Key Takeaways
- Liquidated damages for genuine contract breach are not taxable under GST per CBIC Circular 178/10/2022-GST.
- Payments where one party has a contractual right to breach (toleration of an act) remain taxable at 18%.
- Hotel, airline, and ticketing cancellation charges are taxable since the cancellation itself is a service.
- Earnest money forfeited on failure to complete a transaction is not taxable under GST.
- Pure interest on delayed payment is exempt under Section 15(2)(d), but amounts labeled "service charges" may attract GST.
- Reverse charge may apply when liquidated damages are paid to a foreign party without a GST registration.
Is GST applicable on liquidated damages in India? After CBIC Circular 178/10/2022-GST, liquidated damages recovered for genuine contract breach are not considered "supply" under GST. No GST applies because the payment is purely compensatory and no service is rendered. However, where a contract specifically allows one party to breach in exchange for a pre-agreed fee, the payment constitutes consideration for "tolerating an act" under Entry 5(e), Schedule II of the CGST Act, and GST at 18% applies. (Source: CBIC Circular 178/10/2022-GST dated 3 August 2022)
Frequently Asked Questions
Is GST applicable on liquidated damages in India?
No, GST is not applicable on liquidated damages recovered for genuine breach of contract. CBIC Circular 178/10/2022-GST clarified that such payments are purely compensatory and do not constitute consideration for any supply. However, if the contract grants a party the right to breach in exchange for a fee (toleration of an act), GST at 18% applies.
Are cancellation charges subject to GST?
Yes. CBIC Circular 178 confirms that cancellation charges for hotels, airlines, and event bookings are taxable under GST. The cancellation facility itself is treated as a service provided by the supplier, making the charge consideration for that service.
Is GST payable on forfeiture of earnest money?
No. Circular 178 clarifies that earnest money forfeited due to failure to complete a transaction is not GST-taxable, provided the forfeiture is a genuine consequence of the buyer's default and not a pre-arranged fee for withdrawal.
Construction companies lose crores to LD deductions. EPC contractors see penalty clauses triggered on project delays. Airlines and hotels charge cancellation fees daily. The question every CFO and CA asks: does GST apply to these payments?
For years, GST officers treated all such recoveries as taxable under the "tolerating an act or omission" entry in Schedule II. Businesses received show-cause notices demanding 18% GST on amounts that were, in substance, compensation for breach. CBIC Circular 178, issued on 3 August 2022, drew a clear line between what is taxable and what is not. But the line is not always easy to apply, and post-Circular rulings have added nuance.
This guide breaks down every category of payment, explains the legal reasoning, and provides a decision framework you can apply to your own contracts.
Looking for expert help with GST compliance and advisory for liquidated damages and penalty clauses? The team at Tax Garden, based in Kondapur, Hyderabad, helps Indian SMEs stay compliant end-to-end: filings, notices, and advisory, all in one place.
The Pre-Circular 178 Problem
Before August 2022, the GST department's position was straightforward and aggressive: any payment received for breach of contract, delay penalty, or forfeiture was taxable under Entry 5(e) of Schedule II of the CGST Act. This entry deems "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 service.
The logic ran like this: when Party A pays liquidated damages to Party B for a project delay, Party B is "tolerating" the delay. Therefore, Party B is supplying a service (tolerating an act), and the LD payment is consideration for that service. GST at 18% applies.
This interpretation created real problems:
| Problem | Impact |
|---|---|
| Double taxation | The party suffering the breach paid GST on the very compensation meant to make it whole |
| Working capital drain | LD recipients had to deposit 18% GST on amounts that were often disputed or paid under protest |
| Contractual confusion | Parties could not determine at the time of contracting whether future damages would attract GST |
| Inconsistent treatment | Different AARs reached opposite conclusions on identical fact patterns |
Several Advance Ruling Authorities upheld the department's view. The Maharashtra AAR in M/s Bharat Oman Refineries Ltd. (2019) held that LD for delayed completion of a refinery project was taxable. The Rajasthan AAR similarly ruled against the taxpayer in multiple construction-sector cases. The result was widespread uncertainty and a flood of litigation.
CBIC Circular 178/10/2022-GST: The Landmark Clarification
On 3 August 2022, the CBIC issued Circular No. 178/10/2022-GST to settle the matter. The Circular addressed whether various payments such as liquidated damages, compensation, penalty, and forfeiture charges constitute consideration for supply under GST.
The Core Distinction
Circular 178 draws a critical distinction between two scenarios:
Scenario 1: Genuine breach of contract (NOT taxable)
When a party defaults on contractual obligations and pays damages as a consequence, no service is being supplied. The payment is compensatory. The party receiving the LD has not "agreed to tolerate" the breach. It had no choice in the matter. There is no supply, and therefore no GST.
Scenario 2: Contractual right to breach / toleration arrangement (TAXABLE at 18%)
When a contract specifically allows one party to exit, cancel, or underperform in exchange for a pre-determined fee, the other party has effectively agreed to tolerate that act. The fee is consideration for the service of toleration. GST applies.
How to Tell the Difference
The Circular provides a practical test. Ask these questions:
-
Was there an agreement to tolerate? If the contract contemplates and permits the breach in exchange for a payment, it is toleration. If the breach is a default that the contract tries to prevent (through the LD clause), it is not toleration.
-
Is there a service being supplied? Genuine damages compensate for loss. There is no identifiable service. But where one party's forbearance or tolerance is itself the "service," the payment is consideration.
-
Is the payment compensatory or transactional? Pure compensation for loss suffered is not supply. A fee for a facility (like the right to cancel) is supply.
Step-by-Step Guide
Decision Tree: Is Your Payment GST-Taxable?
Apply this 5-step test to determine GST applicability on damages, penalties, and compensation
Is there a contract between the parties?
If no contract exists, the payment is likely ex-gratia or a court-ordered award. Generally not taxable under GST as there is no supply relationship.
ThresholdDoes the contract permit the act that triggered payment?
If the contract allows a party to cancel, exit, or underperform by paying a specified fee, this is 'toleration of an act.' Move to Step 5. If the contract tries to prevent the act through penalties, move to Step 3.
Key TestIs the payment purely compensatory for a breach?
If the LD, penalty, or forfeiture compensates the injured party for loss caused by an unintended breach, it is NOT consideration for any supply. No GST applies per Circular 178.
Not TaxableIs the payment labeled as a 'service charge' or 'facility fee'?
Labels matter. If a payment is structured as a fee for a service (e.g., 'cancellation processing fee'), it may be taxable regardless of its compensatory nature. Substance over form applies, but poor labeling invites scrutiny.
CautionThe payment is consideration for toleration of an act
GST at 18% applies. The supplier must issue a tax invoice, charge GST, and the recipient can claim ITC if used for taxable outward supply. HSN/SAC: 999794 (agreeing to do or abstain from doing an act).
TaxableSource: CBIC Circular 178/10/2022-GST read with Entry 5(e), Schedule II, CGST Act
Category-Wise GST Analysis
1. Liquidated Damages for Contract Breach
This is the most litigated category. Circular 178 settled it clearly:
- Construction delays: LD deducted from contractor bills for missing project milestones is NOT taxable. The contractor defaulted; the employer did not agree to tolerate the delay.
- Supply chain defaults: Penalty imposed on a vendor for delivering defective goods or short shipment is NOT taxable.
- Procurement contract breach: Damages paid for failure to supply agreed quantities on time are NOT taxable.
The key factor is that the party receiving LD did not willingly accept the breach. The LD clause exists precisely to deter the breach, not to permit it.
2. Cancellation Charges
Circular 178 treats cancellation charges differently from breach damages. When a hotel, airline, or event venue allows a customer to cancel a booking and charges a cancellation fee, the supplier is providing a service: the facility to cancel. The cancellation charge is consideration for that service.
| Payment Type | GST Position | Reasoning |
|---|---|---|
| Hotel booking cancellation fee | Taxable at 18% | Hotel provides a facility to cancel; fee is for that service |
| Airline ticket cancellation charge | Taxable at 18% | Airline offers cancellation as a service option |
| Event/venue cancellation penalty | Taxable at 18% | Venue agrees in advance to permit cancellation |
| Railway ticket cancellation | Taxable at 18% | IRCTC charges are inclusive of GST |
| "No-show" charges | Taxable at 18% | Treated as cancellation by conduct; same principle applies |
The distinction from LD is important: the contract explicitly contemplates and permits cancellation. The customer has a right to cancel. The fee is for exercising that right, not for breaching the contract.
3. Earnest Money Forfeiture
Circular 178 provides welcome clarity here. When earnest money or security deposit is forfeited because a buyer fails to complete a property transaction or a bidder fails to honour a tender, the forfeiture is NOT taxable under GST.
The reasoning: the seller did not agree to tolerate the buyer's withdrawal. The earnest money clause exists to ensure the buyer's seriousness. Forfeiture is a consequence of default, not consideration for a service.
However, there is a caveat. If the contract gives the buyer an explicit option to withdraw by forfeiting the earnest money (i.e., the forfeiture acts as a "walk-away" fee), the payment could be re-characterized as consideration for tolerating withdrawal. Drafting matters enormously here.
4. Non-Compete and Non-Solicitation Fees
This category produces the most mixed results. When a company pays a former director or employee not to compete for a specified period, is it paying for "toleration of an act" (the restriction on competition) or compensating the individual for giving up a right?
Arguments for taxability (18% GST):
- The individual is providing a service: refraining from competing
- Entry 5(e) covers "agreeing to refrain from an act"
- There is a clear supply-consideration relationship
Arguments against taxability:
- Non-compete clauses are typically part of broader employment or business sale agreements
- The payment compensates for loss of livelihood or business opportunity
- Circular 178's spirit suggests genuine restrictions should not be taxed
As of mid-2026, no definitive Circular or Supreme Court ruling has settled this category. The safer position is to treat standalone non-compete payments as taxable under Entry 5(e), while non-compete clauses bundled within business transfer agreements may fall outside GST if the payment is part of the overall sale consideration.
5. Delayed Payment Charges and Interest
Section 15(2)(d) of the CGST Act includes interest, late fee, or penalty for delayed payment in the value of supply. This means if a supplier charges interest on overdue invoices, that interest is part of the taxable value and GST applies at the same rate as the underlying supply.
However, there are critical exceptions:
| Type of Charge | GST Position | Legal Basis |
|---|---|---|
| Interest on delayed payment for goods/services already supplied | Taxable (added to value of supply) | Section 15(2)(d) CGST Act |
| Pure interest on a loan or deposit (time value of money) | Exempt | Entry 27, Notification 12/2017-CT(R) |
| "Penal interest" charged by banks/NBFCs for EMI default | Exempt (if genuinely interest) | RBI classification as interest |
| Amount labeled "service charge" on delayed payment | Taxable at 18% | Substance determines treatment; labels create risk |
The practical risk is in labeling. If a contract calls delayed payment compensation a "service charge" or "processing fee" rather than "interest," GST officers may treat it as consideration for a service rather than exempt interest. Use precise terminology in contracts.
6. Court-Awarded Damages and Arbitral Awards
Circular 178 does not explicitly address court-ordered or arbitral damages, but the principle applies. Where a court or arbitrator awards damages for breach of contract, the payment is compensatory. No supply relationship exists between the parties in respect of the damages. GST should not apply.
Some practitioners note that if an arbitral award includes a component for "loss of profit" on a supply that was never made, the department could argue that the amount represents consideration for a deemed supply. This remains an untested position, but it is worth flagging in high-value disputes.
Post-Circular Judicial and AAR Developments
Circular 178 has not ended all disputes. Several post-Circular developments are worth tracking:
Karnataka AAR (2023) - Infrastructure sector: Applied Circular 178 to hold that LD deducted by a government agency from a road contractor for delayed completion was not taxable. The AAR noted that the government did not "agree to tolerate" the delay; the LD clause was punitive, not permissive.
Gujarat AAAR (2023) - Power purchase agreement: Held that penalty charges imposed by a power distribution company on a generator for deviation from scheduled supply were not taxable. The penalty was compensatory, imposed for grid discipline, and not consideration for any service.
Maharashtra AAR (2024) - Telecom sector: Ruled that early termination charges in a telecom service agreement were taxable. The agreement permitted early termination subject to payment, making it a "toleration" arrangement rather than a genuine breach.
These rulings confirm that the line between taxable and non-taxable turns on one question: did the contract permit the act, or did the contract try to prevent it?
Comprehensive Reference: GST on Common Payment Types
| Payment Category | GST Taxable? | Rate | Key Condition |
|---|---|---|---|
| LD for construction delay | No | - | Must be genuine breach, not permitted delay |
| LD for supply default | No | - | Penalty for non-performance, not exit fee |
| Cancellation charges (hotel/airline) | Yes | 18% | Cancellation facility is a service |
| Earnest money forfeiture | No | - | Must be genuine forfeiture on buyer default |
| Non-compete fees (standalone) | Likely Yes | 18% | "Refraining from act" under Entry 5(e) |
| Non-compete in business sale | Possibly No | - | If part of overall sale consideration |
| Interest on delayed payment | Yes | Same as supply | Added to value per Section 15(2)(d) |
| Pure loan interest | No | - | Exempt under Notification 12/2017 |
| Penalty by regulator (SEBI/RBI) | No | - | No supply relationship; sovereign function |
| Insurance claim payout | No | - | Compensatory; no supply by insured |
| Cheque bounce charges | Yes | 18% | Service of processing the dishonoured cheque |
| Warehousing demurrage | Yes | 18% | Service of allowing extended storage |
| Port demurrage | Yes | 18% | Continued use of port facility |
| Contractual "exit fee" | Yes | 18% | Explicit toleration arrangement |
Practical Implications for Businesses
Reverse Charge on LD Paid to Foreign Parties
When an Indian company pays liquidated damages to a foreign entity that does not have a GST registration in India, reverse charge mechanism (RCM) under Section 5(3) of the IGST Act applies - but only if the payment is taxable in the first place.
If the LD is for genuine breach (not taxable per Circular 178), RCM does not apply because there is no supply. If the payment is for toleration of an act (taxable), the Indian company must self-assess and pay IGST at 18% under RCM. The Indian company can then claim ITC on this IGST if the payment relates to its taxable business.
ITC Reversal on GST Paid Under Protest
Many businesses paid GST on LDs before Circular 178 was issued, or continue to pay under protest after receiving show-cause notices. If you paid GST on a payment that Circular 178 now clarifies as non-taxable:
- File a refund application under Section 54 of the CGST Act within two years of payment
- Do not reverse ITC that the recipient claimed on the GST you charged. The recipient should independently assess their ITC position
- Respond to SCNs citing Circular 178 as a binding clarification. Circulars issued under Section 168 are binding on GST officers (though not on appellate authorities or courts)
- Document your position with a contemporaneous legal opinion for audit purposes
Drafting Contracts to Reduce GST Exposure
How you draft penalty and damages clauses directly affects GST treatment. Follow these principles:
Use "damages" or "compensation," not "fee" or "charge." Terminology signals intent. A "cancellation fee" suggests a service being provided. "Liquidated damages for cancellation" suggests compensation for breach.
Do not grant a "right to breach." If your contract says "Party A may terminate by paying Rs. X," you have created a toleration arrangement. Instead, write: "In the event of breach by Party A, Party A shall be liable to pay liquidated damages of Rs. X."
Separate interest from service charges. If you charge interest on delayed payments, label it as "interest at X% per annum on the outstanding amount." Do not bundle it with processing fees or administrative charges.
Include a GST-specific clause. State explicitly: "Any liquidated damages payable under this agreement are purely compensatory and do not constitute consideration for any supply of goods or services under the CGST Act, 2017."
Maintain contemporaneous records. Document the actual loss suffered when enforcing an LD clause. If you can demonstrate that the LD amount correlates with actual damages, the "compensatory" characterization is stronger.
Looking for expert help with GST notice response and compliance advisory? The team at Tax Garden, based in Kondapur, Hyderabad, helps Indian SMEs stay compliant end-to-end: filings, notices, and advisory, all in one place.
Frequently Asked Questions
Does Circular 178 apply retrospectively to past GST demands on liquidated damages?
Circular 178 is clarificatory in nature, meaning it explains existing law rather than changing it. The CBIC's position is that the law was always as stated in the Circular. Therefore, it applies to past periods as well. However, GST officers may not always accept retrospective application voluntarily. Taxpayers may need to contest demands at the appellate level citing the Circular.
What SAC code should be used if GST applies on toleration of an act?
SAC 999794 covers 'agreeing to do an act' or 'refraining from doing an act.' This is the appropriate classification for payments that constitute consideration for tolerating an act or omission under Entry 5(e) of Schedule II. The applicable rate is 18% (9% CGST + 9% SGST, or 18% IGST for inter-state transactions).
Can the recipient of liquidated damages claim ITC on GST charged by the payer?
If GST is legitimately chargeable on the payment (i.e., it is a toleration arrangement, not a genuine breach), the recipient can claim ITC under Section 16 of the CGST Act, provided the payment relates to the recipient's taxable business and all other ITC conditions are met.
Are cheque bounce charges taxable under GST?
Yes. Cheque bounce or dishonour charges are considered taxable under GST. The bank or payee provides a service of processing the dishonoured instrument, and the charge is consideration for that service. GST at 18% applies.
What happens if a contract does not clearly classify the payment as damages or fees?
Ambiguous contracts invite departmental scrutiny. If the contract does not clearly characterize the payment, GST officers may treat it as consideration for supply based on the surrounding facts. Courts apply a substance-over-form test, but litigation is expensive. Clear drafting is the most cost-effective protection.
Is GST applicable on demurrage charges at ports and warehouses?
Yes. Demurrage and detention charges at ports, container freight stations, and warehouses are taxable at 18% GST. These charges represent consideration for the service of allowing continued use of infrastructure beyond the free period. This is distinct from LD for breach because the contract explicitly permits extended use subject to payment.
Does Circular 178 override earlier AAR rulings that held LDs as taxable?
Circular 178 does not technically override AAR rulings, as AARs are quasi-judicial bodies. However, the Circular is binding on all GST officers under Section 168 of the CGST Act. In practice, any new assessment or audit must follow the Circular. Taxpayers with adverse AAR rulings from before August 2022 should file appeals citing the Circular as a change in departmental position.
Are insurance claim settlements taxable under GST?
No. Insurance claim payouts by the insurer to the insured are not taxable under GST. The insured is not providing any service to the insurer by suffering a loss. The premium paid by the insured is taxable (it is consideration for the insurance service), but the claim payout in the reverse direction is compensatory and outside GST.
Tax Garden Can Help
Liquidated damages and penalty clauses sit at the intersection of contract law and GST compliance. Getting the classification wrong means either paying GST you do not owe or facing demands with interest and penalties later. Tax Garden's GST advisory team reviews your contract clauses against Circular 178 criteria, prepares responses to show-cause notices, files refund applications for GST paid on non-taxable LDs, and advises on contract drafting to minimize future GST disputes.
Explore our plans or see how it works.
Sources: CBIC Circular No. 178/10/2022-GST dated 3 August 2022; Entry 5(e), Schedule II, CGST Act 2017; Section 7(1)(a), CGST Act 2017; Section 15(2)(d), CGST Act 2017; Section 5(3), IGST Act 2017; Notification No. 12/2017-Central Tax (Rate); Karnataka AAR Order No. KAR/ADRG/2023; Gujarat AAAR Order 2023; Maharashtra AAR rulings on telecom early termination (2024). All legal positions stated reflect the law as of July 2026.
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