Introduction
Liquidated damages (LD) are pre-agreed compensation payable for breach of contract. A supplier may delay delivery; a contractor may fail to meet quality standards. The question arises: Are liquidated damages subject to GST?
The Karnataka High Court has recently provided clarity on this issue, holding that liquidated damages for breach of contract are not taxable as they are compensatory in nature. This guide explains the legal framework and the judicial precedents.
Legal Framework: Section 7 and Schedule II of the CGST Act, 2017
Supply Requires Consideration
Under Section 7, GST applies only where there is a supply for consideration in the course or furtherance of business. If any element is missing, GST does not apply.
Tolerating an Act Under Schedule II, Para 5(e)
Schedule II, Para 5(e) treats "agreeing to the obligation to refrain from an act, or to tolerate an act or a situation" as a supply of services. Revenue authorities often invoke this provision to tax liquidated damages.
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.
- They 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.
The CBIC Circular No. 178/10/2022-GST
The circular clarifies that:
- Payments that are the object of a contract: Taxable.
- Payments that arise because the contract failed: Not taxable.
Liquidated damages fall into the second category — they are a consequence of a breach, not a supply.
The MSETCL AAR Ruling
The Maharashtra AAR in the MSETCL case held that liquidated damages for breach of contract are taxable as supply under GST, attracting 18% tax. This creates a divergence with the Karnataka High Court ruling. The matter may ultimately be resolved by the Supreme Court.
GST Rate on Liquidated Damages
Where liquidated damages are held to be taxable, they attract 18% GST.
Documentation Required
- Contract Agreement: Documentation of the liquidated damages clause.
- Breach Documentation: Documentation of the breach.
- Payment Records: Records of the liquidated damages payment.
Best Practices
- Determine Taxability: Assess whether the liquidated damages are compensatory or consideration for a supply.
- Document the Nature of Payment: Clearly document whether the payment is compensatory.
- Maintain Records: Document all liquidated damages transactions.
- Seek Professional Assistance: Given the divergence in rulings, seek professional guidance.
Conclusion
Liquidated damages for breach of contract are generally not taxable as they are compensatory in nature. The Karnataka High Court has provided a taxpayer-friendly interpretation. However, the MSETCL AAR has taken a contrary view. Given the divergence, professional guidance is essential.
Dealing with liquidated damages? Anuj Desai & Associates provides expert guidance on GST taxability. Contact us today.
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