Liquidated damages, penalties and notice pay recovery
Amounts received because something went wrong. A circular says they are not consideration. Officers still demand tax on them.
Circular 178/10/2022-GST clarified that liquidated damages, penalties for breach, forfeiture of earnest money, cancellation charges and notice pay recovery are not consideration for a supply where they are payments flowing from a breach or from the exercise of an option, and not the price of an independent agreement to tolerate an act. The distinction is whether there is an independent contract to do, refrain from doing, or tolerate an act, for which the payment is the consideration.
The test the circular applies
Schedule II entry 5(e) treats agreeing to the obligation to refrain from an act, to tolerate an act or situation, or to do an act, as a supply of service. The department had used this entry to tax almost every non performance payment.
The circular holds that the entry applies only where there is an independent agreement in which the consideration is paid for the tolerance itself. Where the payment flows from a breach of the principal contract, it is not consideration for a supply.
Liquidated damages for delay are therefore not taxable, because the contract's object was performance, not delay.
A non compete payment, by contrast, is consideration for an independent agreement to refrain, and is taxable. The distinction is the presence of an independent bargain.
The heads the circular covers
Liquidated damages for delay or non performance: not taxable.
Forfeiture of earnest money or security deposit on breach: not taxable, being in the nature of compensation.
Cancellation charges for a booking: the circular treats these as consideration for the facilitation of the booking in specified situations, so the treatment depends on the nature of the charge and the contract.
Notice pay recovery from an employee: not taxable, because the employment contract's object is employment and the recovery is compensation for short notice.
Penalty for cheque dishonour, and late payment surcharge: the late payment charge is includible in the value of the underlying supply under Section 15(2)(d), which is a different provision and must not be confused with the damages analysis.
How to hold the position
Draft the contract so that the damages clause is a remedy for breach, quantified as compensation, and not a priced option to delay.
Where an option is genuinely being sold — a right to terminate, a right to cancel — recognise that it may be taxable and price it accordingly.
Cite the circular in the reply and identify the head under which the receipt falls. Officers frequently apply Schedule II entry 5(e) without addressing the circular at all.
Keep the accounting treatment consistent with the characterisation; damages credited to revenue as a service fee undermine the argument.
Authorities relied on
Liquidated damages, penalties for breach, forfeiture of earnest money and notice pay recovery are not consideration for a supply where they flow from a breach and not from an independent agreement to tolerate an act.
What to do on Monday
Review damages, termination and cancellation clauses so the characterisation follows the intended treatment.
Cite Circular 178/10/2022-GST and identify the head in every reply on this issue.
Keep the accounting treatment consistent with the characterisation.
Separate genuine priced options from remedies for breach at the drafting stage.
This page states the general position. A reader with a specific question on their own facts may write to the GST practice at AMLEGALS.
Write to the GST practiceQuestions we are asked on this
Is notice pay recovery taxable?
Per the circular, no. It is compensation for short notice under an employment contract, not consideration for a service.
Are liquidated damages for project delay taxable?
No, where they compensate a breach. Draft the clause as a remedy, not as a priced option.
Is a non compete payment taxable?
Yes. It is consideration for an independent agreement to refrain from an act.
Are cancellation charges taxable?
The circular treats certain cancellation charges as consideration for facilitation. The answer depends on the contract and the nature of the charge.
Is a late payment surcharge taxable?
Yes, under Section 15(2)(d), as part of the value of the underlying supply. That is a separate provision from the damages analysis.
In this cluster
- Valuation under Section 15: transaction value and its exceptions
- Rule 28 in practice: related party and distinct person supplies
- Corporate guarantees between group companies: the one percent rule
- Northern Operating Systems: secondment, and the notice that follows every expatriate
- Cross charge of common costs between branches
- Mandatory Input Service Distributor: the compliance rebuild
- Post sale discounts: the agreement requirement and the credit note trail
- Free of cost supplies, warranty replacements and moulds
- Reimbursements and the pure agent exclusion under Rule 33
- Vouchers and gift cards: the amended treatment
GST Insights is published by AMLEGALS for general information. Law stated as on 3 September 2026. Not advice on any particular set of facts; not an advertisement or a solicitation under Rule 36 of the Bar Council of India Rules. Readers with a question on their own facts may write to the GST practice of their own accord.