Liquidated Damages and GST: Karnataka High Court Clarifies Non-Taxability

If you’ve ever wondered whether liquidated damages, penalties, or compensation clauses in contracts attract GST, you’re not alone. This issue has been a recurring pain point for businesses, especially after tax authorities began classifying such receipts as consideration for “tolerating an act”.

Krazybee Services Pvt. Ltd. v. DGGI –  judgment clarified the matters forever considering the practical approach rather then opting revenue approach.

The Karnataka High Court, in W.P. No. 16471 of 2024, has now stepped in with a clear, taxpayer-friendly interpretation, firmly grounded in the CGST Act, 2017 and CBIC Circular No. 178/10/2022 dated 03.08.2022.

Facts in simple terms

Krazybee Services Pvt. Ltd., a Non-Banking Financial Company (NBFC), had entered into a Framework / Master Service Agreement with certain Lending Service Providers (LSPs).

Under the agreement:

• LSPs were required to meet specific performance and compliance standards.
• Any breach or failure triggered pre-agreed compensation, labelled as liquidated damages.

The DGGI issued a Show Cause Notice, alleging that:

• These receipts were actually “deficiency service fees”
• They amounted to consideration for tolerating an act, taxable under Para 5(e) of Schedule II of the CGST Act

Krazybee challenged the notice before the High Court.

Core legal question

Does compensation received for breach of contract (liquidated damages) amount to a “taxable supply” under GST?

GST law framework – explained conversationally

1. What is a “supply” under GST?

Under Section 7 of the CGST Act, 2017, GST applies only when there is:

• A supply
• For consideration
• In the course or furtherance of business

If any one of these elements is missing, GST fails.

2. The department’s favourite weapon: Schedule II, Para 5(e)

Para 5(e) treats the following as a supply of services:

“Agreeing to the obligation to refrain from an act, or to tolerate an act or a situation”

Revenue authorities often argue:

“If you received money because someone failed to perform, you tolerated it—so GST applies.”

But is that interpretation always correct? The High Court says NO.

CBIC Circular No. 178/10/2022 – the game changer

The Court heavily relied on Paragraphs 7.1 to 7.1.6 of this circular.

What the circular actually clarifies

The circular draws a crucial distinction between:

1. Payments that are the object of a contract, and

2. Payments that arise only because the contract failed

Liquidated damages fall into the second category.

Understanding Liquidated Damages (without legal jargon)

Contract Act connection

• Section 73, Indian Contract Act, 1872 → compensation for loss due to breach
• Section 74 → pre-agreed compensation (liquidated damages)

These payments:

• Are compensatory
• Do not reward any service
• Merely attempt to put the injured party back in the same position

Real-life example

Imagine this:

• A logistics company promises delivery within 24 hours
• Contract says ₹1,00,000 payable if delivery is delayed
• Delay happens, and compensation is paid

Did the customer hire the logistics company to delay delivery?

Was there an agreement to “tolerate” delay as a service?

Obviously not.

The delay was a failure, not a supply.

What the High Court held

1. Liquidated damages ≠ consideration

The Court observed that:

• Liquidated damages are not the objective of the contract
• They are triggered only when the contract breaks down

As clarified in Para 7.1.6 of the Circular, unless the payment is linked to a conscious supply, it cannot be treated as consideration.

2. No “tolerating an act” arrangement

The Court rejected the department’s argument that Krazybee:

• Agreed in advance to tolerate deficiencies

Instead, it held:

A clause meant to deter breach cannot be re-characterised as a taxable service.

3. Circulars are binding on the department

Once CBIC itself clarifies that liquidated damages are not taxable, officers cannot selectively rely on other paragraphs while ignoring the specific ones that apply.

Practical implications for businesses

When GST will NOT apply

Compensation for breach
Liquidated damages
Penalties for non-performance
Contractual damages with no underlying service

When GST MAY apply

Early termination fees

Cancellation charges forming part of pricing

Late payment charges where facility is consciously provided

The key test is intent and object of the contract, not the label.

GST is a tax on supplies—not on failures.

If money changes hands because a contract collapsed, and not because a service was provided, GST has no role to play.

Important GST provisions discussed