GST On Liquidated Damages, Compensation And Penalty Arising Out Of Breach Of contract: CBIC

There has to be an express or implied agreement, oral or written, to do or abstain from doing something against payment of consideration for doing or abstaining from such an act for a taxable supply to exist. An agreement to do an act or abstain from doing an act or to tolerate an act or a situation cannot be imagined or presumed to exist just because there is a flow of money from one party to another.

Unless there is an express or implied promise by the recipient of money to agree to do or abstain from doing something in return for the money paid to him, it cannot be assumed that payment was for doing an act or for refraining from an act or for tolerating an act or situation. Payments such as liquidated damages for breach of contract, penalties under the mining act for excess stock found with the mining company, forfeiture of salary or payment of amount as per the employment bond for leaving employment before the minimum agreed period, penalty for cheque dishonour, etc. are not a consideration for tolerating an act or situation.

They are rather sums recovered for refusing to tolerate an act or situation and for deterring acts; such sums are for preventing breach of contract or non-performance and are thus merely "events" in a contract.The amounts do not constitute payment (or consideration) for tolerating an act, because there cannot be any contract for breach, or for holding more stock than permitted under the mining contract, or for leaving the employment before the agreed minimum period, or for doing something leading to the dishonour of a cheque. Unless payment has been made for the independent activity of tolerating an act under an independent arrangement entered into for the purpose of tolerating an act, payments will not constitute "consideration" and hence such activities will not constitute "supply."

If a payment constitutes a consideration for a supply, then it is taxable irrespective of what name it is called. It must be remembered that a "consideration" cannot be considered de hors an agreement/contract between two people wherein one person does something for another and the other pays the first in return. If the payment is merely an event in the course of the performance of the agreement and it does not represent the "object" of the contract, then it cannot be considered "consideration".

A contract, for example, may state that payment for goods or services must be made before a certain date, and that failure to make payment by the due date will result in a late fee or penalty.A contract for passenger transportation may state that the ticket amount will be partially or entirely forfeited if the passenger fails to appear.A contract for a package tour may stipulate forfeiture of a security deposit in the event of cancellation of the tour by the customer. Similarly, a contract for the lease of movable or immovable property may state that the lessee may not terminate the lease before a certain period and that if he does, he must pay an early termination fee or penalty.

Some banks similarly charge a prepayment penalty if the borrower wishes to repay the loan before the maturity of the loan period. Such amounts paid for acceptance of late payment, early termination of lease or for pre-payment of loan or the amounts forfeited on cancellation of service by the customer as contemplated by the contract as part of commercial terms agreed to by the parties, constitute consideration for the supply of a facility, namely, acceptance of late payment, early termination of a lease agreement, pre-payment of loan, and making arrangements for the intended supply by the tour operator, respectively.

Therefore, payments, even though they may be referred to as fines or penalties, are actually payments that amount to consideration for supply and are subject to GST in cases where supply is taxable. If supplies are ancillary to the principal supply for which the contract is signed, they shall be eligible to be assessed as the principal supply. Naturally, the payments will not be taxable if the principal supply is exempt.

No supplier wants a cheque given to him to be dishonoured. It entails extra administrative cost to him and disruption of his routine activities and cash flow. The promise made by any supplier of goods or services is to make supply against payment within an agreed time through a valid instrument. There is never an implied or express offer or willingness on the part of the supplier that he would tolerate deposit of an invalid, fake or unworthy instrument of payment against consideration in the form of a cheque dishonour fine or penalty. The fine or penalty that the supplier or a banker imposes for dishonour of a cheque is a penalty imposed not for tolerating the act or situation but a fine or penalty imposed for not tolerating, penalising, and discouraging an act or situation. Therefore, a cheque dishonour fine or penalty is not a consideration for any service and is not taxable.

"It was also clarified vide Circular No. 192/02/2016-Service Tax, dated 13.04.2016 that fines and penalties chargeable by the government or a local authority imposed for violation of a statute, bye-laws, rules or regulations are not leviable to Service Tax. The same holds true for GST also," the circular read.

The facility of accepting late payments with interest or late payment fee, fine or penalty is a facility granted by a supplier naturally bundled with the main supply. It is not uncommon or unnatural for customers to sometimes miss the last date of payment for electricity, water, telecommunication services, etc. Almost all service providers across the world provide the facility of accepting late payments with a late fine or penalty. Even if the service is described as a service of tolerating the act of late payment, it is an ancillary supply naturally bundled and supplied in conjunction with the principal supply, and therefore should be assessed as the principal supply. Since it is ancillary to and naturally bundled with the principal supply, such as electricity, water, telecommunication, cooking gas, insurance, etc., it should be assessed at the same rate as the principal supply.

The facilitation of allowing cancellation of an intended supply against payment of a cancellation fee or retention or forfeiture of a part or whole of the consideration or security deposit in such cases should be assessed as the principal supply. For example, cancellation charges of railway tickets for a class would attract GST at the same rate as applicable to the class of travel (i.e., 5% GST on first class or air-conditioned coach tickets and nil for other classes such as second sleeper class). It applies to air travel.

The circular read: "Field formations are advised that while the taxability in each case shall depend on the facts of that case, the above guidelines may be followed in determining whether tax on an activity or transaction needs to be paid by way of agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act."

Circular No. 178/10/2022-GST

Dated: 03.08.2022

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