[Opinion] Taxability of liquidated damages, penalties and similar charges

  • Blog|News|GST & Customs|
  • 3 Min Read
  • By Taxmann
  • |
  • Last Updated on 29 August, 2022

Taxability of liquidated damages

Krishan Arora, Sachin Sharma & Rahul Jhawar – [2022] 141 taxmann.com 403 (Article)

An essential requisite of any contract is a timely discharge of agreed terms and conditions. A failure to do so usually results in payment of damages by one party to another to indemnify against losses. Such damages are referred to as penalty or liquidated damages.

Black Law dictionary defines liquidated damages as “Cash compensation, agreed to by signed, written contract for breach of contract, payable to the aggrieved party.” In simpler terms, the liquidated damage refers to compensation paid by one party to another party for non-performance of any obligation agreed to in the contract. Similarly, there are different types of penalties or compensations imposed for non-fulfilment of terms. For instance, compensation to the employer for not serving the minimum agreed period is known as notice pay, compensation paid for cancelling the intended supply is known as cancellation charges and so on.

Taxability of liquidated damages, penalties, notice pay, etc.

The taxability of payment of damages, penalties, compensation has always been unsettled. Under the erstwhile Service Tax law, Section 66E of the Finance Act 1994 included an entry “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act” as declared service. Similar approach was adopted in the Goods and Service Tax (GST) regime by inserting entry 5(e) in Schedule II of CGST Act, 2017 that classified such transactions as a supply of service.

Basis the above-mentioned legal provisions, the tax authorities have interpreted the liquidated damages, notice pay, cheques dishonour charges, etc. to be taxable. On the other hand, various courts have pronounced contrasting judgements on the taxability of the said transaction.

The following are few of the judicial precedents which held the service to be taxable:

    • In the matter of Maharashtra State Power Generation Company Ltd. In re [2018] 93 taxmann.com 266/13 GSTL 177/68 GST 494 (AAR-Maharashtra), Authority of Advance Ruling (AAR) and Appellate Authority of Advance Ruling (AAAR) of Maharashtra has held that liquidated damages are to be viewed as consideration for an act of tolerance of non-performance, and thus are subject to GST at 18%.
    • In the matter of Bajaj Finance Limited, AAR of Maharashtra held that cheque dishonour charges are the act of delay by one party which is tolerated by the financial institution and would be taxable under entry 5(e) of the Schedule II of the CGST Act 2017. (GST-ARA-25/2020-21/B-05)
    • In Fastrack Deal Comm Pvt. Ltd., In re [2021] 124 taxmann.com 399/[2022] 61 GSTL 125 (AAR – Gujarat) matter, Gujarat AAR held that the GST is leviable on the amount forfeited on account of breach of agreement of sale of land as it is a supply of service as per entry 5(e) of Schedule II.

On the contrary, following judgments by courts posed a different view of the said transaction to not be taxable under the indirect tax laws:

    • The Hon’ble High Court of Madras in the matter of GE T & D India Ltd. v. Dy. CIT [2020] 115 taxmann.com 213/35 GSTL 89 held that notice pay is not taxable under service tax as the employer has not “tolerated” an act of the employee. Rather, employer has permitted a sudden exit upon being compensated by the employee in this regard.
    • In the matter of CST v. Repco Home Finance Ltd. [2020] 117 taxmann.com 755/42 GSTL 104, the larger bench of CESTAT Chennai held that service tax is not levied on the foreclosure charges charged by the bank as it is recovered as compensation for disruption of a service and not towards lending services. Further, it held that no service is sought to have been rendered by the banks to borrowers against the charges.
    • The Hon’ble High Court of Bombay in the matter of Bai Mumbai Trust v. Suchitra [2019] 109 taxmann.com 200/31 GSTL 193 pronounced that the services of Court Receiver are to be considered as services provided by the Court itself and it is specifically excluded from definition of supply as per schedule III. Also, held that compensation paid as damages for violation of a legal obligation was not a supply under GST.

With the contrasting view of the authorities, the matter has always been controversial and problematic for the taxpayers.

Click Here To Read The Full Article

Disclaimer: The content/information published on the website is only for general information of the user and shall not be construed as legal advice. While the Taxmann has exercised reasonable efforts to ensure the veracity of information/content published, Taxmann shall be under no liability in any manner whatsoever for incorrect information, if any.

Leave a Reply

Your email address will not be published. Required fields are marked *

Everything on Tax and Corporate Laws of India

To subscribe to our weekly newsletter please log in/register on Taxmann.com

Author: Taxmann

Taxmann Publications has a dedicated in-house Research & Editorial Team. This team consists of a team of Chartered Accountants, Company Secretaries, and Lawyers. This team works under the guidance and supervision of editor-in-chief Mr Rakesh Bhargava.

The Research and Editorial Team is responsible for developing reliable and accurate content for the readers. The team follows the six-sigma approach to achieve the benchmark of zero error in its publications and research platforms. The team ensures that the following publication guidelines are thoroughly followed while developing the content:

  • The statutory material is obtained only from the authorized and reliable sources
  • All the latest developments in the judicial and legislative fields are covered
  • Prepare the analytical write-ups on current, controversial, and important issues to help the readers to understand the concept and its implications
  • Every content published by Taxmann is complete, accurate and lucid
  • All evidence-based statements are supported with proper reference to Section, Circular No., Notification No. or citations
  • The golden rules of grammar, style and consistency are thoroughly followed
  • Font and size that's easy to read and remain consistent across all imprint and digital publications are applied