Find what the payer receives in return
A payment solely compensating injury, loss or damage from a contract breach is not automatically consideration for a service of tolerating that breach. Under CBIC Circular 178/10/2022-GST, genuine compensation with no independent express or implied agreement to refrain, tolerate or do something is not consideration for a supply. A payment actually purchasing an agreed obligation can be consideration even if the document calls it damages.
Read Schedule II through the supply test
CBIC Circular 178/10/2022-GST dated 3 August 2022 explains that Schedule II paragraph 5(e) does not dispense with the requirement that the arrangement constitute a supply. Paragraphs 6–7.1 distinguish an independent reciprocal arrangement from compensation triggered by an unwanted breach. Sources were checked on 22 October 2026. This article applies that distinction; it does not classify every penalty, cancellation fee or payment under one blanket rule.
The relevant question is not simply whether the parties have a written contract. Most breach damages arise under a contract. Identify the actual promise allegedly supplied in exchange for this payment. A clause deterring non-performance differs from a separately purchased non-compete undertaking or a facility sold to the customer. The parties’ conduct and commercial substance can establish an implied arrangement, so the absence of a separate invoice or document is not decisive either.
Build an evidence-based damages file
Retain the performance obligation, breach evidence, demand, loss explanation, contractual calculation, settlement and payment trail. Identify who suffered the loss and who receives the money. A ledger headed penalty income is not sufficient evidence that no supply exists. Equally, a GST debit note cannot establish taxability where the underlying payment is only a non-supply compensatory flow.
The circular describes liquidated damages as a contractual compensation mechanism and explains its treatment where no independent supply is agreed. Whether a contractual amount is enforceable or reasonable under contract law is a different question from this GST analysis. The examples assume the stated compensation is validly established and do not express an opinion about labour-law enforceability or a disputed damages award.
Employment-related recoveries need the actual arrangement
Paragraph 7.5 addresses salary forfeiture or employment-bond recovery where an employee leaves before the minimum agreed period. In the circumstances described, the employer recovers the amount to deter premature departure, the employee receives nothing in return, and the recovery is not taxable as consideration for tolerating an act. Do not convert that explanation into an exemption for every amount collected from employees, contractors or trainees.
A genuine separate training course, sale of goods, accommodation supply or other employee-facing transaction needs its own analysis. The fact that a receipt is posted through payroll does not determine it. Conversely, adjusting a qualifying bond recovery against final salary instead of receiving a separate transfer does not by itself turn the employer into a supplier of an exit service. Record the legal amounts and settlement independently; payroll netting should not erase the evidence.
Separate a bought obligation from compensation
An agreement to refrain from competition for consideration is one of the circular’s examples of an actual obligation to refrain. Establish the supplier, territorial facts, applicable rate, exemption and any reverse-charge condition under the relevant notification. The taxable illustrations below expressly assume an ordinary domestic taxable supply under forward charge at 18%; they are not a universal rate or charge-mechanism conclusion for every non-compete or restraint payment.
A settlement can combine genuine damages and payment for a new ongoing promise. Classify the supported components instead of taxing or excluding the entire settlement by its heading. Artificial allocations unsupported by the agreement are unsafe. Where the reciprocal promises cannot be separated on the facts, examine the arrangement as a whole rather than inventing a damages percentage.
Net settlement does not automatically rewrite the original invoice
When a buyer deducts a valid separate damages claim from the amount payable for goods or services, reconcile the original taxable invoice, compensation claim and cash settlement as separate items. Non-taxability of the buyer’s genuine damages receipt does not itself establish a statutory reduction in the seller’s original supply value. Any actual price change and GST credit-note adjustment require their own legal conditions and documentation.
Late-payment charges and cancellation facilities have separate discussion in the circular and should not be treated as genuine breach compensation by default. This article focuses on compensation and independent obligations; it does not repeat the supplier late-payment calculation or decide all cancellation-fee cases. A non-supply conclusion also is not the same as an exemption notification or a finding that input-tax-credit and accounting questions are automatically resolved.
Worked illustrations
These illustrations use fictional facts and expressly stated assumptions. Amounts are Indian rupees unless a different currency or unit is specified. They are independent examples, not findings about any actual client.
Illustrative example 1: a contractual delay formula measures genuine loss
A supply contract of ₹10,00,000 provides compensation of 0.5% of the contract value per week of delay. Assume three chargeable weeks, established loss-compensation facts, and no independent promise by the buyer to tolerate delay for consideration. Compensation = ₹10,00,000 × 0.5% × 3 = ₹15,000. On these facts the circular’s genuine-damages analysis gives no GST on the ₹15,000; the contract-price formula alone does not prove a supply.
Illustrative example 2: employment bond adjusted against final salary
Assume a valid qualifying employment-bond recovery equal to two months of an agreed ₹60,000 monthly measure, because the employee leaves before the minimum period. Recovery is ₹1,20,000. If independently determined final salary payable is ₹3,00,000, net settlement is ₹1,80,000. On the stated paragraph 7.5 facts, the bond recovery is not consideration for an exit service. This example does not decide the enforceability or payroll income-tax treatment of the deduction.
Illustrative example 3: a genuine non-compete supply is different
A supplier receives ₹2,00,000 exclusive of GST for an independently enforceable promise not to compete. Assume verified domestic taxability, forward charge and an applicable 18% rate, with no exemption. GST is ₹36,000 and gross consideration ₹2,36,000. Describing the ₹2,00,000 as compensation does not remove the reciprocal promise bought by the payer.
Illustrative example 4: supported settlement components receive separate analysis
An agreement separately identifies genuine breach damages ₹4,00,000 and consideration ₹1,00,000 exclusive of tax for an independently taxable ongoing restraint. Assume 18% forward-charge tax applies only to that restraint component. GST is ₹18,000; settlement total is ₹4,00,000 + ₹1,00,000 + ₹18,000 = ₹5,18,000. This assumes the allocation reflects the actual promises and evidence, rather than a tax-motivated label.
Illustrative example 5: damages deducted from a goods invoice
Original goods value is ₹10,00,000 plus assumed applicable GST ₹1,80,000. The buyer has a separately established genuine damages claim ₹50,000 and nets it against the gross ₹11,80,000 payable. Cash paid is ₹11,30,000. Assume the original supply price is unchanged and no qualifying GST credit-note adjustment exists. Original seller output GST remains ₹1,80,000; the buyer’s non-supply damages treatment does not automatically reduce it.
Illustrative example 6: a compensation cap is not a GST threshold
Assume a supported breach loss ₹5,00,000 and an enforceable contractual recovery cap ₹3,00,000; only ₹3,00,000 is settled as genuine compensation, with no separate reciprocal supply. Unrecovered loss is ₹2,00,000. GST on the stated compensatory receipt is nil because of its nature, not because ₹3,00,000 is below a special damages threshold. No such monetary threshold is assumed here.
Ten-step verification table
| Step | Verification | Evidence to retain |
|---|---|---|
| 1 | Identify the agreement and actual payer/recipient. | Executed contract and party details. |
| 2 | Describe the breach and unwanted consequence. | Performance, delay or exit evidence. |
| 3 | Find any independent reciprocal promise. | Express terms and relevant conduct. |
| 4 | Classify compensation and supply components. | Reasoned circular-based analysis. |
| 5 | Recalculate the contractual amount and cap. | Rate, period and loss working. |
| 6 | Validate the stated employment or other special facts. | Bond, payroll and entitlement records. |
| 7 | For actual supplies, verify rate and charge mechanism. | Applicable notifications and place-of-supply analysis. |
| 8 | Separate original invoice value from settlement netting. | Invoice, damages claim and cash bridge. |
| 9 | Check adjustment-document requirements independently. | Credit/debit note and return analysis. |
| 10 | Retain one consistent accounting and tax trail. | Settlement approval, reporting and evidence file. |
Sixteen practitioner FAQs
1. Does every damages clause create a toleration service?
No. The circular distinguishes compensation for unwanted breach from a reciprocal agreed obligation.
2. Does merely having a contract establish a taxable supply?
No. Identify the relevant promise and consideration nexus for the payment in question.
3. Is the word penalty decisive?
No. Examine the actual arrangement and substance.
4. Can an independent obligation be implied?
Yes. The circular considers express and implied agreements; conduct and terms matter.
5. What does paragraph 7.5 address?
The stated employment-related forfeiture or bond recovery for leaving before the minimum agreed period.
6. Does payroll recovery exempt all employee transactions?
No. A separate training, goods or other actual supply needs its own analysis.
7. Does a non-supply conclusion establish labour-law enforceability?
No. Enforceability and GST classification are different issues.
8. Are non-compete payments automatically genuine damages?
No. Consideration for an agreed restraint can be payment for an actual obligation.
9. Is 18% always the rate on every restraint payment?
No. The examples assume that rate and forward charge only after the relevant conditions are verified.
10. Can a settlement allocation be invented by accounting entries?
No. The supported legal and commercial components must drive the analysis.
11. Does netting damages reduce original invoice GST automatically?
No. Any adjustment to original value and tax needs its own legal basis and documents.
12. Are late-payment fees necessarily the same as breach damages?
No. The circular separately discusses late-payment facilities and their relationship to the main supply.
13. Are all cancellation charges covered by the no-supply conclusion?
No. Their actual contractual facility and the circular’s specific discussion require separate review.
14. Is there a general rupee exemption threshold for genuine damages here?
No. These examples turn on whether consideration for a supply exists.
15. Does a credit note itself prove the receipt is not taxable?
No. A document label cannot replace the underlying supply analysis.
16. What is the strongest practical defence?
A consistent file showing the breached obligation, actual loss mechanism, absence of an independent supplied promise and reconciliation to the settlement.
Working-paper organisation
Keep the source documents, calculation and final conclusion together for the same entity and period. If using assureTax or other assureOffice tools, use only confirmed available functions and retain this evidence with the output.
Conclusion
Document the actual reciprocal promises before deciding GST. Genuine compensation, an independently bought obligation and a net adjustment of an existing invoice can appear in the same settlement but require distinct conclusions.