This circular provides clarification on whether amounts such as liquidated damages, compensation, penalties, cancellation charges and similar payments are taxable under GST as a supply of service by way of agreeing to refrain from an act, tolerate an act or situation, or do an act under paragraph 5(e) of Schedule II of the CGST Act.

It clarifies that for any such payment to be taxable, there must be a clear contractual agreement where one party agrees, for consideration, to refrain from an act, tolerate an act or situation, or do an act. Mere flow of money, without such an independent and explicit or implied agreement, does not constitute consideration for a supply. Payments made as a consequence of breach of contract, such as liquidated damages or penalties, are generally compensatory in nature and are intended to deter non-performance rather than to permit or tolerate a breach. Accordingly, liquidated damages paid for breach of contract, forfeiture of earnest money, penalties for cheque dishonour, penalties for violation of law, and recovery of bond amount or salary from employees leaving employment prematurely are not taxable, as they are not consideration for any supply.

The circular also clarifies that certain charges, though termed as penalties, are taxable where they represent consideration for a facility or option provided under the contract. Examples include late payment charges, early termination fees, cancellation charges for travel, hotel or similar services, and capacity or fixed charges that are ancillary to the principal supply. Such amounts are to be treated as part of the principal supply and taxed at the same rate as the main service, unless the principal supply itself is exempt.

These clarifications aim to distinguish compensatory payments from taxable consideration and ensure uniform treatment of such transactions under GST.