Compensation amounts for contract breaches constitute taxable supply of services under GST at 18%

AAR held that compensation amounts including liquidated damages, trade settlements, and damages collected from customers for non-performance or breach of contract constitute taxable supply of services. The ruling determined these payments represent consideration for tolerating non-performance under agreements, not ad-hoc penalties. Such compensation amounts are subject to GST at 18% (9% CGST + 9% SGST) under HSN chapter 9997, serial 35 of Notification 11/2017, as they constitute supply of services ancillary to the principal contract.

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Issues Involved:
1. Whether GST is leviable on compensation amounts such as liquidated damages/trade settlement/damages collected from the customers for non-performing of contractual obligations or breach of the contract.
2. If GST is leviable on the said activity, what is the HSN Code applicable and the rate of GST applicable for the said activity.
3. If GST is not leviable on the said activity, does the restriction of input tax Credit of common services under 42 & 43 of CGST/APGST Rules, 2017 will attract.

Summary:

Issue 1: GST on Compensation Amounts for Breach of Contract
The applicant, M/s. South India Krishna Oil & Fats Pvt Ltd, engaged in manufacturing edible oils, collects compensation amounts such as liquidated damages/trade settlement from customers for breach or non-performance of contracts. The applicant initially discharged GST liability under the entry heading 9997 - Agreeing to tolerate an act. However, after the issuance of CBIC Circular No. 178/10/2022-GST, the applicant discontinued collecting GST on these amounts, arguing that the activity does not satisfy the definition of "Supply" under Section 7 of CGST/APGST Act, 2017.

The applicant contends that liquidated damages are not consideration for any supply of goods or services but compensation for breach of contract. Several legal precedents and the CBIC Circular support the view that such compensation is not taxable as it does not constitute consideration for a supply.

Issue 2: HSN Code and GST Rate
The Authority for Advance Ruling examined the definition of "consideration" under Section 2(31) of the GST Act, which includes any payment made in respect of, in response to, or for the inducement of the supply of goods or services. The Authority concluded that compensation amounts paid by the defaulting party to the non-defaulting party for tolerating the act of non-performance or breach of contract constitute consideration for a supply of service. Therefore, such compensation amounts are exigible to tax under CGST @ 9% and SGST @ 9%, each under chapter head 9997 at serial no. 35 of Notification No. 11/2017-Central/State tax rate.

Issue 3: Restriction of Input Tax Credit
Since the activity of collecting compensation amounts for breach of contract constitutes a taxable supply, the question of restriction of input tax credit under Rules 42 & 43 of CGST/APGST Rules, 2017 does not arise.

Ruling:
1. GST is leviable on compensation amounts such as liquidated damages/trade settlement/damages collected from the customers for non-performing of contractual obligations or breach of the contract.
2. The activity would be covered within chapter head 9997 - 'Other Services' and is taxable at 18% (9% CGST and 9% SGST) rate of tax.
3. The question of restriction of input tax credit does not arise.

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