Published 26 October 2026
A contractor finishes late, and the employer deducts liquidated damages from the final bill. An employee leaves without serving notice, and the company recovers a month’s salary. A customer’s cheque bounces, and the supplier charges a fine. Each of these is money paid because something went wrong, and for years the question was whether GST treats it as payment for “tolerating” the breach. Paragraph 5(e) of Schedule II makes “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act” a supply of services, and tax officers and some advance ruling authorities read it widely. CBIC’s Circular No. 178/10/2022-GST of 3 August 2022 drew the line. Compensation for a breach is generally not consideration for any supply. A charge that the contract builds into the commercial terms (late payment fees, cancellation charges, early termination fees) is consideration, and it is taxed with the main supply.
This guide sets out that line as it stands on 23 October 2026, and then what each party does when tax is or is not due.
The provision in question: Schedule II, paragraph 5(e)
Paragraph 5 of Schedule II lists what “shall be treated as supply of services”. Clause (e) reads: “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act”. Schedule II does not create a supply. Under section 7(1A), it classifies as goods or services a transaction that is already a supply under section 7(1). So clause (e) applies only where there is a supply for consideration in the first place.
“Consideration” under section 2(31) includes “any payment made or to be made … in respect of, in response to, or for the inducement of, the supply of goods or services”. It also includes “the monetary value of any act or forbearance” made for the same purpose.
The circular’s test: an independent agreement to tolerate
Circular No. 178/10/2022-GST gives examples of what clause (e) does cover: a non-compete agreement for a fee; a builder paid by a neighbour to build fewer floors; an industrial unit paid by a school to stop work during school hours; a shopkeeper paid to let a hawker use the pavement. In each case one party is paid to refrain, tolerate or act, and that is the object of the arrangement.
It then states the test (para 6.1). The obligation must arise under an agreement, “express or implied”. Consideration must flow for that obligation. And “such contractual arrangement must be an independent arrangement in its own right”. Para 7 adds:
“An agreement to do an act or abstain from doing an act or to tolerate an act or a situation cannot be imagined or presumed to exist just because there is a flow of money from one party to another.”
Liquidated damages, penalties and forfeitures are, in the circular’s words, “amounts recovered for not tolerating an act or situation and to deter such acts”. They are “mere ‘events’ in a contract”, and so not consideration.
Liquidated damages and compensation: generally not a supply
The circular’s reasonable view (para 7.1.4) is that where liquidated damages are paid “only to compensate for injury, loss or damage suffered by the aggrieved party due to breach of the contract”, and the party receiving them has not agreed “to refrain from or tolerate an act or to do anything for the party paying” them, they are “mere a flow of money” and “are not taxable”.
Its examples (para 7.1.5) include damages for harm to property, negligence, piracy and unauthorised use of a trade name or copyright. They also include the penalty a builder pays buyers for delayed construction, and forfeiture of earnest money when a buyer breaks an agreement to sell immovable property, or when a successful bidder for natural resources fails to proceed.
The circular adds a caution (para 7.1.6): “If a payment constitutes a consideration for a supply, then it is taxable irrespective of by what name it is called”. A clause labelled “liquidated damages” that in substance prices an option to stop early, or to deliver late against a fee, is taxed for what it is.
Two related points are outside the circular. First, it does not address whether a supplier may reduce its own taxable value when the buyer deducts liquidated damages from the bill. A reduction in price after the supply is made through a credit note under section 34, subject to the conditions on post-supply discounts in section 15(3)(b). Second, it is a clarification under section 168(1). It binds officers but not courts or the Appellate Tribunal.
Notice pay, bond amounts and forfeited salary
Para 7.5 of the circular deals with employment. An employer that recovers “forfeiture of salary or … bond amount in the event of the employee leaving the employment before the minimum agreed period” recovers it “as penalties for dissuading the non-serious employees”, not “as a consideration for tolerating the act of such premature quitting”. The employee “does not get anything in return”. The circular concludes that “such amounts recovered by the employer are not taxable”.
The circular does not use the words “notice pay”. Salary forfeited or recovered for leaving without serving the agreed notice period is the closest case it addresses. Separately, paragraph 1 of Schedule III keeps “services by an employee to the employer in the course of or in relation to his employment” outside GST altogether.
Cheque dishonour fines and statutory penalties: not a supply
Cheque dishonour. No supplier “would tolerate deposit of an invalid, fake or unworthy instrument of payment”. The fine is imposed “for not tolerating, penalizing and thereby deterring” the act, and “is not a consideration for any service and not taxable” (para 7.3).
Penalties for breaking the law. Penalties imposed for traffic violations, pollution norms, excess mining and similar breaches “are also not consideration for any supply received and are not taxable”. The reason given is that “Laws are not framed for tolerating their violation” (para 7.4). This reiterates Circular No. 192/02/2016-Service Tax for GST.
Statutory compensation. Compensation paid to earlier allottees of coal blocks, after the Supreme Court cancelled the allocations, was paid under a statute and a court order, not under a contract to tolerate the cancellation. It was not taxable (para 7.2).
Where a charge is taxed: late fees, cancellation charges, early termination
The same circular explains why some payments that look like penalties are taxed (para 7.1.6). Examples are a late payment fee under a supply contract, forfeiture of a no-show passenger’s ticket, forfeiture of a tour deposit on cancellation, an early termination fee on a lease, and a bank’s pre-payment penalty on a loan. These are payments for “the supply of a facility”. The facilities are accepting late payment, allowing early termination or pre-payment, and making arrangements for a supply the customer later cancels. Such payments, “even though they may be referred to as fine or penalty”, “are subject to GST, in cases where such supply is taxable”.
Each is ancillary to the principal supply, so it is taxed as that supply. It is exempt if the principal supply is exempt (paras 9 and 11). The circular’s example is railway cancellation charges, which carry the GST rate of the class of travel booked (para 11.3). Late payment surcharge on electricity is exempt because electricity is exempt (paras 9 and 10).
Two provisions of the Act reach the same result for late payment charges. Section 15(2)(d) includes in value “interest or late fee or penalty for delayed payment of any consideration for any supply”. Sections 12(6) and 13(6) set the time of supply for that addition as “the date on which the supplier receives such addition in value”.
A short table
| Payment | Treatment under Circular No. 178/10/2022-GST |
|---|---|
| Liquidated damages for delay or defective performance, purely compensatory | Not a supply |
| Builder’s penalty to flat buyers for late possession | Not a supply |
| Forfeited earnest money on a failed sale of immovable property, or a failed bid for natural resources | Not a supply |
| Bond amount or forfeited salary when an employee leaves early | Not a supply |
| Cheque dishonour fine | Not a supply |
| Fines and penalties for breaking a law | Not a supply |
| Late payment fee or interest on a supply contract | Taxed as part of the principal supply (s.15(2)(d)) |
| Cancellation charges, no-show forfeitures | Taxed at the rate of the principal supply |
| Early termination fee on a lease, pre-payment charge on a loan | Taxed as part of the principal supply |
| Fee paid for a non-compete, or to refrain or tolerate, as the object of the agreement | Supply of services under Schedule II para 5(e) |
What each party needs
| Item | Where it comes from |
|---|---|
| The contract clause under which the amount arises, and what it compensates for | Contract file |
| Whether the payer receives anything in return (a right, an option, a facility) | Contract file |
| The principal supply and its rate, for ancillary charges | Books, rate notifications |
| Amounts deducted by customers as liquidated damages, invoice by invoice | Books (receivables ledger) |
| Recoveries from employees on exit | Payroll |
Reporting, timing and signing
Where no supply arises, there is no tax invoice. The recipient of the money issues no invoice, and the payer takes no credit. Liquidated damages received are not taxable supplies. Whether they count in turnover for other purposes, such as the exempt turnover used in Apportionment and Reversal of Credit, turns on the definitions used there.
Where the charge is taxable, the supplier issues a tax invoice or a debit note under section 31 or section 34 for the late fee, cancellation charge or termination fee. It reports this in GSTR-1, in table 4A for a registered customer or tables 5 and 7 for unregistered customers. Debit notes go in table 9B. The tax is paid through table 3.1(a) of GSTR-3B. For late payment interest, the date of receipt fixes the period. GSTR-1 is due by the 11th of the following month (13th after the quarter under QRMP); GSTR-3B by the 20th, or the 22nd or 24th for QRMP filers under rule 61. The portal steps are in Filing GSTR-1 and Filing GSTR-3B and Paying the Tax. Returns are verified by DSC (mandatory for companies) or EVC under rule 26.
The payer of a taxable charge takes credit on it like any other input service, subject to section 16 and section 17.
Interest, penalty and corrections
Tax not paid on a taxable charge carries interest at 18 per cent a year under section 50(1), and is recovered through the demand provisions (GST Notices: DRC-01A and DRC-01). Tax paid on an amount that was not a supply can be recovered only by a refund claim (Refund of Excess Tax), or by a credit note within the section 34 time limit. That limit is 30 November after the end of the financial year, or the annual return if earlier. Corrections to returns are covered in Correcting Mistakes in Returns.
The sequence
- Identify the clause under which the amount is paid, and what it pays for.
- Ask whether the payer gets anything in return: a right, an option or a facility. If not, and the amount only compensates for a breach, it is not consideration (Circular No. 178/10/2022-GST, paras 7 and 7.1.4).
- Treat employee bond recoveries and forfeited salary, cheque dishonour fines and statutory penalties as outside GST (paras 7.3 to 7.5).
- Treat late fees, cancellation charges, no-show forfeitures and early termination fees as part of the principal supply, taxed at its rate and exempt if it is exempt.
- Where tax is due, issue a tax invoice or debit note, report it in GSTR-1 and pay through GSTR-3B. For late payment interest, the period is the one in which it is received.
- Where tax was paid on an amount that was not a supply, correct it within the section 34 limit or claim a refund.
The next guide in this set covers Vouchers and Gift Cards.