GST Applicability on penalties in case of Breach of Contract

GST on penalties: A breach of contract is a situation when one or more party to a contract fails to perform or deliver under the contract. Whether GST is applicable on penalty? GST taxability on breach of contract? GST is leviable on fines? Industries were raising question on taxability of an activity or transaction as the supply of service 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 issued by CBIC clarifying GST applicability on liquidated damages, compensation and penalty arising out of breach of contract or other provisions of law, and taxability of various goods and services.

The CBIC examined the scope of relevant entry of Schedule II of the Central Goods and Services Tax Act, 2017 (CGST Act) in respect of the applicability of GST on payments like liquidated damages, compensation, penalty, cancellation charges, late payment surcharge, etc. arising out of breach of contract. They have explained the same in three paragraphs. They are:

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

Under this contract, one party agrees to not compete with the other party, in a product or service, or geographical area which is taken into consideration of supply.

For instance, A supplier undertakes a contract with one of his competitors to not sell his product in the same local market.

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

Under this contract, one party agrees to allow the other party to perform an act, and the performance of such contract is considered to supply.

For Instance, a shopkeeper allows a hawker to operate on the common pavement in front of his shop, against a monthly payment.

3. Agreeing to the obligation to do an act:

Under this contract, it becomes an obligation of the other party to perform such act whether or not it is not obligatory to do under any other act.

For Instance, the Industrial unit agrees to install equipment for zero-emission/discharge against a consideration paid by RWA.

The description agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act was intended to cover services such as described above. However, over the year doubts have persisted regarding various transactions being classified under the said description. Further, the CBIC has provided detailed clarifications on specific activities or transactions, which are as below:

GST on Different types of Penalties

Particulars	Clarification	Taxability
Liquidated Damages paid for breach of contract	Liquidation Damages are a kind of compensatory payment paid to the aggrieved party in case of breach of contract. These damages are not treated as consideration to the supply. Since it is not the outcome of the contract.	Where the amount paid as ‘liquidated damages’ is an amount paid only to compensate for injury, loss or damage suffered, its just glow of money and are not taxable. However, if a payment constitutes a consideration for a supply, then it is taxable.
Compensation is given to previous allottees of coal blocks for cancellation of their licenses according to Supreme Court Order	The compensation paid to the allottees of coal blocks by the government is not the consideration of service, it is merely damages paid for the cancellation of the allocations.	The compensation cannot be taken into consideration for such service, Hence No GST is levied.
Cheque dishonor fine/ penalty charged by a power distribution company from the customers	These transactions are like fines or a penalty in case of dishonor of cheque imposed by the banker. It is not considered as supply, since this is not the final consideration for the bank.	No amount is taxable, hence no GST. Since the penalty is not a consideration here.
Penalty paid by a mining company to the State Government for unaccounted stock of river bed material	Law is framed with an object other than penalty i.e. when a law is framed for tolerating a violation.	The penalty is not considered a consideration of the law. Hence, the same is not taxable under GST.
Penalty or fines imposed for violation of laws	There is no agreement between the Government and the violator specifying that violation would be allowed or permitted against payment of fine or penalty.	Penalty imposed for violation of laws such as traffic violations, or pollution norms etc are also not consideration for any supply received and are not taxable.
Forfeiture of salary or payment of the bond amount in case of premature leaving of employment by the employee	Recovery of such an amount by an employee does not consider consideration of supply. It is nothing but a penalty to discourage non-serious employees.	Amounts recovered by the employer are not considered as supply and are not taxable under GST.
Compensation for not collecting toll charges	It has been clarified that the toll operators had provided services of access to a road or bridge and toll charges are considered for the supply.	In case of service by way of access to a road or a bridge on payment of toll charges taxable as a service by way of agreeing to refrain from collection of toll from users.
Late payment surcharge or fee	The facility of accepting late payments with interest or late payment fee, fine or penalty is a facility granted by supplier naturally bundled with the main supply. It is not uncommon or unnatural for customers to sometimes miss the last date of payment of electricity, water, telecommunication services etc.	GST on these charges is levied at the same rate as the rate of primary supply. Since secondary supply in a bundle supply is charged at the rate of primary supply.
Fixed Charges collected by a power generating company from State Electricity Board (SEBs) or by SEBs/DISCOMs from an individual customer for the supply of electricity	The price charged for electricity has two components, i.e., minimum fixed charges/ capacity charges and the variable/energy charges per unit charge. The minimum fixed charge or part thereof cannot be considered as a supply.	These charges are in respect of the sale of electricity and are not taxable under GST. Hence, the same is not taxable.
Cancellation Charges recovered by railways for cancellation of tickets, hotels etc.	Facilitation supply of allowing cancellation of an intended supply against payment of 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.	Cancellation Charges money should be assessed at the same rate as applicable to the service contract.
Forfeiture of earnest money by a seller in case of breach of ‘an agreement to sell’ an immovable property by the buyer or such forfeiture by Government or local authority in the event of a successful bidder failing to act after winning the bid for allotment of natural resources.	Forfeiture of earnest money is these cases not a consideration for tolerating the breach of contract but as a compensation for the losses suffered and as a penalty for discouraging the non-serious buyers or bidders.	Such payments being merely flow of money are not a consideration for any supply and are not taxable.