In simple terms, a ‘Contract’ is an agreement entered between the parties creating mutual obligations enforceable by law. Accordingly, as and when one party fails to deliver according to the terms of the contract, the same is termed as a ‘Breach of Contract’. Article thoroughly explain on GST applicability, liquidity damages and more on breach of contract section 73 and 74.
It goes without saying that every breach of contract entitles the suffering party to claim damages or losses so suffered. The amount so paid on account of breach of contract is referred to as liquidated damages or compensation or penalty or late payment surcharge or cancellation charges etc.
Taxability of such amounts paid on account of breach of contract (i.e. liquidated damages/ cancellation charges/ penalty/ etc.) has been a subject matter of debate under GST. Fortunately, detailed clarification on the applicability of GST on the same has recently been provided by the Government of India, vide circular no. 178/10/2022-GST dated 3rd August 2022.
The present article covers the background and treatment of amounts paid due to breach of contract; GST applicability on amounts paid due to breach of contract vis-à-vis scope of para 5(e) of schedule II; detailed clarification on liquidated damages and also other relevant payments as covered vide circular no. 178/10/2022-GST dated 3rd August 2022.
Read for More:
Penalties under GST | Precautionary List to Avoid Penalties to a Maximum Extent
What is Breach of contract under GST
The debate regarding the applicability of GST on amounts paid on account of breach of contract has obviously taken up the face of litigation. Referring to the latest advance ruling pronounced by Andhra Pradesh AAR, in the matter of Rashtriya Ishpat Nigam Ltd., we can conclude as under
- Liquidated damages are supply of service;
- GST is applicable on the amount of liquidated damages in terms of para 5(e) of Schedule II of the Central Goods and Services Tax Act, 2017;
- Sr. no. 35 of notification no. 11/2017- Central Tax (Rate) dated 28th June 2017 will cover the levy of GST on liquidated damages. Accordingly, it will be classified under heading 9997 and 18% GST [9% CGST + 9% SGST] will be leviable on the same.
On account of such controversial judgements, there was a lot of hue and cry amongst the trade and industry with regard to the applicability of GST in case of such liquidated damages/ fine/ penalty. Thus, circular no. 178/10/2022-GST dated 3rd August 2022 came as a ray of hope.
Read for More:
GST applicability on amounts paid due to breach of contract
According to para 5(e) of Schedule II of the Central Goods and Services Tax Act, 2017, ‘Agreeing to the obligation to refrain from an act or to tolerate an act/ a situation or to do an act’ is the supply of services. Let us understand the said phrase by dividing the same into the following three limbs
Limbs of para 5(e) of Schedule II | Corresponding examples |
|---|---|
Agreeing to the obligation to refrain from the act |
|
Agreeing to the obligation to tolerate an act/ a situation |
|
Agreeing to the obligation to do an act |
|
Read More on:
Accordingly, in terms of para 5(e) of Schedule II, the transaction can be stated as ‘supply of service’ if the following criteria are satisfied
- One of the parties must be under a contractual obligation to-
- Agreeing to refrain from an act; or
- Agreeing to tolerate an act/ situation; or
- Agreeing to do an act.
- Some amount (i.e. consideration) must flow in return for refraining/ tolerating/ doing an act.
- It must be an independent arrangement in its own right, express or implied.
- The agreement/ arrangement can take the form of an independent contract or may form part of another contract.
In this regard, some important clarification as provided vide circular no. 178/10/2022-GST dated 3rd August 2022 are highlighted hereunder –
- Simply because there is a flow of money from one party to another party, it cannot be imagined or presumed that there is an agreement to do an act/ abstain from doing an act/ tolerate an act.
- Following payments are not a consideration for tolerating an act or a situation. These are mere events in a contract –
- Liquidated damages due to the breach of contract;
- Penalty for the dishonor of cheque;
- Forfeiture of salary/ payment of an amount for leaving employment before completion of minimum agreed period;
- Penalty as per the mining act for excess stock found with the mining company; etc.
Penalties under GST is very common problem through this video understand how business can suffer.
GST Applicability on Liquidated Damages
As per section 73 of the Indian Contract Act, 1872, when the contract is breached/ broken, the suffering party is entitled to receive compensation for any loss/ damage caused to him on account of such breach. Such an amount is generally termed as ‘liquidated damages’.
It is important to note here that the compensation so paid on account of breach of contract is not by way of consideration for any other independent activity. It is just an event in the course of the performance of the contract.
The dictionary meaning of the term ‘Liquidated damages’ is ‘an amount contractually stipulated as a reasonable estimation of the actual damages to be recovered by one party if another party breaches’.
Now, let us figure out the applicability of GST in case of liquidated damages in the below tableGST applicability | Reasons |
|---|---|
Doesn’t qualify as supply and hence not taxable under GST | The contract is entered between two parties for execution and not for its breach. Accordingly, liquidated damages are not desired outcome of any contract.
|
Qualify as supply and taxable under GST | Any payment, by whatever name called, if constitutes a consideration for a supply, then, the same will be taxable under GST. For example, amounts paid for –
|
Summing up the important clarifications with regard to ‘liquidated damages’ based on which it can be concluded that ‘liquidated damages’ don’t constitute consideration for a supply and hence are not taxable under GST
- It is a measure of loss/ damage that the contracting parties agrees. Such loss/ damage will arise only on account of breach of contract.
- It cannot be said to be a consideration against the non-performance of the contract or tolerating the breach.
- It doesn’t act as a remedy for the breach of contract.
- It is not the desired outcome of the contract.
However, it is also clarified that if any payment constitutes a consideration for a ‘supply’, then, the same will be taxable under GST.
The following flowchart provides the thumb rule answering which one can easily figure out the GST applicability in case of liquidated damages –
Which Types of Payments are Taxable under GST
After briefing going through the GST applicability in case of liquidated damages, let us quickly go through the clarifications as provided vide the above referred circular with regard to other similar payments in the below table
Types of payments | GST applicability | Reason |
|---|---|---|
Compensation for cancellation of coal blocks | Not taxable under GST |
|
Cheque dishonor fine/ penalty | Not taxable under GST |
|
Penalty imposed for violation of laws | Not taxable under GST |
|
Forfeiture of salary/ payment of bond amount when the employee leaves the employment prior to completion of the minimum agreed period | Not taxable under GST |
|
Late payment surcharge/ fee | Taxable under GST |
|
Fixed capacity charges for power | Exempt from GST |
|
Cancellation charges | Taxable under GST |
|
File your GST returns in minutes, not hours!
Get Live Demo and experience the simplicity by yourself.