Liquidated Damages and explained: this guide covers what it means, who it applies to, the step-by-step process, documents required, fees, due dates and penalties in India — so you can stay compliant with confidence and avoid costly mistakes.
Schedule II paragraph 5(e) treats as a supply of services: "agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act."
For five years that entry was read as a catch-all. Departments applied it to liquidated damages, contractual penalties, forfeited earnest money, notice pay recovery, cheque bounce charges, cancellation fees — on the reasoning that the recipient of the money had "tolerated" the payer's default.
Circular No. 178/10/2022-GST dated 03.08.2022 rejected that reading, and the ICAI commentary in Volume I treats it as the governing analysis.
A payment is taxable under paragraph 5(e) only where there is an independent agreement to refrain, tolerate or do an act, with a direct link between that agreement and the payment. Where a sum flows because a party breached the contract, it is compensation for the breach, not consideration for tolerating it — there was no agreement to tolerate the breach; the contract required performance. Liquidated damages are generally not taxable. Charges the parties agreed to price in advance as an alternative mode of performance may be.
The test the circular applies
Three questions, in order:
1. Is there an express or implied agreement to do, refrain from, or tolerate something? Not a contract that happens to contain a damages clause — an agreement whose subject matter is the forbearance.
2. Is there a direct link between that agreement and the payment? The payment must be consideration for the forbearance, not merely occasioned by an event.
3. Did the parties intend the payment as the price of a permitted alternative, or as a deterrent against breach? A deterrent is not a price.
The circular's central point: liquidated damages under s.74 of the Indian Contract Act, 1872 are a remedy for breach. The contract did not offer the counterparty a choice to perform or pay; it required performance. Damages flow from the failure. Nobody agreed to tolerate anything.
Where each common payment lands
| Payment | Position |
|---|---|
| Liquidated damages for delay or non-performance | Not taxable — compensation for breach |
| Penalty for breach of contract | Not taxable, same reasoning |
| Forfeiture of earnest money or security deposit on default | Not taxable — flows from breach, and serves as a deterrent |
| Cheque dishonour charges | Not taxable — the payee never agreed to tolerate dishonour |
| Late payment surcharge or interest | Taxable, but not under 5(e) — s.15(2)(d) includes interest, late fee or penalty for delayed payment in the value of the underlying supply |
| Cancellation charges on a booking | Taxable — facilitation of the booking is itself a service; the cancellation charge is consideration for it |
| Notice pay recovery from an employee | Not taxable — the employment contract's alternative, and Schedule III excludes employment |
| Compensation for pre-mature termination of a lease, agreed in the contract | Fact-specific — where the contract prices termination as an option, it can be taxable |
| Fine or penalty imposed by a statute or court | Not taxable — no agreement at all |
The two rows that most often surprise people are late payment interest and cancellation charges.
Late payment interest is taxable, but as part of the value of the original supply under s.15(2)(d), at the original supply's rate — not as a separate 18% service. That distinction matters where the underlying supply is at 5% or exempt.
Cancellation charges are taxable because the supplier provided a real service — reserving and holding the booking — and the charge is consideration for that, not damages. This is why a hotel or airline cancellation fee bears GST at the rate of the underlying service.
The distinction that decides the hard cases
Ask whether the contract gave the counterparty a genuine option.
No option — pure breach. "Deliver by 31 March. Damages of ₹1 lakh per week of delay." The contractor was never permitted to deliver late. Damages are compensation. Not taxable.
Genuine option — priced alternative. "Take a minimum of 1,000 units, or pay ₹50 per unit short-lifted." Here the buyer may lawfully choose either. The short-lift charge is the price of the alternative, and the supplier agreed in advance to tolerate under-lifting. Taxable.
The drafting will not always be clear, and a "penalty" label does not settle it. What settles it is whether performance was required or elective.
Practical consequences
Do not charge GST reflexively on damages. Charging tax that was never leviable engages s.32 and s.76 — the amount is payable to the Government whether or not the supply was taxable. Collecting tax you should not have →
Do not omit it reflexively either. A "penalty" that is really a priced option is a supply, and non-payment is a demand with interest.
Get the credit note right on damages deducted from a running bill. Where a customer deducts liquidated damages from the contractor's invoice, the deduction is not a reduction in the value of the supply — the contractor supplied the full scope and was compensated less. A credit note under s.34 is usually inappropriate; the tax stays on the gross value.
Document the characterisation in the contract, and again when the amount is levied.
Key takeaways
- Circular No. 178/10/2022-GST governs: paragraph 5(e) requires an independent agreement to tolerate, with a direct link to the payment.
- Liquidated damages and breach penalties are generally not taxable.
- Forfeited earnest money and cheque bounce charges are not taxable.
- Late payment interest is taxable — under s.15(2)(d), at the underlying supply's rate.
- Cancellation charges are taxable as consideration for the booking service.
- The dividing line is whether the contract offered a genuine priced alternative or required performance.
Read next
- Schedule II: Activities Treated as Goods or Services
- GST on Employee Recoveries: Canteen, Transport, Notice Pay
- Inclusions in Value of Supply: Packing, Freight, Commission
- Collecting Tax You Should Not Have: Sections 32 and 76
Disclaimer: Positions stated as on 5 September 2026, based on ICAI Background Material on GST, Volume I (2026 edition) and Circular No. 178/10/2022-GST.