The Central Board of Indirect Taxes and Customs (CBIC) issued a clarificatory circular on the applicability of service tax / GST on payments in the nature of liquidated damages arising out of breach of contract, on August 03, 2022. “Agreeing to the obligation to refrain from an act or to tolerate an act or a situation, or to do an act” has been specifically declared to be a supply of service in para 5 (e) of Schedule II of the Central Goods and Services Tax Act, 2017 (CGST Act) if the same constitutes a “supply” within the meaning of the CGST Act. The CBIC has provided clarification on treatment of liquidated damages within the scope of such an entry.
The CBIC opines that “where the amount paid as ‘liquidated damages’ is an amount paid only to compensate for injury, loss or damage suffered by the aggrieved party due to breach of the contract and there is no agreement, express or implied, by the aggrieved party receiving the liquidated damages, to refrain from or tolerate an act or to do anything for the party paying the liquidated damages, in such cases liquidated damages are mere a flow of money from the party who causes breach of the contract to the party who suffers loss or damage due to such breach. Such payments do not constitute consideration for a supply and are not taxable.”