Introduction
Cancellation charges and forfeited deposits are common in commercial contracts. A customer may cancel an order, or a lessee may terminate a lease prematurely. The supplier or lessor may retain a portion of the deposit or charge a cancellation fee. The question arises: Are cancellation charges and forfeited deposits subject to GST?
The answer depends on whether the forfeiture is consideration for tolerating an act under Schedule II, Para 5(e) of the CGST Act.
This guide explains the legal framework and the AAR rulings.
Legal Framework: Schedule II, Para 5(e) of the CGST Act, 2017
Tolerating an Act or Situation
Schedule II, 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, or to do an act."
Revenue authorities often argue that where a party receives compensation for tolerating a breach, GST applies. However, this interpretation has been challenged in courts.
The MSETCL AAR Ruling
The Maharashtra State Electricity Transmission Company Ltd. (MSETCL) AAR ruling (April 2025) provides clarity on the taxability of various receipts:
- Liquidated Damages/Penalty for Breach of Contract: Taxable as supply under GST, attracting 18% tax.
- Forfeiture of Earnest Money Deposit: Not taxable, as it does not qualify as supply.
- Write-Back of Unclaimed Creditors' Balances: Not taxable.
- Security Deposit Write-Backs: Not taxable.
The Karnataka High Court Ruling: Krazybee Services
The Karnataka High Court in Krazybee Services Pvt. Ltd. v. DGGI (W.P. No. 16471 of 2024) held that:
- Liquidated damages recovered for breach or delay in contractual obligations are compensatory in nature and do not constitute consideration for any supply under GST.
- The court relied on CBIC Circular No. 178/10/2022-GST, which distinguishes between payments that are the object of a contract and payments that arise because the contract failed.
Taxability of Cancellation Charges
When Taxable
- Cancellation Charges as Consideration for a Service: Where the supplier provides a service — such as the right to cancel — and charges a fee, GST may apply.
- Liquidated Damages for Breach: The MSETCL AAR held that liquidated damages are taxable.
When Not Taxable
- Forfeiture of Earnest Money Deposit: Not taxable as it does not qualify as supply.
- Purely Compensatory Payments: Where the payment is purely compensatory and not linked to any supply.
- Security Deposit Write-Backs: Not taxable.
GST Rate on Cancellation Charges
Where cancellation charges are taxable, they attract 18% GST.
Documentation Required
- Contract Agreement: Documentation of the cancellation terms.
- Forfeiture Order: Documentation of the forfeiture.
- Credit Note: Credit note for the forfeited amount.
- Payment Records: Records of the forfeiture.
Best Practices
- Determine Taxability: Assess whether the forfeiture is taxable under Schedule II, Para 5(e).
- Document the Nature of Payment: Clearly document whether the payment is compensatory or consideration for a service.
- Maintain Records: Document all cancellation charges and forfeitures.
- Seek Professional Assistance: For complex forfeiture arrangements, seek guidance.
Conclusion
Cancellation charges and forfeited deposits are taxable only where they constitute consideration for tolerating an act under Schedule II, Para 5(e). Forfeiture of earnest money deposit is generally not taxable. The Karnataka High Court and AAR rulings provide clarity on this issue.
Charging cancellation fees or forfeiting deposits? Anuj Desai & Associates provides expert guidance on GST taxability. Contact us today.
Contact us:
- Email: office@anujdesaiassociates.com
- Phone: 9619456656
- Website: https://anujdesaiassociates.com
- LinkedIn: linkedin.com/in/ca-anuj-desai-122547230