GST Implications on Penal Charges Under RBI’s 2023 Directions: All You Need to Know

The Reserve Bank of India ( RBI ), through its circular dated 18th August 2023, directed all Regulated Entities ( REs ) including banks and Non-Banking Financial Companies ( NBFCs ) to discontinue the practice of charging penal interest on loan accounts for non-compliance with material terms and conditions of loan contracts.

Instead, from 1st January 2024, REs must levy penal charges in place of penal interest. The RBI’s intent behind this directive is to inculcate credit discipline among borrowers while enhancing transparency in the imposition of such charges. This change, however, does not apply to credit cards, external commercial borrowings, trade credits, and structured obligations, which continue to be governed by their respective product-specific guidelines.

Following the RBI’s directive, representations were received from stakeholders to the indirect taxes board seeking clarity on whether GST would be applicable on such penal charges. This was because some field formations were viewing penal charges as a consideration for tolerating an act or situation, potentially making them taxable under GST Act.

Reference to Earlier Clarification: Circular No. 178/10/2022-GST

According to Circular No. 178/10/2022-GST dated 3rd August 2022, which clarified that payments like liquidated damages for breach of contract do not constitute consideration for a separate supply.Such payments are not for tolerating an act but for deterring breach of contractual obligations. The essence of any contract is its performance, not its breach, thus, any penalty for breach merely arises as an event within the original contract and does not give rise to a separate taxable supply.

Penal Charges by REs Fall Within Same Principle

The CBIC has clarified that penal charges levied by REs, in line with RBI’s directions, are in the nature of penalties for breach of the material terms of loan agreements. Hence, they are to be treated on the same footing as liquidated damages discussed in the 2022 Circular.

GST Council’s Recommendation and Final Clarification

Following the RBI's directives from August 18, 2023, the 55th GST Council has suggested that penal charges imposed by banks and NBFCs not be subject to GST. This explanation clears up any confusion and benefits both borrowers and the financial industry by ensuring that there won't be any extra GST burden brought on by fines for loan terms violations.

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