Liquidated Damages for Breach of Contract Not Taxable under GST: Karnataka HC Orders Refund of Rs. 5 Crore Paid under Protest [Read Order]

In a recent ruling, the Karnataka High Court held that liquidated damages received for breach of contract are not taxable under the Goods and Services Tax law and directed refund of Rs. 5 crore that was collected during investigation and paid under protest by the taxpayer.

KrazyBee Services Private Limited, the petitioner, filed a writ petition challenging a show cause notice issued by the Directorate General of GST Intelligence proposing to levy GST on amounts received by it from its lending service providers as compensation for breach of contractual obligations.

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The petitioner is a non-banking financial company which had entered into a master service agreement with lending service providers. Under the agreement, the service providers were required to perform certain obligations, and the contract provided for payment of liquidated damages in case of breach or deficiency in performance.

The petitioner argued that the amounts received were purely compensatory in nature and represented liquidated damages arising from breach of contract. It was argued that such payments do not amount to consideration for any supply and are not taxable under GST, as clarified by the CBIC Circular dated 3 August 2022.

The petitioner’s counsel further argued that the show cause notice wrongly treated the receipts as consideration for “tolerating an act” under Schedule II of the CGST Act. They also argued that the notice ignored the specific paragraphs of the circular dealing with liquidated damages. The counsel also sought a refund of Rs. 5 crore that was collected during the investigation under protest, stating that the amount was not paid voluntarily.

The department argued that the amounts were received as “deficiency service fees” and represented consideration for tolerating deficiencies in service, which is taxable under the CGST Act. The department stated that the show cause notice was valid and should not be interfered with at the initial stage.

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After examining the agreement and the show cause notice, the bench comprising Justice S.R. Krishna Kumar observed that any breach committed by the lending service providers only gave the petitioner a right to claim liquidated damages as compensation. The court observed that such compensation is clearly covered by paragraphs 7.1 to 7.1.6 of the CBIC Circular, which state that compensation for breach of contract is not consideration for a supply and does not attract GST.

The court pointed out that there was no agreement between the parties to tolerate a breach as a service and that breach of contract was not the object of the agreement. It explained that the amounts were paid only as a result of non-performance and could not be treated as taxable consideration.

On the issue of the Rs. 5 crore paid during the investigation, the court observed that the amount was collected without adjudication and could not be treated as a voluntary payment. The court explained that such a collection during an investigation is not permissible in law.

The court held that the show cause notice was issued by wrongly treating liquidated damages as taxable and was contrary to the binding circular. The court quashed the impugned show cause notice and directed the authorities to refund the entire amount of Rs. 5 crore paid under protest along with applicable interest within eight weeks. The writ petition was allowed.

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