GST on Liquidated Damages, Penalties, Cancellation Charges & Notice Pay: Practical Guide 2026

1. Start here: the GST decision test

A payment received after a contract goes wrong is not automatically consideration for a service. Equally, calling an amount “damages” does not automatically make it non-taxable. The contract, commercial substance and what the recipient actually supplies must be examined.

Do not apply a blanket “18% on every penalty” rule. Nor should every amount booked as damages be excluded from GST without reviewing the underlying arrangement.

2. Legal framework: supply, consideration and Schedule II

CGST Act, section 7

Section 7 defines the scope of supply, including supplies of goods or services for consideration in the course or furtherance of business, subject to the statutory inclusions and exclusions. The threshold question is whether the recipient has supplied anything to the payer for the payment.

Section 2(31): consideration

Consideration generally includes payment made or to be made in respect of, in response to, or for the inducement of a supply, whether by the recipient or another person, subject to the statutory exclusions. A mere movement of money is not enough; the payment must have the required nexus with a supply.

Schedule II, paragraph 5(e)

Agreeing to the obligation to refrain from an act, tolerate an act or situation, or do an act is treated as a supply of services. CBIC Circular 178/10/2022-GST explains that an agreement to tolerate breach should not be presumed merely because a contract provides consequences for breach. There must be an express or implied reciprocal arrangement and consideration for the relevant activity.

Primary authority: CBIC Circular No. 178/10/2022-GST dated 3 August 2022, especially its discussion of liquidated damages, penalties, cancellation charges, late payment surcharge and forfeiture. The circular instructs that each transaction be evaluated on its facts.

3. Liquidated damages for breach of contract

Liquidated damages are amounts stipulated in a contract as compensation for breach or non-performance—often delay in completion, failure to meet service levels, short supply, failure to lift minimum quantities or non-compliance with contractual milestones.

Typical non-taxable compensation fact pattern

• A contractor delays completion and pays the customer an amount intended to compensate for delay-related loss.
• A supplier fails to meet a delivery schedule and pays agreed damages to the buyer.
• A customer fails to lift contracted minimum quantities and a refundable deposit is forfeited as compensation for the breach.

In these cases, the payment may be a consequence of breach rather than consideration for a separate service of tolerating that breach. Circular 178 discusses that genuine liquidated damages are generally not consideration for an independent supply.

Fact pattern requiring closer review

If the contract effectively gives the payer a commercial right to delay, cancel, or underperform by paying a specified amount, and the other party undertakes to provide that option or facility for consideration, the amount may relate to a taxable supply. Read the entire agreement and actual performance, not only the damages clause.

4. Penalties and statutory fines

Penalties imposed under law for contraventions, and contractual penalties intended to deter non-performance, do not automatically represent consideration for a service supplied by the person receiving the amount. Circular 178 distinguishes amounts recovered for not tolerating or deterring an act from consideration paid for an independent act of toleration.

Examples for classification review include mining or environmental penalties, regulatory fines, cheque dishonour charges, and contractual non-compliance penalties. Determine who imposes the amount, under which law or contract, what right or benefit the payer receives, and whether the payment is actually a fee for a service.

5. Cancellation fees, no-shows and forfeitures

Circular 178 treats cancellation arrangements differently from pure breach damages. A supplier may offer a customer the facility to cancel a booked supply within specified terms, against a cancellation fee or retention of part of the amount paid. In that case, the cancellation facility is linked to the intended principal supply and the amount is generally assessed by reference to the principal supply's GST treatment.

Do not automatically apply the principal supply's rate to every forfeiture. First decide whether the amount is a cancellation fee under an agreed facility, a part of the consideration for the original supply, or compensation for breach with no reciprocal supply.

6. EMD, security deposits and bid forfeiture

Earnest money deposits (EMD) and security deposits are often collected to secure performance. At receipt, they may be refundable and may not yet be consideration. On adjustment, refund or forfeiture, document the event and legal basis.

Government and commercial tenders

Circular 178 explains that forfeiture of earnest money where a successful bidder fails to proceed after winning a bid for allotment of natural resources is generally a compensatory flow of money where the bidder receives nothing in return. The same circular discusses forfeiture by a seller for breach of an agreement to sell immovable property.

Controls

• Maintain a deposit register showing party, tender/contract, GSTIN, receipt date, refundability and due date.
• On forfeiture, attach the breach notice, contract clause, approval, calculation and correspondence.
• Separate deposit forfeiture from consideration for a supply, tender processing fees, application fees or other separately charged services.
• Review whether the deposit was originally adjusted against taxable invoice consideration; that adjustment may have a different GST consequence.

7. Employee notice pay and employment bonds

Notice pay recovery occurs where an employee leaves without serving the required notice period, or an employer recovers an amount under an employment bond for early departure. Circular 178 expressly discusses forfeiture of salary or amounts paid under an employment bond for leaving employment before the agreed minimum period as amounts that are not, merely for that reason, consideration for tolerating an act.

For employers, retain the appointment letter, notice clause, resignation/termination correspondence, waiver or shortfall computation, payroll working and settlement statement. Review the facts where the employer separately supplies recruitment, training or other services, or where a payment is not actually a breach recovery but a separately agreed service fee.

Payroll and accounting treatment should be consistent with the employment contract and labour-law requirements. GST classification does not decide whether the recovery is legally enforceable or whether it is a salary adjustment for other statutory purposes.

8. Late payment interest, surcharge and delayed payment compensation

Section 15(2)(d) includes interest or late fee or penalty for delayed payment of consideration for a supply in the value of that supply. Accordingly, where the amount is charged because the recipient pays the original invoice late, examine section 15(2)(d) and the time-of-supply rule in section 12(6) for goods or section 13(6) for services, as applicable.

This is distinct from damages for breach unrelated to delayed payment of consideration. Do not classify all “penalties” together: late-payment interest connected to an underlying taxable supply has a specific statutory valuation treatment.

9. When “tolerating” is actually a supply

Paragraph 5(e) of Schedule II is relevant where a party has undertaken, under an express or implied arrangement, to refrain from an act, tolerate an act or situation, or do an act for consideration. A real reciprocal arrangement is required; the fact that one party pays another does not by itself establish such a supply.

Indicators requiring detailed review include a separately negotiated fee for granting a commercial right, an agreed option to cancel or vary performance, a service-level arrangement where payment buys a defined facility, or a payment expressly linked to an independently promised act. These indicators are not conclusive; contract substance controls.

Also consider whether the amount is actually a price adjustment to the original supply, damages, a discount, or a separate supply. The GST result can differ materially.

10. Accounting entries and GST ledgers

A. Genuine damages received by a company (assume not consideration for supply)

On receipt/recognition, subject to the applicable accounting framework and recognition criteria:

Bank / Receivable Dr.                 ₹1,00,000
    To Compensation / Damages Income             ₹1,00,000

No output GST should be booked solely because money was received, where documented analysis concludes there is no supply. Consider whether presentation should be other income, recovery of expense, or adjustment to the related cost based on the facts and accounting policy.

B. Compensation paid to customer for supplier's delay

Contractual Damages / Expense Dr.     ₹2,00,000
    To Customer Payable                         ₹2,00,000

Where it is a genuine price reduction and statutory conditions are met, assess whether a GST credit note under section 34 is appropriate. A damages payment that is not a reduction in taxable value should not be forced into a GST credit note merely for accounting convenience.

C. Taxable cancellation fee

Where analysis establishes a taxable cancellation service/facility, recognise the fee and output tax using the correct classification, rate and time of supply. Illustrative entry for a fee of ₹10,000 plus GST at an assumed 18% (confirm actual rate for the principal supply):

Bank / Customer Receivable Dr.       ₹11,800
    To Cancellation Fee Revenue                 ₹10,000
    To Output CGST                              ₹900
    To Output SGST                              ₹900

For an inter-State supply, the tax components would instead be IGST, if applicable. The assumed 18% above is only an illustration, not a universal rate.

11. Invoice, credit note and return reporting

• Non-supply compensation: ordinarily do not issue a tax invoice for a non-existent supply. Issue a debit note, recovery note or other commercial document as appropriate, clearly describing the contractual basis and avoiding a false GST charge.
• Taxable cancellation fee or independent service: issue the prescribed tax invoice and report the taxable value and tax in GSTR-1 and GSTR-3B in the appropriate period.
• Original supply price reduction: evaluate section 34 credit-note conditions, time limits and recipient ITC adjustment requirements. A commercial credit note alone does not automatically reduce GST liability.
• Late payment interest: track the underlying invoice, date of actual receipt and tax computation, and report consistently with the applicable time-of-supply rule.
• Reconciliation: map contract recoveries to the general ledger, sales register, credit/debit notes, GSTR-1, GSTR-3B and e-invoice records where applicable.

Maintain separate ERP codes for damages, statutory penalties, EMD forfeiture, cancellation fees, notice pay recovery and late payment interest. Avoid a single generic “other income” code that prevents tax review.

12. Worked business examples

Example 1 — Contractor delay damages

A contractor owes ₹5 lakh as damages under a construction contract for delayed completion. The clause is a remedy for breach; there is no contractual right to delay purchased for a fee. Document the breach and loss basis. On those facts, the amount is generally analysed as compensation rather than consideration for tolerating delay under Circular 178.

Example 2 — Hotel cancellation

A guest pays ₹20,000 for a room booking and cancels under a published policy; the hotel retains ₹4,000 as cancellation fee. Review the cancellation facility and the hotel accommodation service. Circular 178 indicates that cancellation charges/forfeiture connected with such intended services are assessed with reference to the principal supply and applicable rate.

Example 3 — Bidder forfeits EMD

A successful bidder deposits ₹10 lakh and then fails to execute the contract. The authority forfeits the EMD under tender conditions. Where the bidder receives no supply in return and forfeiture is compensation/deterrence, Circular 178 supports non-taxability as consideration for a supply. Confirm that the amount is not a separately charged processing or facilitation fee.

Example 4 — Late invoice payment

A customer pays a taxable invoice late and is charged ₹12,000 interest. Evaluate section 15(2)(d) and section 12(6)/13(6), as applicable. Do not apply the non-taxability analysis for breach damages without addressing the express delayed-consideration provisions.

13. Contract review, evidence and audit checklist

• Obtain the executed agreement, amendments, purchase order, tender and relevant commercial policy.
• Identify the exact clause creating the payment and whether it is a remedy, option fee, price adjustment or separate service charge.
• Record the event triggering payment and whether the payer receives any identifiable reciprocal benefit.
• Keep breach notices, delay reports, service-level calculations, loss workings, correspondence and approval notes.
• For deposits, retain original receipt, ledger, refund/adjustment trail and forfeiture approval.
• For cancellation charges, retain booking, cancellation request, policy accepted by customer and computation.
• For notice pay, retain employment terms, notice period, waiver and final settlement calculation.
• For late payment interest, link the computation to the taxable invoice and actual payment date.
• Prepare a written GST position memo for material or recurring amounts; cite Circular 178 and relevant statutory provisions.
• Reconcile the position with accounting, GSTR-1, GSTR-3B, credit notes, e-invoices and financial statement disclosures.

Audit red flags: GST charged on all “penalty” receipts without analysing supply; non-taxable treatment based only on ledger narration; cancellation fees treated as damages despite a published cancellation facility; late payment interest excluded without section 15(2)(d) review; or commercial credit notes used to reduce output tax without section 34 compliance.

14. Judicial decisions and legal status

CBIC Circular No. 178/10/2022-GST dated 3 August 2022 is the principal administrative clarification addressed in this guide. It explains the distinction between compensation for breach and consideration for an independent activity of tolerating or facilitating cancellation. The circular states that taxability in each case depends on the facts.

Hindustan Zinc Ltd. v. Commissioner, CGST & Central Excise (CESTAT, 17 July 2025) discusses Circular 178 in the context of liquidated damages and the “tolerating” entry. It is a tribunal decision under the service-tax dispute context and should be cited with its precise procedural and statutory context; it is not a universal GST ruling for every contract.

Golkanda Aluminium Extrusion Ltd. v. Medchal (reported decision dated 21 July 2026) discusses forfeited die-development deposits in an excise valuation dispute and refers to Circular 178 for its reasoning. Because the dispute concerns central-excise transaction value, treat it as persuasive context on characterization, not as a direct GST ruling.

Always verify the complete judgment, appeal status, jurisdiction and subsequent treatment before relying on a case in a notice reply or litigation. This article does not represent that every cited decision is final or binding on all taxpayers.

15. FAQs and quick decision matrix

Is GST payable on every liquidated damages receipt?

No blanket rule. Genuine compensation for breach without a reciprocal supply is generally not consideration; assess contract substance and Circular 178.

Does calling a payment “penalty” make it non-taxable?

No. The label is not decisive. A payment for an agreed cancellation facility or independent service can be taxable.

Is forfeiture of EMD always outside GST?

No. Circular 178 supports non-taxability for specified compensatory forfeitures where nothing is received in return, but examine whether a distinct taxable service or fee exists.

What about interest for late payment?

Review section 15(2)(d) and the applicable time-of-supply provisions. It is not interchangeable with damages for unrelated breach.

Should we issue a GST invoice for damages?

Not where there is no supply. Use an appropriate commercial document. If the amount is consideration for a taxable supply, comply with invoicing and return rules.

This article is an educational practical guide, not a substitute for review of the actual contract, current law, notifications, rate entries and facts of a particular transaction.