INTRODUCTION:
Issues arising under the Goods and Services Tax (‘GST’) regime have generated significant litigation and a growing body of advance rulings. One particularly contentious area concerns the taxability of liquidated damages, settlement amounts, and compensation paid pursuant to settlement agreements, as well as amounts paid in terms of arbitral awards based on settlement of disputes referred to arbitration. The issue assumes particular significance because the GST framework adopts an expansive definition of ‘supply’, while mutual settlements often incorporate reciprocal undertakings, including the withdrawal of claims, abandonment of proceedings, release or extinguishment of liabilities, and an agreement not to pursue further remedies. The question then boils down to one narrow but consequential point – does a payment made to compensate for breach of contract, or to settle a dispute, or in pursuance of arbitral award based on a mutual settlement, amount to ‘consideration’ for a ‘supply’ of service under Entry 5(e) of Schedule II to the Central Goods and Services Tax Act, 2017 (‘CGST Act’), which treats “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act“[1] as a supply of service.
The controversy here is not merely one of nomenclature. While a settlement may contain an undertaking to withdraw claims or refrain from pursuing further proceedings, the mere existence of such a contractual undertaking does not necessarily establish that the settlement amount is consideration for an independently identifiable service. The crucial inquiry is whether there exists a direct and sufficient nexus between the payment and an identifiable obligation to refrain, tolerate, or do an act, such that the payment can properly be regarded as consideration for that obligation. This distinction becomes particularly important where the payment represents damages, compensation, or an amount determined in resolution of a pre-existing dispute, rather than remuneration for any activity undertaken by the recipient.
This article aims to trace the evolution of this crucial distinction through recent Advance Rulings, judicial pronouncements by the High Courts of India, and Circulars issued by the Ministry of Finance. Taken together, these developments have substantially clarified the legal position and have crystallised the proposition sought to be examined in this article.
STATUTORY FRAMEWORK:
Section 7 of the CGST Act provides for an expansive, inclusive definition of ‘supply’ – including all forms of supply of goods and services made for consideration in the course or furtherance of business – and by virtue of Section 7(1A) activities listed under Schedule II are taxable where they otherwise satisfy the test of ‘supply’. Entry 5(e) of Schedule II deems “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act”[2] to be a supply of service. Section 2(31) of the CGST defines ‘consideration’ to include the monetary value of any act or forbearance, in respect of, in response to, or for the inducement of, the supply of goods or services or both. These provisions, when read together, require the existence of an identifiable reciprocal obligation before GST can be levied on the transaction. In other words, there must be a discernible promise or undertaking by one party to refrain from an act, tolerate an act or situation, or do an act, undertaken in exchange for payment, for such payment to constitute consideration for a taxable supply and thus attract GST.
In this regard, the Circular dated 03.08.2022,[3] issued by the Ministry of Finance, is particularly significant. Recognising that questions had been raised in this regard from several quarters, the Ministry of Finance, vide its circular, clarified that liquidated damages paid for breach or non-performance of a contract constitute “a flow of money from the party who causes breach of the contract to the party who suffers loss or damage due to such breach.”[4] The Circular further clarified that such payments do not, by themselves, constitute consideration for a supply. The relevant portions of the Circular dated 03.08.2022 are reproduced hereinbelow:
7.1.4In this background a reasonable view that can be taken with regard to taxability of liquidated damages is that where the amount paid as ‘liquidated damages’ is an amount paid only to compensate for injury, loss or damage suffered by the aggrieved party due to breach of the contract and there is no agreement, express or implied, by the aggrieved party receiving the liquidated damages, to refrain from or tolerate an act or to do anything for the party paying the liquidated damages, in such cases liquidated damages are mere a flow of money from the party who causes breach of the contract to the party who suffers loss or damage due to such breach. Such payments do not constitute consideration for a supply and are not taxable.
7.1.5 Examples of such cases are damages resulting from damage to property, negligence, piracy, unauthorized use of trade name, copyright, etc. Other examples that may be covered here are the penalty stipulated in a contract for delayed construction of houses. It is a penalty paid by the builder to the buyers to compensate them for the loss that they suffer due to such delayed construction and not for getting anything in return from the buyers. Similarly, forfeiture of earnest money by a seller in case of breach of ‘an agreement to sell’ an immovable property by the buyer or by Government or local authority in the event of a successful bidder failing to act after winning the bid, for allotment of natural resources, is a mere flow of money, as the buyer or the successful bidder does not get anything in return for such forfeiture of earnest money. Forfeiture of Earnest money is stipulated in such cases not as a consideration for tolerating the breach of contract but as a compensation for the losses suffered and as a penalty for discouraging the non-serious buyers or bidders. Such payments being merely flow of money are not a consideration for any supply and are not taxable. The key in such cases is to consider whether the impugned payments constitute consideration for another independent contract envisaging tolerating an act or situation or refraining from doing any act or situation or simply doing an act. If the answer is yes, then it constitutes a ‘supply’ within the meaning of the Act, otherwise it is not a “supply”.
(emphasis supplied)
The Circular draws a crucial distinction between compensation for a breach and consideration for a taxable service. Thus, the mere fact that a contractual arrangement contains an obligation to tolerate or refrain from an act, or that a settlement agreement records the withdrawal or abandonment of claims, does not, in itself, render the corresponding payment taxable under Entry 5(e) of Schedule II to the CGST Act.
ADVANCE RULINGS APPLYING CIRCULAR DATED 03.08.2022:
Following issuance of the Circular, the issue has been tested before several State Authorities for Advance Rulings, with appeals before the relevant Appellate Authorities. Two advance rulings are specifically significant and relevant to the issue under consideration – (i) Order-in-Appeal No. AAAR/10/2022 dated 19.10.2022 by the Telangana State Appellate Authority for Advance Ruling (‘TSAAR’)[5]; and (ii) Advance Ruling (Appeal) No. GUJ/GAAAR/APPEAL/2025/02 dated 22.01.2025 by the Gujarat Appellate Authority for Advance Ruling (‘GAAAR’)[6]. These rulings are particularly instructive, as they examine the taxability of amounts arising from contractual breaches, settlement of disputes, and reciprocal obligations to refrain from pursuing claims or proceedings, while applying and interpreting the principles laid down in the Ministry of Finance’s Circular dated 03.08.2022.
The principal issue before the TSAAR in its ruling dated 19.10.2022 was whether liquated damages recoverable by the applicant from one Belectric India, on account of delay in commissioning, qualified as a ‘supply’ under the CGST Act, thereby attracting the levy of GST? Applying the principles laid down in the Circular dated 03.08.2022, the TSAAR observed that where the amount paid as ‘liquidated damages’ is an amount paid only to compensate for injury, loss or damage suffered by the aggrieved party due to breach of the contract, and there is no agreement, express or implied, by the aggrieved party receiving the liquidated damages to do or abstain from doing anything for the party paying the liquidated damages, liquidated damages are mere a flow of money from the party who causes breach of the contract to the party who suffers loss or damage due to such breach. Such payments do not constitute consideration for a supply and are not taxable.[7]
In its ruling of 22.01.2025 the GAAAR considered a more complex fact pattern involving an international Production Sharing Contract (‘PSC’) for petroleum exploration in the Joint Petroleum Development Area shared by Timor-Leste and the Government of Australia. Following arbitration proceedings between Timor-Leste and the Government of Australia, which threatened to void the underlying treaty, the concessionaires (including the appellant) sought termination of the PSC. The regulatory authority, the National Petroleum and Minerals Authority (ANP), terminated the PSC and raised a demand for the estimated cost of exploration not carried out and damages for breach of local content obligations. The ANP thereafter initiated ICC arbitration, and the dispute was settled through a Deed of Settlement and Release[8]. The forum of first instance – the Gujarat Authority for Advance Rulings (‘GAAR’) had held that the settlement amount was consideration for ANP agreeing to tolerate the concessionaires’ breach and for refraining from pursuing arbitration, which was taxable under the Reverse Charge Mechanism (“RCM”) as an import of service. The Appellate Authority disagreed with the GAAR’s ruling and, applying the principles laid down in the Circular dated 03.08.2022, the Appellate Authority set aside GAAR’s ruling, while holding that the liquidated damages paid in this case were paid only to compensate for loss due to breach of PSC and there was no agreement, express or implied, between ANP and the six concessionaires that on receiving the liquidated damages ANP would refrain from or tolerate an act or do an act for the concessionaires, including the appellant. Hence the liquidated damages, in terms of the aforementioned circular, were merely a flow of money and such payments did not constitute consideration for a supply and hence, were not taxable.[9]
GST ON SATISFACTION OF AN ARBITRAL AWARD: THE TATA-DOCOMO PRINCIPLE:
The most significant judicial development on the issue under consideration is the judgment of the Bombay High Court in Tata Sons Private Limited v. Union of India[10]. The facts, in brief, are that Tata Sons paid damages to Japan’s NTT Docomo pursuant to an international arbitral award, which was subsequently enforced by the Delhi High Court. Upon receipt of the full award amount, Docomo withdrew its enforcement proceedings, pending in the United Kingdom and the United States of America. Following withdrawal of the enforcement proceedings, the Directorate General of GST Intelligence (‘DGGI’) issued an intimation and, subsequently, a show cause notice seeking to levy Integrated Goods and Services Tax (‘IGST’) exceeding Rs. 1,500 crores, on the premise that Docomo’s withdrawal of the foreign enforcement proceedings constituted a ‘supply of services’ within the meaning of the CGST Act. The DGGI specifically invoked the service of “agreeing to refrain from an act”[11] under Entry 5(e) of Schedule II of the CGST Act.
The Bombay High Court rejected the DGGI’s characterisation, holding that the damages awarded to Docomo were compensation for Tata’s breach of contract, and not consideration for any independent obligation to tolerate, refrain from, or do an act. Docomo’s entitlement to damages arose only upon the arbitral tribunal determining the breach, quantifying the loss, and awarding compensation. The Court observed that Entry 5(e) necessarily contemplates an independent agreement under which parties, in the normal course of business, bind themselves to refrain from an act, tolerate a situation or do an act for consideration, which was absent in the present case. Accordingly, the Court held that there was no independent reciprocal obligation, dehors the arbitral proceedings and satisfaction of the award, that could constitute a ‘supply’ under Section 7(1)(c) read with Entry 5(e) of Schedule II to the CGST Act. The subsequent withdrawal of enforcement proceedings was merely a consequence of satisfaction of the arbitral award and could not transform the compensation into consideration for a taxable service.[12]
CONCLUSION:
Reading the above judgment and rulings alongside the Ministry of Finance’s Circular, three consistent principles emerge. First, the mere existence of liquidated damages or penalty clause does not establish an agreement to tolerate a breach – such clauses ordinarily serve as deterrents against non-performance, rather than consideration for permitting it. Second, the invocation of Entry 5(e) of Schedule II requires evidence of an independent and identifiable obligation to tolerate, refrain from, or do an act, distinct from the parties’ primary contractual obligations. Third, where a dispute is settled, whether through negotiation or during arbitration, the settlement amount will generally represent a quantification or resolution of the original claim for breach, rather than consideration for a fresh supply, unless the settlement itself creates an independent obligation of tolerance.
The Bombay High Court’s 2026 decision in Tata Sons[13] takes this principle further, holding that once an arbitral award has adjudicated a monetary liability, its subsequent satisfaction, including an undertaking to discontinue or not pursue enforcement proceedings, does not, by itself, constitute a fresh supply under Section 7, merely because the settlement records such an undertaking.
The essential distinction emerging from the foregoing discussion is between ‘payment for forbearance’ and ‘forbearance consequent upon payment’. The former may constitute consideration for a taxable service under Entry 5(e) of Schedule II to the CGST Act, however, the latter, being merely incidental or consequential to the payment or satisfaction of an existing liability, ordinarily does not constitute consideration for a taxable service.
The trajectory of advance rulings following the Ministry of Finance’s Circular dated 03.08.2022 and the Bombay High Court’s landmark decision in Tata Sons (supra) reflects a marked and welcome shift away from the earlier expansive interpretation of Entry 5(e) of Schedule II, under which almost any payment arising from a contractual breach risked being characterised as consideration for tolerating that breach. The emerging position instead requires the tax authorities to identify a genuine and independent reciprocal obligation to refrain from, tolerate, or undertake an act before GST can be levied on liquidated damages, settlement amounts, or compensation arising from arbitral awards. For parties and businesses negotiating commercial settlements, the practical takeaway is that the characterisation of a settlement, whether it merely quantifies a pre-existing claim for breach or instead records a fresh, freestanding obligation of forbearance, will be decisive of its GST treatment, and this characterisation should be considered carefully at the drafting stage of settlement deeds and consent terms.
*Advocate Amit Singh Chauhan is one of the Co-Founders of TKC Partners LLP. He pursued his LLB from the University of Delhi and LLM from the Harvard Law School. He is a dual qualified attorney with license to practice law in India and the State of New York, U.S.A.
**Advocate Arindam Bharadwaj is an Associate at TKC Partners LLP. He pursued his BA-LLB (Hons.) from the Jindal Global Law School and his MSc (Criminal Justice) from the London School of Economics & Political Science (LSE).
[1]The Central Goods and Services Tax Act, 2017, No. 12 of 2017, Schedule II, Entry 5(e) (India).
[2] Ibid.
[3] Circular No. 178/10/2022-GST dated 03.08.2022, Department of Revenue (Tax Research Unit), Ministry of Finance, Government of India.
[4] Ibid, Para 7.1.4.
[5] Order-in-Appeal No. AAAR/10/2022 dated 19.10.2022 by the Telangana State Appellate Authority for Advance Ruling (TSAAR).
[6] Advance Ruling (Appeal) No. GUJ/GAAAR/APPEAL/2025/02 dated 22.01.2025 by the Gujarat Appellate Authority for Advance Ruling (GAAAR).
[7] TSAAR Ruling (n 5), Para 14.
[8] GAAAR Ruling (n 6), Paras 3.1 – 3.6.
[9] Ibid, Para 20.
[10] Writ Petition no. 4914 of 2022, Judgement dated 30.04.2026.
[11] Ibid, Para 16.
[12] Ibid, Paras 83 – 84.
[13] Judgement dated 30.04.2026 (n 10).