GST applicability on liquidated damages, compensation and penalty arising out of breach of contract or other provisions of law

The Ministry of Finance, Department of Revenue vide Circular No. 178/10/2022-GST dated August 03, 2022 has inter-alia observed and clarified that-

1. the service of agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act is nothing but a contractual agreement;
2. a contract to do something or to abstain from doing something cannot be said to have taken place unless there are two parties, one of which expressly or impliedly agrees to do or abstain from doing something and the other agrees to pay consideration to the first party for doing or abstaining from such an act;
3. there must be a necessary and sufficient nexus between the supply (i.e. agreement to do or to abstain from doing something) and the consideration;
4. 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;
5. one of the parties must be under a contractual obligation to either (a) refrain from an act, or (b) to tolerate an act or a situation or (c) to do an act for the purpose of falling under entry at serial 5(e) of Schedule II. Further some “consideration” must flow in return from the other party to this contract/agreement (the second party) to the first party for such (a) refraining or (b) tolerating or (c) doing;
6. liquidated damages cannot be said to be a consideration received for tolerating the breach or non-performance of contract as payment of liquidated damages is stipulated in a contract to ensure performance and to deter non-performance, unsatisfactory performance or delayed performance.
7. the recovery by the employer by way of forfeiture of salary or recovery of bond amount in the event of the employee leaving the employment before the minimum agreed period is not a consideration for tolerating the act but as penalties for dissuading the non-serious employees from taking up employment and to discourage and deter such a situation.

It has been advised to the field formations that while the taxability in each case shall depend on facts of that case and the guidelines issued may be followed for determining whether tax on an activity or transaction needs to be paid treating the same as service 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.

Related Document:- Circular dated August 03,2022

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