Does compensation received for breach of contract (liquidated damages) amount to a taxable “supply” under GST?
4️⃣ GST Law Framework (Clean Test)
A. What Is a “Supply”? — Section 7, CGST Act
Mandatory Elements
Status in Liquidated Damages
Supply
❌ No
Consideration
❌ Not for a service
In course of business
Irrelevant if no supply
📌 If any element fails → GST fails.
B. Department’s Usual Argument — Schedule II, Para 5(e)
Provision
Text
Para 5(e), Sch. II
“Agreeing to refrain from an act, or to tolerate an act or a situation”
Revenue logic: Money received → tolerance → taxable service.
Court’s answer: ❌ Incorrect when payment arises due to breach.
5️⃣ CBIC Circular No. 178/10/2022 — The Decisive Clarification
Circular Para
What It Clarifies
7.1 – 7.1.6
Distinguishes object of contract vs consequence of failure
Key principle
GST applies only if payment is for a conscious supply
Liquidated damages
Compensation, not consideration
📌 Circulars are binding on the Department.
6️⃣ Contract Law Backbone (Why LD Is Compensation)
Provision
Relevance
Section 73, Contract Act
Compensation for loss due to breach
Section 74, Contract Act
Pre-agreed damages (liquidated damages)
Nature
Restorative, not remunerative
📌 LD aims to make good the loss, not to reward tolerance.
7️⃣ High Court’s Key Findings (Issue-wise)
A. Liquidated Damages ≠ Consideration
Observation
Reason
Not object of contract
Triggered only on failure
No service intention
No buyer–seller relationship
Circular para 7.1.6
Directly applicable
B. No “Tolerating an Act” Arrangement
Department’s Claim
Court’s Rejection
Pre-agreed tolerance
Clause deters breach
Payment = service
Payment = failure consequence
📌 Deterrence clause ≠ service contract.
C. Circular Binding on Officers
Principle
Impact
CBIC clarification issued
Must be followed
Selective reliance
Not permissible
8️⃣ Practical GST Matrix (Very Important)
When GST Does NOT Apply
Nature of Receipt
GST
Liquidated damages
❌
Compensation for breach
❌
Penalty for non-performance
❌
Damages without service
❌
When GST MAY Apply
Nature of Receipt
Why
Early termination fee
Part of pricing
Cancellation charges
Linked to supply
Late payment charges
Facility consciously provided
📌 Key test: intent & object of the contract — not the label.
9️⃣ Simple Real-Life Illustration
Scenario
GST Result
Delay penalty in logistics contract
❌ Not taxable
Was delay “hired” as a service?
❌ No
Was contract meant to fail?
❌ No
👉 Failure ≠ Supply
🔟 Statutory Provisions Referenced
Provision
Why It Matters
Section 7, CGST Act
Definition of supply
Schedule II, Para 5(e)
“Tolerating an act”
Sections 73–74, Contract Act
Legal basis of LD
Rule 142, CGST Rules
Voluntary payment procedure
CBIC Circular 178/10/2022
Taxability clarification
🔚 Finin2min Bottom Line
Principle
Final Take
GST is a tax on supplies
✔
GST is not a tax on failures
✔
Compensation ≠ consideration
✔
Intent matters more than wording
✔
Final Finin2min Verdict
Liquidated damages are compensatory, not taxable. Unless money is paid for a conscious supply, GST has no role to play. GST taxes performance — not breach.
⚠️ Disclaimer
For information only. This summary is based on prevailing statutory provisions and judicial precedents. Applicability depends on facts, timing, and documentation. Professional advice recommended.
Article related to – GST on compensation Is liquidated damages taxable under GST Schedule II Para 5(e) GST Tolerating an act GST CBIC Circular 178/10/2022 explained GST on breach of contract
