Compensation is not ‘consideration’ - GST on liquidated damages, penalties and forfeiture

Between 2018 and 2022, numerous show cause notices were issued by the GST Department treating liquidated damages (‘LD’)and forfeited deposits as ‘consideration’ for having "agreed to tolerate an act" under paragraph 5 (e) of Schedule II to the Central Goods and Services Tax Act, 2017 (“Schedule”).

On Augusy 3, 2022, such view was ultimately remodelled by the Central Board of Indirect Taxes and Customs (“CBIC”) vide Circular No. 178/10/2022-GST (“the Circular”)which was issued after the 47^th GST Council meeting under the chairmanship of Union Finance Minister Nirmala Sitharaman.

Demands nonetheless continue, largely because paragraph 12 of the Circular states that taxability in each case depends on its facts and circumstances. As such, it acts like a caveat that facts would be required to be examined and that it does not permit the Circular to be ignored. Where the facts show nothing more than compensation for a breach, the Circular binds the Department.

Paragraph 5(e) of the Schedule treats “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act” as a supply of services. It thus has a 3 three pronged approach as to what constitutes a ‘Supply’ - refraining from an act, tolerating an act/ situation and then doing the act.

As per Section 7(1A) of Central Goods and Services Tax Act, 2017 (“CGST Act”), Schedule II only classifies what is already a supply under Section 7(1) of CGST Act, which requires consideration.

However, a ‘breach’ does not fit the above description - a party that suffers a breach cannot be said to have agreed to put up/tolerate with the said breach, in return for payment; what it receives is compensation for its loss and not a price for tolerating the breach.

Paragraph 6.1 and 7 of the Circular requires that the 3 prongs contemplated under paragraph 5(e) of the Schedule must be an  ‘agreement ‘ or ‘contract’ between the parties on consideration – be it an independent standalone contract or part of another contract. On being faced with a breach, the same cannot be presumed to have existed. The following are not considered as ‘consideration’:

a) Liquidated damages for delay, defective performance or non-performance (paragraphs 7.1 to 7.1.5);

b) Forfeiture of earnest money on breach of an agreement to sell immovable property, or on a bidder’s default (paragraphs 7.1.5 and 11.5);

c) Penalties for violation of law, and cheque dishonour penalties (paragraphs 7.3 and 7.4); and

d) Forfeited salary or bond amounts from employees leaving early (paragraph 7.5).

Conversely, the following are consideration for an ancillary facility, taxed as the principal supply unless it is exempted (paragraph 7.1.6):

a) Cancellation charges and no-show forfeitures in transport, tours and hotels (paragraphs 11 to 11.4);

b) Late payment surcharge, fee or interest, includible in value under Section 15(2)(d) (paragraph 9);

c) Lease early termination fees and loan pre-payment charges (paragraph 7.1.6); and

d) Fixed or capacity charges for electricity, which is exempt (paragraphs 10 to 10.2).

As such, the name given to a payment does not decide its tax treatment; its true nature does (paragraph 7.1.6) – it borders on the meaning of ‘consideration’ which cannot be de hors an agreement/contract and cannot be “merely an event in the course of the performance of the agreement and it does not represent the ‘object’”. For instance, a deposit forfeited to compensate for loss caused by a breach is outside the levy, whereas a deposit retained as the agreed charge for allowing the customer to cancel, is consideration for that facility and is taxable.

The Circular can be said to have its genesis from the law of contract: compensation for injury cannot, automatically, fall under the heading of consideration and is governed under Section 74 of the Indian Contract Act, 1872 (“Contract Act”).

Recall to Fateh Chand v. Balkishan Dass, 1963 SCC OnLine SC 49, is made where the Constitution Bench had held that Section 74 of the Contract Act covers every penalty stipulation, including forfeitures, and allows only reasonable compensation. Maula Bux v. Union of India, (1969) 2 SCC 554, thereafter dispensed with proof of damage only where loss is difficult to establish. ONGC Ltd. v. Saw Pipes Ltd., (2003) 5 SCC 705, upheld genuine pre-estimates as compensation while Kailash Nath Associates v. DDA, (2015) 4 SCC 136, held loss incurred was essential and set aside a forfeiture where neither breach nor loss was established.

Even then, the award of LD is compensation, not a price or ‘consideration’.

It is seen that under the identically worded Section 66E(e) of the Finance Act, 1994, LD was held not to be a consideration. [Neyveli Lignite Corporation Ltd. v. CCE & ST, 2021 SCC OnLine CESTAT 2511; South Eastern Coalfields Ltd. v. CCE, 2020 SCC OnLine CESTAT 4872].

The Madras High Court has held that payment during notice period as recovered from employees who leave without serving the full duration of the notice is not taxable. [GE T&D India Ltd. v. CCE, 2019 SCC OnLine Mad 33202]

The Bombay High Court in Tata Sons (P) Ltd. v. Union of India, 2026 SCC OnLine Bom 2927, held that satisfying a foreign arbitral award for damages, including the award-holder’s agreement not to pursue enforcement elsewhere, was not considered a supply under the CGST Act, where an independent agreement “to tolerate” was clearly absent. Paragraph 5(e) of Schedule cannot be read divorced from Section 7 of CGST Act - the Circular’s position on LD extends beyond and covers unliquidated damages too. However, such expansion of meaning to encompass unliquidated damages remains unchallenged till date.

Other High Courts have also agreed to the above anology ie., foreign Awards for damages, where agreement “to tolerate” was absent, cannot be considered as supply [Krazybee Services (P) Ltd. v. Additional Director, 2025 SCC OnLine Kar 24177 (liquidated damages); Aswathy Gas Agencies v. Indian Oil Corpn. Ltd., 2024 SCC OnLine Ker 7291 (penalties on LPG distributors); and Bai Mamubai Trust v. Suchitra, 2019 SCC OnLine Bom 1854 (unauthorised occupation)]

Rulings issued prior to the Circular, some of which treated such receipts as taxable, do not alter the position for such period due to Section 103 of CGST Act - an advance/prior ruling binds only the Applicant who sought it and the jurisdictional officer in respect of that Applicant.

Section 168(1) of CGST Act, much like Section 37B of the Central Excise Act, 1944, obliges departmental officers to follow CBIC’s instructions, and the Department cannot repudiate a Circular in force as inconsistent as its clarificatory [Paper Products Ltd. v. CCE, (1999) 7 SCC 84; Ranadey Micronutrients v. CCE, (1996) 10 SCC 387].

Kalyani Packaging Industry v. Union of India, (2004) 6 SCC 719, limited the observation in CCE v. Dhiren Chemical Industries, (2002) 2 SCC 127, that a Circular’s differing interpretation binds the Department, to cases which have already settled ie., it can be used retrospectively.

Therefore, three things follow: Firstly, a demand contradictory to the Circular can be challenged, if raised expressly; Secondly, the Circular cannot override a Statute and thirdly, for the period before August 2022, taxpayers may argue that the Circular, being clarificatory and beneficial, applies retrospectively [Suchitra Components Ltd. v. CCE, (2006) 12 SCC 452].

Once compensation is excluded, three issues may still remain –

a) Deduction from running bills - A unilateral deduction for breach is not a discount under Section 15(3) of the CGST Act - so tax remains payable on the full contract price. The employer should record it as a set-off against a fully paid invoice, protecting its credit under the second proviso to Section 16(2) of CGST Act.

b) Price variation and escalation - Escalation is additional consideration, raised by debit note under Section 34(3) of CGST Act - With Section 14 of CGST Act governing rate changes, reductions would ideally need a credit note under Section 34(1) of CGST Act. From October 1, 2025, the proviso to Section 34(2) of CGST Act, substituted by Section 126 of the Finance Act, 2025 (Notification No. 16/2025–Central Tax), allows the supplier to reduce output tax only if a registered recipient has reversed the credit.

c) Interest and delayed payment charges - These are includible in value under Section 15(2)(d) of CGST Act and are taxed at the rate of the principle supply.

The character of the payment decides the tax. Compensation for breach, measured by injury under Section 74 of the Contract Act, falls outside Paragraph 5(e), as the Circular confirms, while receipts referable to the supply itself take its tax character. Contracts and records should reflect this before any demand arrives.

As such, the mode to opt may be to: Classify by substance (Record whether a payment is a price or compensation), establish breach and loss (Kailash Nath Associates (Supra) makes loss essential,) segregate your ledger (Composite heads invite omnibus demands), test receipts against Section 15(2) of CGST Act (Delayed payment charges are includible in value), use statutory documents (Record escalation through notes as per Section 34 of CGST Act) and preserve pre-August 2022 position (Place the contract on record).

About the authors: Amit Meharia is a Managing Partner and Swarbhanu Bhattacharya is an Associate Partner at MCO LEGALS (Meharia & Company).

Disclaimer: The opinions expressed in this article are those of the author(s). The opinions presented do not necessarily reflect the views of Bar & Bench.

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