When Damages Aren't Debts: Karnataka HC Stays GST Demand on Liquidated Damages

In a significant ruling for the fintech and NBFC sector, the High Court of Karnataka has clarified the boundary between contract law and tax liability. Justice S.R. Krishna Kumar, presiding over M/s. Krazybee Services Private Limited v. Additional Director, DGGI , has quashed an aggressive GST demand, affirming that liquidated damages arising from contractual breaches do not constitute taxable supplies under the Central Goods and Services Tax (CGST) Act.

The Conflict: Consideration or Compensation?

The dispute centered on payments received by Krazybee Services, a non-banking financial company (NBFC), from its Lending Service Providers (LSPs). The Directorate General of GST Intelligence (DGGI) had issued a show-cause notice (SCN) demanding GST on these payments, characterizing the funds as "deficiency service fees" or consideration for "tolerating an act" of poor service.

The petitioner, represented by Senior Counsel G. Shivadass, argued that these payments were strictly liquidated damages as defined under Sections 73 and 74 of the Indian Contract Act, 1872. They contended that because these payments served to compensate for breach of contract, they lacked the character of a taxable "supply" or "consideration."

The Court’s Reasoning: The Circular as a Shield

Justice Krishna Kumar leaned heavily on the government’s own Circular No. 178/10/2022 (dated August 3, 2022). The court emphasized that the Circular explicitly distinguishes between payments that are part of business facilitation and those that are purely compensatory.

The court observed that:

> "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."

By distinguishing liquidated damages from payment for "tolerating an act," the Court provided much-needed relief to entities struggling with the broad interpretative reach of the revenue authorities. The bench noted that merely labelling a breach-compensation fee as a "deficiency service fee" does not magically transform non-taxable damages into a taxable supply under Schedule II of the CGST Act.

The "Involuntary" Payment Problem

A pivotal aspect of the ruling involved the recovery of Rs. 5 crores that the respondent authorities had collected from the petitioner under protest. Invoking the precedent set in Ramesh Chand vs. Union of India , the Court dissected the procedure used by the DGGI during their search and seizure operations.

The Court maintained that payments made by taxpayers under the duress of search-and-seizure proceedings cannot be deemed "voluntary." Since the tax office failed to follow the due process of adjudication and quantification prior to collection, the Court ordered a full refund with interest.

Key Observations

• On the nature of damages: "Any breach of contract committed by the aforesaid LSPs would entitle the petitioner to claim liquidated damages which is covered by Paragraph No.7 of the aforesaid Circular."
• On Revenue overreach: "The amount received by the petitioner from its LSPs by way of liquidated damages fall outside the purview of GST... and the said amounts cannot be made amenable/exigible to GST."
• On the standard of 'Voluntary' payments: "The undisputed fact that the respondents themselves ascertained the actual amount payable by the petitioner only during the pendency of the present petition... is sufficient to come to the conclusion that prior thereto... there was no ascertainment of the actual tax."

Implications for the Future

This decision serves as a stern reminder to tax authorities that Circulars issued by the Central Board of Indirect Taxes and Customs (CBIC) are binding and must be strictly followed. For businesses in the fintech space, this is a major victory, protecting them from arbitrary classification of damages as services. Moving forward, the ruling solidifies the principle that an agreement-based recovery for a contract breach is fundamentally different from a service-based consideration.