1. GST on Liquidated Damages (LD) remains a grey area, despite various clarifications issued over time. While many believed that the matter had been settled through CBIC circulars and judicial precedents, taxpayers across sectors are still receiving GST notices demanding tax on LD amounts. The department, at the time of the audit, raised unreasonable demands for tax along with interest and penalty on the liquidated damages, causing anxiety and uncertainty. Taxpayers are confused.
2. This article aims to analyse the reasons behind the ongoing ambiguity and provide insights into how businesses can effectively address such notices.
3. The core issue revolves around the interpretation of Section 5(e) of Schedule II of the CGST Act, which classifies the act of agreeing to refrain from an act, tolerate an act or a situation, or perform an act as a supply of service.
This provision has often been used by tax authorities to levy GST on payments such as liquidated damages, cancellation charges, and penalty recoveries, which has resulted in widespread litigation.
4. To address this ambiguity, a retrospective amendment was made to Section 7 of the CGST Act in 2019, effective from 07.2017, which clarified that Schedule II only helps classify a supply as goods or services, but does not determine whether a transaction is a supply in the first place.
Paragraph 5(e) of Schedule II, when read with Section 7(1A) of the CGST Act, cannot by itself be used to treat liquidated damages as a supply of services. The Schedule II is operative only after an activity is determined to be a “supply. It cannot independently deem liquidated damages as taxable. Accordingly, GST should not be applicable on liquidated damages that are purely compensatory in nature.
5. Further, CBIC Circular No. 178/10/2022-GST, dated 03 August 2022, clearly stated that liquidated damages, penalty, or fines paid merely as a deterrent or compensation for breach of contract, without any intention of tolerating such breach, do not constitute a supply and hence are not liable to GST.
The circular clearly lays down the principle that the description in Para 5 (e) is similar to the definition of contract under the Contract Act, 1872. This goes on to show that there should be an agreement or contract (express or implied) to supply the service of agreeing to the obligation to refrain from an act or service to tolerate an act or a situation.
The CBIC Circular made the things clear that GST will not apply to the Liquidated Damages as there is no consideration involved and thus there is no supply.
6. However, despite the retrospective amendment and the clarificatory Circular No. 178/10/2022-GST, tax authorities have not entirely refrained from issuing notices demanding GST along with interest and penalties on such transactions. In many cases, these notices appear to disregard the circular’s intent and legal position, and are routinely issued.
7. Fortunately, in certain cases, the Hon’ble Courts have stepped in to address such overreach by the tax authorities. In the case of M/s Aavanti Solar Energy (P.) Ltd. v. Joint Commissioner of Central Tax, Bengaluru (2024), the Hon’ble Karnataka High Court set aside the demand order that had been issued without considering CBIC Circular No. 178/10/2022-GST. The Court remitted the matter back to the authorities for reconsideration, emphasizing the necessity of adhering to the statutory provisions and binding clarifications issued by the CBIC
8. The issue of taxability of liquidated damages has remained debatable since the erstwhile Service Tax regime. The tax authorities often attempted to levy service tax by treating LD as a service of “agreeing to tolerate an act,” similar to the current GST stance under Section 5(e) of Schedule II.
9. However, CESTAT has consistently taken a favourable view in multiple cases, holding that liquidated damages are in the nature of compensation for breach of contract and not a consideration for any service.
In case of South Eastern Coalfields Ltd. v. Commissioner of CGST & Central Excise, Raipur [2020 (43) G.S.T.L. 209 (Tri. – Del.)], the Hon’ble Tribunal held that the recovery of liquidated damages for breach of contractual terms does not amount to a declared or taxable service, and hence, no service tax was payable.
The Hon’ble Tribunal, in case of Bharat Dynamics Ltd. (BDL) v. Commissioner of Service Tax, Hyderabad (Final Order No. A/31084/2022, dated 15.03.2022 – CESTAT Hyderabad), ruled that the amount recovered by BDL towards delay in delivery by vendors is in the nature of compensation and not towards any service rendered by the vendors. Hence, such amounts cannot be subjected to service tax under the category of “tolerating an act”. The Tribunal further emphasized that for a service to be taxable, there must be a clear agreement to tolerate an act for consideration, which was not present in the case.
10. There have been contradictory and inconsistent rulings by various Advance Ruling Authorities (AARs) on the issue of whether GST is leviable on liquidated damages (LD). While some rulings recognized LD as compensatory in nature and thus non-taxable, several AARs—particularly prior to the issuance of Circular No. 178/10/2022-GST—held that GST was applicable, treating such payments as consideration for “agreeing to tolerate an act
11. Post-issuance of Circular No. 178/10/2022-GST, the legal position has become more settled — GST is not leviable on liquidated damages when such payments are purely compensatory in nature and not made as consideration for any underlying supply of goods or services. This view has been consistently upheld in various judicial pronouncements. Some of the rulings supporting this interpretation are outlined below for reference.
In a significant relief for public sector undertakings and government entities, the Maharashtra Authority for Advance Ruling (AAR) has ruled that liquidated damages and penalties collected by M/s Maharashtra State Electricity Transmission Company Ltd. (MSETCL) are not subject to GST. The ruling was delivered on 28nd April 2025 under Order No. GST-ARA-31/2024-25/B-208.
The Maharashtra AAR has reaffirmed that contract enforcement measures like penalties, forfeitures, and write-backs are not services and hence do not attract GST. This ruling provides much-needed clarity and relief to government bodies, PSUs, and large infrastructure companies frequently dealing with such contractual deductions.
For businesses, this ruling offers a guideline to ensure that only genuine contractual damages are kept outside GST, while payments made under mutual arrangements or commercial tolerances should be carefully evaluated for tax implications.
In the case of Reserve Bank of India , the AAR Maharashtra(2024) ruled that penalties, late fees, penal interest, and fines levied and collected by the RBI for contravention or violation of statutory provisions are not subject to GST, as such charges are not consideration for any supply. Furthermore, the AAR clarified that penalties imposed by RBI on third-party vendors for non-performance or under-performance under contractual agreements are also not taxable under GST, since these are in the nature of compensatory payments and not linked to any supply of goods or services.
12. Taxpayer’s Course of Action upon receiving a GST Notice on LD. If a taxpayer receives a GST notice demanding tax and interest on liquidated damages, it is important to stay calm and respond strategically.
The first step is to examine the facts — whether the LD was genuinely compensatory for breach or non-performance of a contract, or whether it involved a specific agreement to tolerate an act, which could be taxable.
If the LD is compensatory in nature, the taxpayer can strongly rely on CBIC Circular No. 178/10/2022-GST, which clearly states that such payments are not consideration for a supply and hence not taxable. Further support lies in the retrospective amendment to Section 7 of the CGST Act (via Finance Act, 2019), which clarified that Schedule II does not define whether a transaction is a supply, but only classifies it as goods or services.
13. In response to the notice, the taxpayer should submit a detailed reply, citing relevant clauses of the contract, nature of the LD, and quoting the CBIC circular and statutory amendment.
14. If the demand proceeds further, legal recourse through appellate forums may be necessary. Maintaining proper documentation and obtaining professional legal or tax counsel can be crucial in successfully defending such cases.
Disclaimer: The article is for educational purposes only.
The author may be approached at caanitabhadra@gmail.com
Author Bio
