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

The Central Board of Indirect Taxes and Customs (CBIC) has recently provided crucial clarity on the application of GST concerning liquidated damages, compensation, and penalties arising from breaches of contract or legal provisions via Circular No. 178/10/2022 dated 3rd Aug 2022.

This clarification sheds light on the categorization of activities falling under the scope of "Agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act." This article delves into the nuances of CBIC`s guidance, dissecting its impact on the GST landscape and offering insights into the taxation of contractual obligations and consequences.

Agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act” has been specifically declared to be a supply of service in para 5 (e) of Schedule II of CGST Act if the same constitutes a “supply” within the meaning of the Act. The said entry has 3 components:

1. Agreeing to the obligation to refrain from an act: 

This refers to a contractual commitment where one party undertakes not to engage in specific actions or behaviours. Some prominent examples of this are:

• Non-compete agreements, where a party refrains from competing in a product, service, or geographical area against compensation.

• A builder refraining from constructing more floors than allowed by municipal authorities, against compensation from a neighbouring housing project aiming to protect sunlight.

• An industrial unit refraining from manufacturing activity during specific hours against compensation paid by a neighbouring school to avoid noise.

2. Agreeing to the obligation to tolerate an act or a situation:

This obligation centres on one party accepting or allowing a particular action or situation, usually in exchange for compensation. Some prominent examples of this are:

• A shopkeeper might agree to tolerate a hawker operating from the common pavement in front of the shop, with the hawker making a monthly payment as compensation.

• A Resident Welfare Association (RWA) tolerating the use of loudspeakers for early morning prayers by a school, subject to the school paying compensation to the RWA.

3. Agreeing to the obligation to do an act

When parties agree to an obligation to do an act, it means that one party commits to performing a specific action. Some prominent examples of this are:

• An industrial unit agreeing to install equipment for zero-emission/discharge at the request of the RWA of a neighboring Residential complex, against compensation, even though there is no legal obligation to do so.

• A manufacturing company agrees to implement eco-friendly practices, installing advanced pollution control equipment, in response to concerns raised by the local environmental association. The company undertakes this obligation, going beyond legal requirements, with compensation in the form of enhanced community goodwill.

For the above 3 limbs to fall within the ambit of para 5(e) of Schedule II of this act, the following conditions must be satisfied:

1. Expressed or Implied Agreement or Contract Existence:

For the activities mentioned in para 5(e) of Schedule II to fall within its scope, there must be a clear agreement or contract, either expressed or implied. The first party involved in this agreement is obligated to either refrain, tolerate, or perform a specific act. This contractual arrangement stands as an independent agreement and can either be a standalone contract or part of a larger contractual framework.

It`s crucial to note that the obligation of the first party to refrain, tolerate, or act must be a result of an expressed or implied promise by the recipient of money. The existence of a contract cannot be presumed solely based on a monetary transaction; there must be a commitment by the recipient to perform or abstain from something in exchange for the money received.

2. Consideration Must Flow in Return:

In addition to the existence of a contract, there must be a flow of consideration from the second party to the first party in return for the refraining, tolerating, or performing of the specified act. The consideration serves as the reciprocal element that completes the contractual relationship.

Taxability of some of the transactions has been discussed in detail as under:

1. Liquidated Damages:

Liquidated damages are defined as cash compensation agreed upon in a written contract for the breach of contract. Liquidated damages are argued to be a preventive measure rather than compensation for tolerating a breach. They aim to ensure performance, deter non-performance, and address unsatisfactory or delayed performance.

Some Example of Liquidated Damages are:

• Damages resulting from damage to property, negligence, piracy, unauthorized use of trade name, copyright,

• Penalty stipulated in a contract for delayed construction of houses,

• Forfeiture of earnest money by a seller in case of breach of ‘an agreement to sell’ an immovable property by the buyer.

• Forfeiture of earnest money by Government or Local authority in the event of a successful bidder failing to act after winning the bid, for allotment of natural resources.

Liquidated damages represent a measure of loss agreed upon by the parties due to a breach. They do not act as a remedy for the breach, nor do they restitute the aggrieved party. The contract is entered into for execution, not for its breach.

The taxability of liquidated damages hinges on whether they are compensation for injury, loss, or damage suffered due to breach, without any agreement to refrain, tolerate, or perform an act in return. If the payment is solely compensatory and does not involve an independent contract for tolerating, refraining, or performing an act, it is not considered a supply and is not taxable.

Some more examples are:

• A contract may provide that payment by the recipient of goods or services shall be made before a certain date and failure to make payment by the due date shall attract late fee or penalty.

• A contract for transport of passengers may stipulate that the ticket amount shall be partly or wholly forfeited if the passenger does not show up.

• A contract for package tour may stipulate forfeiture of security deposit in the event of cancellation of tour by the customer.

• A contract for lease of movable or immovable property may stipulate that the lessee shall not terminate the lease before a certain period and if he does so he will have to pay certain amount as early termination fee or penalty.

• Some banks similarly charge pre- payment penalty if the borrower wishes to repay the loan before the maturity of the loan period.

In the above examples, 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, of acceptance of late payment, early termination of a lease agreement, of prepayment of loan and of making arrangements for the intended supply by the Tour operator respectively.

Therefore, such payments, even though they may be referred to as fine or penalty, are actually payments that amount to consideration for supply, and are subject to GST, in cases where such supply is taxable.

Since these 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, such payments will not be taxable if the Principal supply is exempt.

2. Cheque dishonour fine/ penalty

When a cheque bounces, the fine imposed isn`t a fee for tolerating that situation. Instead, it`s more like a penalty to discourage this kind of behaviour. Because it`s not a payment for a service, it`s argued that these fines shouldn`t be taxed under GST.

The reasoning boils down to the nature of the fine—it`s not about putting up with a problem but penalizing and discouraging a certain action. Therefore, the conclusion is that fines for cheque dishonour aren`t considered payments for a service and shouldn`t be taxed.

3. Penalty imposed for violation of laws

The argument presented is that these penalties are not payments for any received service and, therefore, should not be subject to taxation.

The rationale is based on the nature of laws—they are not designed to tolerate violations. Laws establish penalties not for tolerating breaches but for penalizing and deterring such violations. Importantly, there is no agreement between the government and the violator suggesting that violations would be allowed or permitted in exchange for a fine or penalty. Violating the law is inherently not a lawful object or consideration.

In summary, fines and penalties imposed by the government or a Local authority for the violation of statutes, bye-laws, rules, or regulations are deemed not liable for taxation.

4. Forfeiture of salary or payment of bond amount in the event of the employee leaving the employment before the minimum agreed period

This section addresses the taxability of amounts recovered by an employer through the provisions of salary forfeiture or bond amount recovery when an employee leaves the job before the agreed minimum period. The argument is that these amounts are not considered as consideration for tolerating the act of premature employment termination. Instead, they function as penalties aimed at discouraging non-serious candidates from taking up employment, deterring such actions, and maintaining a committed workforce.

Crucially, the employee does not receive anything in return from the employer against the payment of these amounts. As a result, the amounts recovered by the employer are deemed not taxable as consideration for the service of agreeing to tolerate an act or a situation.

5. Late payment surcharge or fee

This segment discusses the facility of accepting late payments, including interest, late payment fees, fines, or penalties, provided by suppliers in conjunction with the main supply. The argument posits that this service is naturally bundled with the principal supply and is not uncommon in various service sectors worldwide. Service providers often grant the facility of accepting late payments, and even if framed as tolerating the act of late payment, it is considered an ancillary supply inherently bundled with the Principal supply.

Given its ancillary nature, this service is assessed as the Principal supply and should be subject to the same rate as the Principal supply, such as electricity, water, telecommunication, cooking gas, insurance, etc. This contrasts with the treatment of cheque dishonor fines or penalties, as discussed earlier, which are not considered as consideration for any service and are not taxable.

6. Fixed charges for power 

This point delves into the pricing structure for electricity by power-generating companies when dealing with State Electricity Boards (SEBs)/DISCOMS or individual customers. It emphasizes that the price charged comprises two components: a minimum fixed charge (or capacity charge) and a variable per unit charge.

Importantly, it clarifies that the constancy of minimum fixed charges, irrespective of actual electricity consumption or scheduling, does not imply that this charge, or any portion of it, is a fee for tolerating the act of not scheduling or consuming the contracted or available capacity.

Both components, the minimum fixed charges and variable energy charges, are asserted to be levied for the sale of electricity and, therefore, are not subject to taxation under GST as electricity itself is exempt from such taxation. 

7. Cancellation charges 

This point discusses the common business practice of suppliers in the service industry, such as hotels, travel agencies, and transportation providers, offering the option of cancelling services within a specified time frame in exchange for a cancellation fee. It asserts that the cancellation fee can be seen as charges related to the costs of arranging and canceling the intended services, as seen in the case of reserved tickets by entities like the Indian Railways.

The broader context of services, particularly in transportation, travel, and tours, is presented as a composite supply, encompassing various elements such as ticket booking, preferred seating options, facility amenities, and cancellation facilitation. The facilitation service of allowing cancellations with associated charges is deemed an integral part of this bundled offering and is typically supplied by all providers of passenger transportation services.

The facilitation service should be assessed as the Principal supply in conjunction with the primary service. Consequently, any amount forfeited for non-refundable tickets or security deposits in case of non-utilization of services should be subject to the same tax rate applicable to the primary service, such as air transport or Tour operator service.

However, it distinguishes cases where forfeiture of earnest money is unrelated to the receipt of any service. For instance, when a seller forfeits earnest money due to a buyer`s breach of an agreement to sell an immovable property or when the government forfeits earnest money after a successful bid, these forfeitures are considered mere flows of money. In such instances, where there is no consideration for any service, these payments are not taxable. Instead, they are viewed as compensation for losses suffered and penalties to discourage non-serious buyers or bidders.