hawker.
3. Agreeing to the obligation to do an act – This would include case where an industrial unit agrees to install equipment for zero emission/discharge at the behest of the RWA of a neighbouring residential complex against a consideration paid by such RWA, even though the emission/discharge from the industrial unit was within permissible limits and there was no legal obligation upon the individual unit to do so.
So the intention was to cover services as described in examples give above.
Agreement to do or refrain from an act should not be presumed to exist. There should be an express or implied promise by the recipient of money to agree to do or abstain from doing something in return for the money paid to him. Payment has to be made for an independent activity of tolerating an act under an independent arrangement entered into for such activity of tolerating an act, unless such payments will not constitute ‘consideration’.
In light of above circular clarified that GST will not be applicable in below cases :
- Liquidated Damages
- Compensation for cancellation of coal blocks
- Cheque dishonor fine/penalty
- Penalty imposed for violation of law
- Notice Pay recovery
- Compensation for not collecting toll charges
- Late payment of surcharge or fee (should be assessed at the same rate as Principal supply)
- Fixed Capacity charges for power
- Cancellation charges (depends upon nature of supply)
Copy of circular is attached herewith.
CBIC Circular 178/10/2022-GST largely settled this issue. Key principles.
Liquidated damages and penalties for breach of contract are NOT subject to GST when they represent compensation for non-performance (the party receiving compensation is not providing any service in exchange). The recipient of the penalty is not tolerating anything, they are receiving restitution for loss.
However, GST DOES apply if the payment is consideration for tolerating an act or situation. Classic examples where GST applies:
– Non-compete fees (paying someone to not compete = they are tolerating a restriction on their business activity)
– Notice pay recovery (employer receives payment for tolerating early exit from employment)
– Spectrum cancellation charges where the operator gets to retain the spectrum for some period
Where GST does NOT apply based on the Circular:
– Construction delay penalty received by client from contractor
– Forfeiture of advance for buyer default (no service rendered)
– Penalty for not meeting minimum offtake in supply agreements
– Cancellation charges where no service will be performed
One grey area still in dispute: bank charges for early pre-payment of loans. Banks take the position this is service consideration; borrowers argue it is a penalty for prepayment. The matter is before various advance ruling authorities with divergent outcomes.