GST Relief For Breach Of Contract, Damages

A much-litigated issue between the indirect tax department and businesses has received some clarity. The government has shared its view on the applicability of goods and services tax on liquidated damages or compensation, penalty, etc. received as a result of breach of contract.

Usually, liquidated damages or compensation has to be paid by a party that breaches the terms of a contract. As per the Central GST law, "agreeing to tolerate an act or situation, or to do an act…" is treated as a supply of service, and is subject to indirect tax.

Broadly, the department's argument has been that GST is leviable on the consideration received for tolerating an act of non-performance of the contract.

Under service tax, several judgments from the indirect tax tribunal concluded favourably that such payments do not qualify as ‘consideration’ for any ‘service’ and thus would not be liable to service tax, Sudipta Bhattacharjee, partner at Khaitan & Co., told BQ Prime.

Unfortunately, under the GST, numerous advance rulings from across the country took a contrary position and held in favour of levy of 18% GST on non-compete fees, early termination charges, liquidated damages, notice pay payments by employees, cancellation charges, late payment charges, etc., he said.

Now the department has clarified that unless payment has been made for an independent activity of tolerating an act under an independent arrangement, such payments will not constitute ‘consideration’. Hence, such activities will not constitute “supply” under the GST.

The circular has elaborated on situations that will be not attract the GST-

• Liquidated damages paid in lieu of breach of contract.

• Compensation offered to previous allottees of coal blocks for cancellation of their licenses pursuant to Supreme Court order.

• Cheque dishonour fine or penalty.

• Fine or penalty charged by a power distribution company from customers.

• Penalty paid by a mining company for unaccounted stocks.

• Bond amount recovered from an employee leaving employment prior to the agreed period.

It also addressed situations where the GST will get attracted-

• Late payment charges collected by service providers.

• Fixed charges collected by a power generating company for supply of electricity.

• Cancellation charges by a hotel or tour operator.

The department has aptly distinguished between two situations, Kanodia explained.

One where parties, expressly or via implied contract, agree to tolerate an act or refrain from doing act, etc. in lieu of agreed consideration. For instance, non-compete agreements.

Versus a situation where the flow of money is not arising out of a contractual quid pro quo between the parties, but is a compensation or penalty or charges to be recovered from another party for the loss or damages that it might have incurred as of result of breach or non-performance. For instance, dishonor of cheque or forfeiture of salary or payment of bond amount in the event the employee leaves the employment prior to minimum agreed period.

It is pertinent to note that the positions as clarified in this circular are largely consistent with the corresponding positions under European Union (EU) VAT, Bhattacharjee said. Even the EU VAT went through a series of changes in positions vis a vis such payments in the last few years and the dust has somewhat settled only now.

According to Kanodia, the clarifications are a welcome move and will be immensely helpful in resolving past litigations and avoiding demands on the issue in the future.