Circular No. 178/10/2022-GST
F. No. 190354/176/2022-TRU
Government of India
Ministry of Finance
Department of Revenue
(Tax Research Unit)
*****
Room No. 146G, North Block,
New Delhi, the 3rd August, 2022
To,
The Principal Chief Commissioners/Chief Commissioners/
Principal Commissioners/
Commissioner of Central Tax (All) /
The Principal Director Generals/ Director Generals (All)
Madam/Sir,
Subject: GST applicability on liquidated damages, compensation and penalty arising out of
breach of contract or other provisions of law – reg.
In certain cases/instances, questions have been raised regarding taxability of an activity or
transaction as the supply of service of agreeing to the obligation to refrain from an act or to tolerate
an act or a situation, or to do an act. Applicability of GST on payments in the nature of liquidated
damage, compensation, penalty, cancellation charges, late payment surcharge etc. arising out of
breach of contract or otherwise and scope of the entry at para 5 (e) of Schedule II of Central Goods
and Services Tax Act, 2017 (hereinafter referred to as, “CGST Act”) in this context has been
examined in the following paragraphs.
2. “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
CGST Act if the same constitutes a “supply” within the meaning of the Act. The said expression
has following three limbs: -
a. Agreeing to the obligation to refrain from an act-
Example of activities that would be covered by this part of the expression would include
non-compete agreements, where one party agrees not to compete with the other party in a
product, service or geographical area against a consideration paid by the other party.
Another example of such activities would be a builder refraining from constructing more
than a certain number of floors, even though permitted to do so by the municipal
authorities, against a compensation paid by the neighbouring housing project, which wants
to protect its sunlight, or an industrial unit refraining from manufacturing activity during
Circular No. 178/10/2022-GST
certain hours against an agreed compensation paid by a neighbouring school, which wants
to avoid noise during those hours.
b. Agreeing to the obligation to tolerate an act or a situation-
This would include activities such a shopkeeper allowing a hawker to operate from the
common pavement in front of his shop against a monthly payment by the hawker, or an
RWA tolerating the use of loud speakers for early morning prayers by a school located in
the colony subject to the school paying an agreed sum to the RWA as compensation.
c. Agreeing to the obligation to do an act-
This would include the case where an industrial unit agrees to install equipment for zero
emission/discharge at the behest of the RWA of a neighbouring residential complex against
a consideration paid by such RWA, even though the emission/discharge from the industrial
unit was within permissible limits and there was no legal obligation upon the individual
unit to do so.
3. The description “agreeing to the obligation to refrain from an act or to tolerate an act or
a situation, or to do an act” was intended to cover services such as described above. However,
over the years doubts have persisted regarding various transactions being classified under the said
description.
3.1. Some of the important examples of such cases are Service Tax/GST demands on –
i.
Liquidated damages paid for breach of contract;
ii.
Compensation given to previous allottees of coal blocks for cancellation of their licenses
pursuant to Supreme Court Order;
iii.
Cheque dishonour fine/penalty charged by a power distribution company from the
customers;
iv.
Penalty paid by a mining company to State Government for unaccounted stock of river
bed material;
v.
Bond amount recovered from an employee leaving the employment before the agreed
period;
vi.
Late payment charges collected by any service provider for late payment of bills;
vii.
Fixed charges collected by a power generating company from State Electricity Boards
(SEBs) or by SEBs/DISCOMs from individual customer for supply of electricity;
viii.
Cancellation charges recovered by railways for cancellation of tickets, etc.
Circular No. 178/10/2022-GST
In some of these cases, tax authorities have initiated investigation and in some advance
ruling authorities have upheld taxability.
4. In Service Tax law, ‘Service’ was defined as any activity carried out by a person for another
for consideration. As discussed in service tax education guide, the concept ‘activity for a
consideration’ involves an element of contractual relationship wherein the person doing an activity
does so at the desire of the person for whom the activity is done in exchange for a consideration.
An activity done without such a relationship i.e., without the express or implied contractual
reciprocity of a consideration would not be an ‘activity for consideration’. The element of
contractual relationship, where one supplies goods or services at the desire or another, is an
essential element of supply.
5. The description of the declared service in question, namely, agreeing to the obligation to
refrain from an act or to tolerate an act or a situation, or to do an act in para 5 (e) of Schedule II of
CGST Act is strikingly similar to the definition of contract in the Contract Act, 1872. The Contract
Act defines ‘Contract’ as a set of promises, forming consideration for each other. ‘Promise’ has
been defined as willingness of the ‘promisor’ to do or to abstain from doing
anything. ‘Consideration’ has been defined in the Contract Act as what the ‘promisee’ does or
abstains from doing for the promises made to him.
6. This goes to show that the service of agreeing to the obligation to refrain from an act or to
tolerate an act or a situation, or to do an act is nothing but a contractual agreement. A contract to
do something or to abstain from doing something cannot be said to have taken place unless there
are two parties, one of which expressly or impliedly agrees to do or abstain from doing something
and the other agrees to pay consideration to the first party for doing or abstaining from such an act.
There must be a necessary and sufficient nexus between the supply (i.e. agreement to do or to
abstain from doing something) and the consideration.
6.1 A perusal of the entry at serial 5(e) of Schedule II would reveal that it comprises the
aforementioned three different sets of activities viz. (a) the obligation to refrain from an act, (b)
obligation to tolerate an act or a situation and (c) obligation to do an act. All the three activities
must be under an “agreement” or a “contract” (whether express or implied) to fall within the ambit
of the said entry. In other words, one of the parties to such agreement/contract (the first party) must
be under a contractual obligation to either (a) refrain from an act, or (b) to tolerate an act or a
situation or (c) to do an act. Further some “consideration” must flow in return from the other party
to this contract/agreement (the second party) to the first party for such (a) refraining or (b)
tolerating or (c) doing. Such contractual arrangement must be an independent arrangement in its
own right. Such arrangement or agreement can take the form of an independent stand- alone
contract or may form part of another contract. Thus, a person (the first person) can be said to be
making a supply by way of refraining from doing something or tolerating some act or situation to
