GST on Liquidated Damages

Liquidated damages are typically levied in cases of breach of contract, failure to perform, non-delivery of supplies, etc. Does payment of liquidated damages attract GST? Indian businesses face a lot of confusion regarding charging GST on liquidated damages such as the penalty paid, compensations, etc. Accordingly, the Ministry of Finance issued a circular no.178/10/2022-GST on 3rd August 2022. 

In this article, we will discuss the meaning of liquidated damages, applicability of GST, the GST Circular 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 Supply definition 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 law. 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.

Decoding GST Circular on Liquidated Damages

The Ministry of Finance issued a circular no. 178/10/2022-GST on 3rd August 2022. The industry raised issues regarding amount of the fine or penalty levied on dishonor of the cheque chargeable to tax, payment of liquidated damages due to contract breached, late payment charges that a service provider collects for any late payment of bills, levy of penalty for contravening laws, and notice pay recovery, etc.

The Circular clarifies the following-

1. ‘Supply of service’ under Para 5 (e) of Schedule II of the CGST Act consists of the following three-
   1. Agreeing to the obligation to refrain from an act
   2. Agreeing to the obligation to tolerate an act or a situation
   3. Agreeing to the obligation to do an act
2. All the above three activities must be bound by “agreement” or a “contract” (whether express or implied).
3. Additionally, some “consideration” must flow in return from the other party to this contract/agreement.
4. GST on specific use cases are clarified as given in the below table-

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.