Ankit Rahangdale is a seasoned finance professional with a distinguished background as a Chartered Accountant. Currently, he leads the Finance Department at Pice. With over five years of invaluable experience in the banking and finance sector, honing his expertise through esteemed institutions such as ICICI Bank and Standard Chartered Bank.
Liquidated damages are pre-determined compensation for contract breaches or non-performance.
GST applies to liquidated damages as they are considered a supply of service under the CGST Act.
The applicable GST rate is NIL for government fines and 18% for other services.
The recipient of liquidated damages must issue a GST invoice for the amount.
Payments purely compensatory in nature and not tolerating a breach are not subject to GST.
Liquidated damages usually come into play when there is a contract breach like failure to meet performance standards or non-delivery of goods. In this blog, you will explore the concept of GST on liquidated damages, understand the applicable GST rates, and find out who can issue the GST invoice in such cases. Read on to get all the details.
What Are Liquidated Damages?
Liquidated damages are a pre-determined amount outlined in a breach of contract, intended to estimate the compensation the aggrieved party owes the other for a specific breach. Simply put, they are monetary compensation for failing to fulfil contractual obligations.
These damages are normally calculated whenever the actual loss is not possible to be quantified. Contracts often include a clause specifying the exact amount payable in case of non-performance.
For example, if a seller delays delivering raw materials and the manufacturer incurs lost revenue, the seller will be liable to pay 0.5% of the lost revenue for each week until the materials are delivered.
Applicability of GST on Liquidated Damages
Under Section 7(1)(d) of the Central Goods and Services Tax (CGST) Act, the definition of "Scope of Supply" includes all forms of supply mentioned in Schedule II of the Act. According to Schedule II, Para (5)(e), "agreeing to an obligation to refrain from an act, tolerate an act or situation, or to do an act” is classified as the supply of services.
Therefore, it can be interpreted that liquidated damages fall under GST’s purview, as they arise from one injured party tolerating the other’s non-performance under the contract.
Since GST is applicable to the supply of goods and services, liquidated damages are considered taxable as a service under the GST Act. The time of taxable supply shall be determined with regard to the moment at which, according to the contract, the breach is identified. Thus, for example, the time of supply of services will be when the contractor fails to complete the construction work within the agreed period, whereby his failure is officially recognised.
The below table mentions the rates of GST on liquidated damages:
Chapter Heading
Description
Applicable GST Rate
9991 to 9997
Services offered by the Central Government, State Government, Union Territory or local authority involving the acceptance of non-performance of contract, where compensation in the form of fines or liquidated damages is paid to these authorities as stipulated under the contract.
NIL
9997
Other services
18%
Who Shall Raise the GST Invoice for Liquidated Damages?
The entity receiving liquidated damages is required to issue a separate GST invoice for the amount.
Availability of Input Tax Credit (ITC) on Liquidated Damages
Input Tax Credit (ITC) on liquidated damages can be claimed to offset future GST liabilities. However, this is subject to the terms and limitations outlined in the GST Act, which must be carefully adhered to.
Liquidated Damages Are Not Taxable Under GST
Liquidated damages cannot be regarded as consideration for accepting a non-performance or breach of a contract. Instead, they represent amounts recovered to penalise such actions and discourage future breaches. Since these payments are aimed at preventing contract violations rather than tolerating them, they do not attract GST liability.
Case Study on Applicability of GST on Liquidated Damages
Here is an example to understand the applicability of GST on liquidated damages:
Suppose Mr. Y is an IT professional who is employed at ABC Tech Solutions in Delhi. After leaving the company, he signed a non-compete agreement with ABC Tech Solutions, agreeing not to join any rival IT firms in the city for a period of one year. The agreement also stated that if Mr. Y violated this clause, he would be required to pay liquidated damages to ABC Tech Solutions.
Mr. Y resigned from ABC Tech Solutions on 1st February 2024. However, on 15th April 2024, he joined XYZ Technologies, a direct competitor of ABC Tech Solutions. By doing so, he breached the non-compete clause and became liable to pay liquidated damages, as mentioned in the agreement.
Since ABC Tech Solutions tolerated the breach of the agreement, this is considered a supply of service under Section 7(1)(d) of the CGST Act, Schedule II Para 5(e). As a result, ABC Tech Solutions must issue a GST invoice to Mr. Y for the liquidated damages at the applicable rate.
GST on liquidated damages applies where the payment is purely compensatory and does not contain any element of service or agreement to tolerate an act. Payments in this regard are treated as compensation for losses and, therefore, are not subject to GST. This is why one needs to understand these provisions so as to ensure business compliance with GST regulations when dealing with liquidated damages.
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FAQs
What are liquidated damages, and why are they included in contracts?
Liquidated damages are pre-determined monetary compensation outlined in contracts to address losses caused by non-performance or breach of contractual obligations. They simplify the process of claiming compensation by avoiding disputes over the actual extent of the loss. Such clauses are particularly useful when actual losses are challenging to quantify.
Is GST applicable to liquidated damages?
Yes, GST is applicable to liquidated damages as they are considered a supply of service under Section 7(1)(d) of the CGST Act. According to Schedule II, agreeing to tolerate an act or a breach is categorized as a taxable service. However, there is debate on this, as some argue these payments are purely compensatory and not taxable.
What is the GST rate on liquidated damages?
The GST rate on liquidated damages varies based on the nature of the service. If the damages are paid to a government or local authority for non-performance, the rate is NIL. For other services, the applicable GST rate is 18%, as specified under Chapter Heading 9997 of the GST classification.
Who is responsible for issuing the GST invoice for liquidated damages?
The entity receiving the liquidated damages is responsible for issuing a GST invoice for the amount. The invoice must specify the nature of the damages, the applicable GST rate, and the GST amount to ensure compliance with GST invoicing regulations.
Can Input Tax Credit (ITC) be claimed on GST paid for liquidated damages?
Yes, ITC can be claimed on GST paid for liquidated damages, provided the payment qualifies as a legitimate business expense under the GST Act. The availability of ITC depends on compliance with GST rules, and the claiming entity must ensure the damages relate directly to taxable business activities.
Ankit Rahangdale is a seasoned finance professional with a distinguished background as a Chartered Accountant. Currently, he leads the Finance Department at Pice. With over five years of invaluable experience in the banking and finance sector, honing his expertise through esteemed institutions such as ICICI Bank and Standard Chartered Bank.
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