Liquidated Damages Do Not Attract GST Under CGST Act: Karnataka HC Quashes DGGI Notice - 2025-12-08

Karnataka HC Stops The Taxman: Liquidated Damages Fall Outside GST Net

In a significant reprieve for non-banking financial companies (NBFCs), the High Court of Karnataka has clarified the boundaries of GST levy on liquidated damages. In the matter of M/s Krazybee Services Private Limited vs. Additional Director, DGGI Bengaluru , Justice S.R. Krishna Kumar quashed a show-cause notice issued by revenue authorities, asserting that compensation for breach of contract, as defined under the Indian Contract Act, does not constitute a "taxable service" under the CGST Act.

The Breach and the Bill

The dispute arose from a Master Service Agreement between the petitioner, Krazybee Services, and its Lending Service Provider (LSP), Finnovation Tech Solutions. When the LSP failed to meet performance standards, the petitioner claimed compensation—a standard practice known as liquidated damages.

The DGGI Bengaluru, however, viewed these receipts differently. They argued that these payments amounted to "consideration for tolerating an act or situation," classifying them as a taxable service under paragraph 5(e) of Schedule II of the CGST Act. Consequently, the authorities demanded GST on these damages, leading to a controversial collection of Rs. 5 crore from the petitioner while under the pressure of search and seizure proceedings.

The Legal Tug-of-War

The petitioner firmly disagreed with the revenue's classification. Relying on Circular No. 178/10/2022 dated August 3, 2022, the petitioner argued that liquidated damages are purely compensatory, meant to cover losses resulting from a breach, and are not an "independent activity" involving a service exchange.

The revenue authorities countered by pointing to other commercial transactions the petitioner had with entities like IIFL and PayU, suggesting that the petitioner was using two separate methodologies to evade tax. They maintained that the receipts were part of a "deficiency service fee" arrangement.

Judicial Reasoning: The Circular as a Shield

Justice S.R. Krishna Kumar sided with the petitioner, emphasizing that the specific provisions of the government's own circular override the DGGI's generic interpretation. By applying paragraphs 7.1 to 7.1.6 of Circular No. 178/10/2022, the court distinguished between "consideration for supply" and "compensation for breach."

The court noted that the mere fact that the petitioner engaged with other LSPs in different capacities did not invalidate the contractual terms governed specifically by the Master Service Agreement at hand.

Key Observations

The judgment offers clear guidance on the nature of contractual damages:

• On the nature of compensation: "The compensation is not by way of consideration for any other independent activity; it is just an event in the course of performance of that contract."
• On taxability: "The amount received by the petitioner from its LSPs by way of liquidated damages fall outside the purview of GST in terms of the said Circular."
• On involuntary payments: Regarding the Rs. 5 crore collected during the search, the Bench found: "The material on record clearly indicates that the aforesaid payment... was involuntary and the same was not voluntary or by way of self-ascertainment."
• On hierarchy of rules: The Court highlighted that the specific paragraphs of the Circular dealing with liquidated damages take precedence over generic interpretations of service fees.

The Verdict: A Clean Slate

The High Court allowed the petition, resulting in two major outcomes:

1. Quashing of Demand: The show-cause notice issued on April 25, 2024, was set aside, nullifying the GST demand on liquidated damages.

2. Refund Ordered: The court directed the authorities to refund the Rs. 5 crore paid "under protest" within eight weeks, along with applicable interest.

This decision serves as a vital precedent for businesses frequently engaged in performance-based contracts, reinforcing that compensation for failure—where labeled as liquidated damages—should not be arbitrarily brought into the tax net as a service cost.