GST on Liquidated Damages & Notice Pay Guide: Circular 178

Executive Overview: The Contentious History of Tolerating an Act under GST

In the foundational structure of the Goods and Services Tax (GST) regime, the concept of a taxable supply is anchored in Section 7 of the Central Goods and Services Tax (CGST) Act, 2017. While Section 7(1)(a) captures transactions made for a consideration in the course or furtherance of business, Section 7(1A) read with Schedule II categorizes specific activities as either supplies of goods or supplies of services. Among the most contested provisions in indirect tax history is Para 5(e) of Schedule II, which classifies "agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act" as a declared supply of service.

For several years following the rollout of GST in July 2017, field formations and tax audit authorities systematically weaponized Para 5(e). Departmental audit teams routinely issued aggressive Show Cause Notices in Form GST DRC-01 seeking to levy 18% GST across an enormous spectrum of commercial transactions: liquidated damages recovered for delayed contract execution, notice pay deductions from resigning employees, forfeiture of earnest money deposits, cheque bounce charges, demurrage fees, cancellation penalties, and pre-payment charges on loans. The department's mechanical position was that whenever one party received money due to the other party's breach or non-performance, the recipient was deemed to be 'tolerating' that non-performance, thereby rendering the compensation a taxable supply of service.

This aggressive administrative stance caused massive commercial disruptions, distorted corporate financial statements, and generated tens of thousands of departmental litigations. Recognizing the fundamental legal error of conflating compensation for breach with consideration for an independent contractual service, the Central Board of Indirect Taxes and Customs (CBIC) issued Circular No. 178/10/2022-GST on 3rd August 2022. This landmark circular established that liquidated damages, breach penalties, notice pay recoveries, and cheque dishonour fees are compensatory in nature and do not constitute consideration for any independent supply of service. Enterprise tax directors, corporate counsels, and practicing chartered accountants utilizing assureOffice, particularly its indirect tax platform assureTax and litigation suite assureNotice, must master the legal principles established in Circular 178 to successfully quash departmental demands, defend ongoing audits, and correctly structure commercial contracts.

Statutory Interpretation: Section 7(1) vs Schedule II Para 5(e)

To understand the binding legal effect of Circular No. 178/10/2022-GST, tax professionals must dissect the statutory relationship between Section 7(1) and Schedule II of the CGST Act:

1. The Substantive Charge: Section 7(1) Takes Precedence

Under Section 7(1)(a), a supply must involve three mandatory ingredients:

There must be an activity involving goods or services (or both).
The activity must be made or agreed to be made for a consideration.
The activity must be made by a person in the course or furtherance of business.

Crucially, Schedule II does not create a charge of tax. Following the retrospective amendment introduced by the CGST (Amendment) Act, 2018 to Section 7(1A), Schedule II only serves to classify a transaction as a supply of goods or a supply of services after the transaction independently qualifies as a 'supply' under Section 7(1). If an activity fails the fundamental test of being a supply supported by reciprocal consideration under Section 7(1), Schedule II cannot be invoked to artificially manufacture a taxable event.

2. The Requirement of a Distinct Contractual Agreement

Para 5(e) of Schedule II uses the phrase "agreeing to the obligation". As clarified by the CBIC in Circular 178, the phrase mandates that there must be an express or implied agreement between two parties where:

One party promises to refrain from doing an act (e.g., a non-compete agreement), or promises to tolerate a specific act/situation (e.g., granting permission to run a telecom cable across private land), or promises to perform a specific act.
The other party pays consideration specifically in return for that promise.

In stark contrast, a contract for the construction of a factory, supply of machinery, or delivery of goods is entered into with the sole intention of having the contract performed according to its terms. Liquidated damages stipulated in such commercial contracts are not paid to secure the service of 'tolerating delay'; they are compensatory damages intended to indemnify the innocent party against losses suffered due to the breach of contract. Therefore, there is no agreement to tolerate delay; the delay is an unintended breach, and the liquidated damages represent reimbursement of damage, not consideration for a supply.

Detailed Dissection of Commercial Categories under Circular 178/10/2022-GST

Category A: Liquidated Damages for Breach of Contract

Liquidated damages represent a pre-estimated sum agreed between contracting parties under Section 74 of the Indian Contract Act, 1872, payable by the defaulting party in the event of a breach (e.g., delay in commissioning a project, failure to meet technical performance warranties). Circular 178 conclusively clarifies:

Breach of contract is not an intended commercial purpose of either party.
The payment of liquidated damages does not flow from any desire or agreement to tolerate the breach; it is merely an eventuality covered by law to provide restitution.
Taxability Verdict: Liquidated damages for breach of contract, delays in EPC milestones, or supply disruptions are NOT taxable under GST.
Exception: Where a contract expressly provides for an option to pay a higher fee to extend a completion deadline or grant temporary tolerance as an independent facility, such additional consideration represents a taxable supply of service.

Category B: Notice Pay Recovery from Resigning Employees

When an employee resigns from service without serving the mandatory contractual notice period (e.g., 30, 60, or 90 days), the employment agreement typically provides for the recovery of salary in lieu of notice pay, deducted from the employee's final full-and-final settlement. Circular 178 clarifies:

Under Entry 1 of Schedule III of the CGST Act, "services by an employee to the employer in the course of or in relation to his employment" are treated as non-supplies (neither a supply of goods nor a supply of services).
The employment contract is an indivisible agreement. The stipulation for notice period or payment in lieu thereof is an integral condition of the employment relationship.
The recovery of notice pay by the employer is not consideration for the employer tolerating the early exit; it is a compensatory recovery for premature termination of employment.
Taxability Verdict: Notice pay recovery from employees is NOT subject to GST. Employers are not required to charge GST or issue tax invoices on notice pay deductions.

Category C: Cheque Dishonour / Bounce Charges

Suppliers and banking institutions frequently charge a penalty fee (e.g., ₹500 or ₹1,000) when a customer's payment cheque or auto-debit ECS mandate is dishonoured due to insufficient funds. Circular 178 establishes:

The cheque dishonour fee is not consideration for the service of tolerating the non-payment; it is a penalty imposed to discourage default and cover administrative friction.
There is no reciprocal agreement between the supplier and the customer to dishonour cheques.
Taxability Verdict: Penal charges levied for cheque dishonour are NOT liable to GST.

Category D: Ticket Cancellation & Hotel Booking Cancellation Charges

Unlike liquidated damages, cancellation charges levied by transportation service providers (airlines, railways, bus operators) and hospitality operators (hotels, banquet halls) occupy a distinct commercial position:

When a passenger or guest books a ticket or room, the operator commits resources and reserves inventory. When the customer cancels the booking, the operator retains a portion of the fee or levies a cancellation charge.
Circular 178 clarifies that cancellation charges are consideration for the facility of cancellation or booking arrangement provided by the operator.
Taxability Verdict: Cancellation charges ARE subject to GST.
Applicable Rate of Tax: Under Circular 178, cancellation charges are taxed at the same rate of GST as applicable to the principal supply (e.g., 5% for economy air travel, 5% for sleeper/third AC train travel, 12% or 18% for hotel room accommodation).

Category E: Forfeiture of Earnest Money Deposits (EMD) and Security Deposits

In commercial tendering and procurement, bidders furnish Earnest Money Deposits (EMD) or security deposits to guarantee compliance with tender terms:

Forfeiture on Breach of Tender Conditions: Where EMD is forfeited because a bidder withdraws its bid prematurely or fails to execute the contract, the forfeiture represents compensation for breach of bidding discipline. Such forfeiture is NOT subject to GST.
Adjustment Against Price: If the security deposit is subsequently adjusted against the taxable purchase price or rental charges upon successful execution, GST must be charged at the rate applicable to the principal supply at the time of adjustment.

8 Practical Case Studies & Worked Numerical Illustrations

Case Study 1: Solar Power Plant EPC Milestone Delay & Liquidated Damages

Context & Facts: Surya EPC Power Ltd entered into a turnkey engineering, procurement, and construction (EPC) contract of ₹100 Crores with GreenTech Energy Solutions Ltd for the installation of a 50 MW solar power farm in Rajasthan. The contract stipulated commercial operation date (COD) by 31st December 2024. Due to supply chain delays in inverter imports, commercial operations commenced on 28th February 2025 (a delay of 59 days). Under Clause 14.2 of the contract, GreenTech levied liquidated damages of 0.5% per week of delay, deducting ₹4,00,00,000 (₹4 Crores) from the final milestone payment to Surya EPC.

Departmental Scrutiny & Legal Defense:

The GST audit division issued a Show Cause Notice in Form GST DRC-01 to GreenTech, alleging that by deducting ₹4 Crores, GreenTech provided a declared service of 'tolerating delay' to Surya EPC under Schedule II Para 5(e), demanding 18% GST of ₹72,00,000 along with mandatory interest under Section 50 and penalty under Section 74.
Legal Analysis under Circular 178:
1. The primary objective of the contract was the timely construction and commissioning of a solar plant. Neither party contracted for delay; delay was an unintended breach of performance timelines.
2. The liquidated damages of ₹4 Crores represent compensatory restitution to mitigate GreenTech's financial loss caused by delayed power generation. GreenTech never agreed to tolerate the delay as a business service.
3. Under Paragraph 7.1 of Circular No. 178/10/2022-GST, liquidated damages for delayed project commissioning are not consideration for a supply.
Outcome: GreenTech files a formal reply citing Circular 178 and the Delhi High Court ruling in Quick Heal Technologies. The Adjudicating Authority drops the entire demand of ₹72,00,000. GreenTech tracks this litigation docket in assurePractice.

Case Study 2: IT Firm Notice Pay Recovery from Resigning Software Engineers

Context & Facts: Vertex Cloud Solutions Pvt Ltd, an IT development firm in Bengaluru, experienced the resignation of 45 software engineers in FY 2024-25. Under their employment contracts, engineers who did not serve the mandatory 60-day notice period had an amount equivalent to basic salary for the unserved period deducted from their final settlement. Total notice pay recovered across the year was ₹65,00,000.

Tax Audit Objection & Statutory Resolution:

Parameter	Departmental Contention	Statutory Defense under Circular 178
Characterization	Supply of service: Employer tolerating employee's premature exit u/s 7(1A) Para 5(e).	Direct employment matter covered by Schedule III Entry 1; non-supply.
Consideration	Notice pay deducted is consideration received by employer.	Compensatory recovery for breach of employment terms; not consideration.
Demanded GST Rate	18% on ₹65,00,000 = ₹11,70,000.	0% GST (Outside Scope of Supply).
Interest & Penalty	Demanded u/s 50 and Sec 122.	Entire demand dropped pursuant to Para 7.5 of Circular 178.

Practitioner Insight: The employer is not performing any independent service for the resigning employee. The recovery of salary is purely an adjustment under the employment relationship. Departmental officers attempting to revive pre-2022 audit memos on notice pay are acting contrary to binding CBIC circulars.

Case Study 3: Commercial Bank Cheque Bounce Charges

Context & Facts: FinTech Urban Bank Ltd levied cheque dishonour charges of ₹750 per instance on non-compliant corporate current accounts where inward cheques were returned unpaid due to insufficient funds. During FY 2024-25, the bank collected ₹1,80,00,000 in cheque dishonour fees. The local GST range officer issued an audit memo demanding 18% GST (₹32,40,000), contending that the bank provided a 'cheque bounce tolerance service'.

Legal Evaluation:

Under Para 7.3 of Circular 178, cheque dishonour charges are penal in nature. The customer does not issue an empty cheque to obtain the service of cheque dishonour from the bank.
The fee is a deterrent to cover operational friction and maintain financial discipline. There is no agreement or meeting of minds between the bank and the drawer to dishonour the instrument.
Verdict: Cheque dishonour charges are completely exempt from GST. FinTech Urban Bank cites Circular 178 and successfully vacates the audit memo before the Joint Commissioner of Commercial Taxes.

Case Study 4: Luxury Resort Wedding Booking Cancellation

Context & Facts: Heritage Palace Resorts, a luxury 5-star heritage hotel in Udaipur, booked a 3-day wedding package for ₹50,00,000 (taxable at 18% GST). The client paid an initial advance of ₹25,00,000 plus ₹4,50,000 GST. Due to personal reasons, the client cancelled the wedding 15 days prior to the event. Under the hotel's cancellation policy, 50% of the booking value (₹25,00,000) was retained as cancellation charges, and the remaining advance was refunded.

GST Computation on Cancellation Charges:

Element	Original Booking Terms	Post-Cancellation Accounting
Gross Accommodation & Banquet Value	₹50,00,000	₹25,00,000 (Retained Cancellation Charge)
Applicable GST Rate	18% (Hotel Accommodation > ₹7,500/night)	18% (Inherits Principal Supply Rate)
GST Applicable on Cancellation	₹9,00,000 (Original Estimate)	₹4,50,000 (18% on ₹25,00,000)
Net Retention by Hotel	-	₹25,00,000 + ₹4,50,000 GST = ₹29,50,000

Practitioner Insight: Under Para 7.2 of Circular 178, cancellation charges for transportation or hospitality are taxable because the facility of cancellation is an inherent part of the accommodation service package. Furthermore, the cancellation charges attract the same rate as the underlying service (18%). The resort must issue a compliant Credit Note for the refunded balance while adjusting output liability in GSTR-1 and GSTR-3B using assureTax.

Case Study 5: Domestic Airline Flight Ticket Cancellation

Context & Facts: Air Bharat operates domestic commercial passenger flights. A passenger booked an economy class flight from Mumbai to Delhi for ₹8,000 (comprising ₹7,619 base fare + ₹381 GST @ 5%). The passenger cancelled the ticket 24 hours before departure. Under the airline fare rules, a cancellation fee of ₹3,000 was deducted, and the balance of ₹5,381 was refunded to the passenger.

Rate Parity Rule Analysis:

The cancellation fee of ₹3,000 is consideration for the cancellation service.
Under Circular 178, the rate of GST on the cancellation fee must not exceed the rate applicable to the main service (economy passenger transport is taxed at 5% GST).
Tax Calculation: The cancellation fee is treated as inclusive of 5% GST:
- Taxable Value = ₹3,000 / 1.05 = ₹2,857.14.
- CGST (2.5%) = ₹71.43; SGST (2.5%) = ₹71.43 (Total GST = ₹142.86).
The airline correctly reports ₹142.86 under 5% outward supplies in its monthly GSTR-3B.

Case Study 6: Government Tender Earnest Money Deposit (EMD) Forfeiture

Context & Facts: The State Public Works Department (PWD) invited tenders for a highway expansion project. InfraBuild Developers Ltd submitted a bid along with an Earnest Money Deposit (EMD) of ₹50,00,000 via bank guarantee. InfraBuild was declared the lowest compliant bidder (L1) and issued a Letter of Award (LOA). However, InfraBuild failed to execute the formal contract within the mandatory 30-day window. PWD invoked the bank guarantee and forfeited the ₹50,00,000 EMD. PWD's internal accounts branch sought advice on whether to remit 18% GST (₹9,00,000) to the government.

Legal Determination:

Under Para 7.4 of Circular 178, forfeiture of earnest money for breach of tender conditions is penal and compensatory. It prevents frivolous bidding and covers administrative tendering costs.
The forfeiture does not involve any supply of service by PWD to InfraBuild. PWD is not tolerating InfraBuild's withdrawal; it is penalizing InfraBuild for failure to execute the contract.
Outcome: No GST is payable on the ₹50,00,000 forfeited EMD. PWD credits the entire amount to its capital receipts without charging or paying GST.

Case Study 7: Port Terminal Demurrage Charges on Delayed Cargo Evacuation

Context & Facts: Maritime Gateway Terminals operates a container terminal at a major seaport. Importers are granted 5 days of 'free storage' after container discharge. For cargo evacuated after Day 5, the terminal levies 'ground rent / demurrage charges' per container per day. Impex Global evacuated 20 containers on Day 12, incurring ₹8,00,000 in demurrage charges. Impex argued that demurrage is liquidated damages for delay and should be exempt under Circular 178.

Demurrage vs Liquidated Damages Distinction:

Dimension	Liquidated Damages (Exempt)	Port Demurrage / Storage (Taxable)
Nature of Transaction	Compensation for breach of main contract terms.	Extended cargo storage and warehousing facility.
Commercial Objective	Restitution for financial damage or project delay.	Payment for continued commercial use of port yard space.
Circular 178 Treatment	Para 7.1: Not a supply of service; 0% GST.	Para 7.6: Supply of cargo handling/storage service; Taxable @ 18%.

Practitioner Insight: Demurrage in port and warehouse operations is NOT a penalty for breach; it is consideration for the continuous use of commercial infrastructure beyond the free period. Maritime Gateway Terminals correctly charges 18% GST (₹1,44,000) on the demurrage invoice, allowing Impex Global to claim full ITC in assureTax.

Case Study 8: Commercial Lease Forfeiture of Security Deposit on Premature Eviction

Context & Facts: Apex Realty leased commercial office space to a retail tenant for a lock-in period of 36 months, taking an interest-free refundable security deposit of ₹15,00,000. In Month 14, the tenant abruptly vacated the premises, violating the mandatory lock-in clause. Under Clause 18 of the lease deed, Apex Realty forfeited the entire security deposit of ₹15,00,000 as compensation for loss of rental during the lock-in period. The GST department issued a DRC-01 claiming that forfeiture represents consideration for tolerating premature lease termination.

Litigation Defense & Strategy:

Breach of Lock-in Clause: The tenant committed an actionable breach of the commercial contract. The lease deed did not offer an optional exit fee; it enforced a mandatory 3-year term.
Judicial Precedents: High Courts (including the Bombay High Court in Bai Mamubhai) have consistently held that damages received for breach of tenancy are capital receipts outside the purview of service tax and GST.
Circular 178 Applicability: Para 7.1 strictly shields damages arising from contractual breach. Apex Realty submits a comprehensive defense reply supported by contract clauses. The Adjudicating Authority drops the demand in full. Apex manages this litigation docket in assurePractice.

10-Step GST Audit Verification Matrix for Damages & Penalties

Corporate tax controllers and practicing CAs must implement the following 10-step audit verification protocol to ensure full compliance and defense readiness:

Step	Audit Procedure	Statutory Authority	Critical Verification Objective	assureOffice Tool
Step 1	Review Primary Contract Terms	Section 74 Contract Act / Sec 7 CGST	Ascertain whether payment is for breach or an optional pre-agreed tolerance fee.	assurePractice
Step 2	Identify Reciprocal Supply	Section 7(1)(a) CGST Act	Verify if any independent performance or service was rendered in exchange for funds.	assureTax
Step 3	Classify under Circular 178	CBIC Circular 178/10/2022-GST	Categorize into exempt breach damages vs taxable cancellation / storage facilities.	assureTax
Step 4	Audit Notice Pay Deductions	Schedule III Entry 1 CGST Act	Ensure no GST is charged or output liability created on employee notice pay.	assureTax
Step 5	Verify Cheque Bounce Accounting	Circular 178 Para 7.3	Segregate cheque dishonour charges into non-taxable income in trial balance.	assureFinancials
Step 6	Examine Cancellation Rate Parity	Circular 178 Para 7.2	Ensure cancellation charges match the GST rate of the underlying service.	assureTax
Step 7	Segregate Forfeited Deposits	Circular 178 Para 7.4	Distinguish forfeited EMD (exempt) from advance adjusted against future sales (taxable).	assureFinancials
Step 8	Draft Audit Defense Dossier	Form GST DRC-01A / DRC-01	Prepare standardized legal response templates citing Circular 178 and case law.	assureNotice
Step 9	Reconcile GSTR-9 Table 4 vs 5	Section 44 & Form GSTR-9	Report non-taxable liquidated damages under Table 5 (exempt/non-GST turnover).	assureTax
Step 10	Annual Financial Footnote Disclosure	Ind AS 115 & Schedule III	Ensure audited financial statements reflect proper notes on contingent claims and damages.	assureFinancials

16 In-Depth Practitioner FAQs

1. Is GST payable on liquidated damages recovered for delay in project completion?

No. Under CBIC Circular No. 178/10/2022-GST, liquidated damages paid for delay in project execution, failure to meet performance parameters, or breach of contract are compensatory in nature and do not constitute consideration for any supply of service. Hence, they are not subject to GST.

2. Does notice pay recovery from resigning employees attract GST?

No. Notice pay recovery is an adjustment arising out of the employment relationship, which is categorized as a non-supply under Entry 1 of Schedule III of the CGST Act. Circular 178 clearly confirms that notice pay recoveries are not liable to GST.

3. Are cheque bounce or mandate dishonour charges taxable under GST?

No. Cheque dishonour charges levied by banks or commercial vendors are penal charges intended to discourage default and cover administrative friction. They are not consideration for tolerating an act and are therefore not subject to GST.

4. Are flight and hotel cancellation charges subject to GST?

Yes. Cancellation charges levied by airlines, railways, and hotels are consideration for the facility of cancellation and booking arrangement provided to customers. They attract GST at the same rate as applicable to the underlying principal supply.

5. At what rate is GST charged on airline ticket cancellation charges?

Under Circular 178, the cancellation fee attracts GST at the same rate as the flight ticket. For domestic economy class tickets, cancellation fees are taxed at 5% GST; for business class tickets, they are taxed at 12% GST.

6. Can an employer claim Input Tax Credit on notice pay recovered?

No. Because notice pay recovery is not a supply and no GST is levied, the question of claiming ITC does not arise. If any GST was mistakenly charged in earlier years, it cannot be claimed as ITC.

7. Does the forfeiture of an Earnest Money Deposit (EMD) in a government tender attract GST?

No. Forfeiture of EMD for breach of bidding discipline, premature bid withdrawal, or failure to execute a contract is penal in nature and does not constitute a supply. No GST is payable on forfeited EMD.

8. Is GST applicable on forfeiture of advance where goods are never supplied?

Under Circular 178, where an advance is received for an intended supply and later forfeited upon contract cancellation without any supply taking place, if the forfeiture is compensation for cancellation, it is treated as cancellation consideration and taxed at the rate of the intended supply.

9. How should liquidated damages be reported in Form GSTR-9?

Compensatory liquidated damages received should be reported in Table 5 of Form GSTR-9 under "Other non-taxable / exempt supplies" so that turnover reconciles with audited financial statements without creating tax liability in Table 4.

10. What is the difference between liquidated damages and penalty under GST?

In law, liquidated damages represent a pre-estimated genuine pre-estimate of loss, whereas penalties are stipulated in terrorem to enforce performance. Under Circular 178, both compensatory liquidated damages and contractual penalties for breach are outside the scope of GST.

11. Are late payment surcharges on delayed customer payments taxable under GST?

Yes. Under Section 15(2)(d) of the CGST Act, the value of supply specifically includes "interest or late fee or penalty for delayed payment of any consideration for any supply". Unlike liquidated damages for breach, interest or late fees charged for delayed customer payments form part of the transaction value of the underlying supply and attract GST at the same rate as the main supply.

12. Are bank loan pre-payment charges subject to GST?

Under Circular 178, pre-payment penalties charged by banks and NBFCs for early loan repayment are consideration for an additional facility granted to the borrower to exit the loan contract early, and are therefore taxable as financial services.

13. Does demurrage charged by container freight stations (CFS) attract GST?

Yes. Demurrage charged for keeping cargo beyond the free period is consideration for the service of storage, warehousing, and cargo handling, and is taxable at 18% GST.

14. What should a taxpayer do if an audit officer issues a DRC-01 demanding GST on liquidated damages?

The taxpayer should file a formal reply in Form GST DRC-06 citing CBIC Circular No. 178/10/2022-GST, Paragraph 7.1, and submit relevant contract clauses demonstrating that the damages were purely compensatory for breach. Practice teams manage this via assureNotice.

15. Can an assessee obtain a refund of GST mistakenly paid on notice pay prior to Circular 178?

Yes. If GST was erroneously deposited on notice pay recoveries, the employer can file a refund application under Section 54 of the CGST Act within two years from the date of payment of tax, citing Circular 178 as clarificatory.

16. Are compensation payments awarded by an Arbitral Tribunal or High Court subject to GST?

No. Damages or compensation awarded by an Arbitral Tribunal or court of law for breach of contract, tort, or statutory violation are compensatory and do not constitute consideration for a taxable supply under GST.