GST on Liquidated Damages

Liquidated damages are typically levied in cases of breach of contract, failure to perform, non-delivery of supplies, etc. In this article, we will discuss the impact and rates of GST applicable on liquidated damages.

What are liquidated damages?

Liquidated damages refer to an amount stipulated in a contract, to estimate the actual damages incurred by one party for a specific breach by the other party. In simple words, liquidated damages are nothing but compensation for breaching a contract.

Liquidated damages are usually ascertained where the loss is intangible. A clause in the contract will specify the amount of money that needs to be paid for failure to perform under the contract.

For example, in case of a delay in the supply of raw materials by a seller, thereby leading to a loss of revenue by a manufacturer, the seller is obligated to pay 0.5% of the revenue lost for each week of delay, until the delivery has been made.

Applicability of GST on liquidated damages

As per the Central Goods and Services Tax (CGST) Act, Section 7(1)(d), the Scope of Supplydefinition includes activities referred to in Schedule II of the Act. Schedule II Para (5)(e) thereon specifies that “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act” comes under the definition of supply of services.

Hence, it can be inferred that liquidated damages are taxable under GST, based on the premise that the aggrieved party has tolerated the non-performance of the other party under the contract.

As GST applies to the supply of goods and services, liquidated damages will be taxable as a service under the GST Act. The time of supply would be the point in time when the breach happens, as defined in the contract. For example, the time of supply will be the point in time when a contractor fails to complete construction within a specified date, and the delay has been established.

Rate of GST on liquidated damages

Liquidated damages will be liable to GST as follows:

Who shall raise the GST invoice for liquidated damages?

The party collecting the liquidated damages is obligated to raise a separate GST invoice for the same. 

Availability of input tax credit (ITC) on liquidated damages

GST paid on liquidated damages can be utilised as an input tax credit in setting off any future tax liability, subject to the restrictions and conditions imposed under GST law.

Case study of GST applicability on liquidated damages

Mr X is a lawyer and senior partner at XYZ and Co., a legal firm based in Mumbai. He entered into a non-compete agreement with XYZ and Co., post-termination of employment with XYZ and Co., for 12 months, he would not set up his firm or join any other competitor firm in Mumbai. In case Mr.X breaches this non-compete agreement, he would be required to pay liquidated damages to XYZ and Co.

He decided to quit his job at XYZ and Co. on 12th January 2021. On 3rd March 2021, Mr X joined ABC and Associates, one of XYZ and Co.’s biggest competitors. Hence, as Mr.X has breached the non-compete clause, he is liable to pay liquidated damages to XYZ and Co., as stipulated in the agreement.

XYZ and Co. have tolerated the breach, which is defined as a supply of service under Section 7(1)(d) of the CGST Act, Schedule II Para 5(e). Hence, XYZ and Co. will need to issue a GST invoice to Mr X for the liquidated damages at the applicable rate in force.