[Opinion] Demystifying – Liquidated Damages, Penalty, Notice Pay Recovery

Gulzar Didwania & Anubhav Jain – [2022] 141 taxmann.com 232 (Article)

The taxability of liquidated damages, penalty, notice pay recovery has been largely debated since inception of the negative list regime under service tax with numerous litigations around the subject in the erstwhile service tax regime and the GST regime. Recently, the Government has issued a circular (no. 178/10/2022-GST) explaining various facets to determine the taxability. In order to analyze the ramifications of the circular, let us first understand the meaning or applicability of the following terms:

• • Liquidated damages (LD): Damages which an injured party is entitled to collect on account of specific breach or non-fulfillment of conditions. These are typically ascertained at the time of forming the contract.
  • Penalty: Penalty is typically imposed for breaking a law or a contract. Generally, the nomenclature “penalty” is used in relation to violation of laws. Further, there is no agreement that the violator would be allowed or permitted to do an act against payment of penalty.
  • Notice Pay recovery: Notice pay recovery is made by an employer from an employee in case where the employee is leaving employment before the minimum agreed period, as stated in the employment contract.

Why taxability of these items is under question?

Section 7 of CGST Act states the scope of supply. Further, Section 7(1A) of CGST Act specifies certain activities or transactions to be treated either as supply of goods or supply of services in Schedule II. Clause 5(e) to Schedule II mentions that “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act shall be treated as supply of services”. The same clause was identical to the declared service stated under Section 66E(e) in the erstwhile service tax regime as well. Now, with inclusion of the above, the moot question is whether the transaction which is in the nature of liquidated damages, penalty or notice pay recovery, is subject to GST or not.

Judgements/Rulings around this issue

Various judgements/rulings around liquidated damages

• • Various Advance Rulings upheld that the payment of liquidated damages for breach of contract is taxable under Clause 5(e) of Schedule II of CGST Act

– Bajaj Finance Ltd., In re [2019] 108 taxmann.com1/[2020] 77 GST 119 (AAAR-Maharashtra)
– Maharashtra State Power Generation Co. Ltd., In re [2018] 97 taxmann.com 408/70 GST 411 (AAAR-Maharashtra)
– Rashtriya Ispat Nigam Ltd, In re [2019] 112 taxmann.com 5 (AAR-Andhra Pradesh)

• • Judgments in the erstwhile Service tax regime wherein CESTAT held that Section 66E (e) of Finance Act, 1994 (identical to Clause 5(e) to Schedule II) not be applicable to cases for payment of liquidated damages for breach of contract

– Amit Metalinks Lts v. Commissioner of Central Goods & Service Tax [2011] 127 taxmann.com 248 (Kol. – CESTAT)
– Vikhroli Corporate Park v. CST [2017] 78 taxmann.com 12/59 GST 455 (mum. – CESTAT)
– KN Foods Industries (P.) Ltd. v. Commissioner of CGST & Central Excise [2020] 38 GSTL 60 (Trib. – All.)

• • European Union Judgements (EU) VAT contains provisions which are identical to Clause 5(e) of Schedule II stating the provisions do not apply to liquidated damages received under the contract

– Societe Thermale d Eugine-les-Bains v. Minister de Economie, des Finance set de I’ Industries [2010] BVC 367
– Lloyds Bank Plc v. Carrick & Carrick [1996] BVC 2875

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