The concept of “tolerance of an act” is not new to indirect tax laws. This concept was introduced in service tax regime from July 2012. Since then, companies have been paying service tax on amount recovered under the head “tolerance of an act” which includes payment / deduction towards late delivery charges, recovery of damages / loss due to any reason, delay in giving possession and many more. Same practice / compliance continued in GST regime also. The term “tolerance of an act” was never clarified with examples to understand the meaning and coverage of transaction under this scenario and therefore, as a standard practice, almost all trade and professionals were of the view of applicability of GST on any recovery / deduction towards suffering of loss / damage.

Now, after more than five years of GST implementation, the Board has issued a clarification vide Circular No. 178/10/2022-GST dated 3^rd August 2022 to discuss meaning and coverage of “tolerance of an act”. The Circular has referred to several transactions to clarify the coverage of “tolerance of an act”. These transactions are summarised as under:

1. Liquidated damages paid for breach of contract – 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. ‘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.

2. Cheque dishonour fine/penalty charged by a power distribution company from the customers – There is never an implied or express offer or willingness on part of the supplier that he would tolerate deposit of an invalid, fake or  unworthy instrument  of  payment  against  consideration  in  the  form  of  cheque dishonour fine or penalty. The fine or penalty that the supplier or a banker imposes, for dishonour of a cheque, is a penalty imposed not for tolerating the act or situation but a fine, or penalty imposed for not tolerating, penalizing and thereby deterring and discouraging such an act or situation. Therefore, cheque dishonour fine or penalty is not a consideration for any service and not taxable.

3. Penalty imposed for violation of any legal provision – penalties imposed for violation of laws cannot be regarded as consideration charged by Government or a Local Authority for tolerating violation of laws. Laws are not framed for tolerating their violation. They stipulate penalty not for tolerating violation but for not tolerating, penalizing and deterring such violations. There is no agreement between the Government and the violator specifying that violation would be allowed or permitted against payment of fine or penalty. Thus, GST is not applicable on such penalties imposed.

4. Bond amount recovered from an employee leaving the employment before the agreed period (Notice Pay Recovery) – The provisions for forfeiture of salary or recovery of bond amount in the event of the employee leaving the employment before the minimum agreed period are incorporated in the employment contract to discourage non-serious candidates from taking up employment. The said amounts are recovered by the employer not as a consideration for tolerating the act of such premature quitting of employment but as penalties for dissuading the non-serious employees from taking up employment and to discourage and deter such a situation. Therefore, such an amount recovered is not taxable under GST.

5. Late payment charges collected by any supplier for late payment of bills – The facility of accepting late payments with interest or late payment fee, fine or penalty is a facility granted by supplier naturally bundled with the main supply. Moreover, as per section 15(2)(d) of the CGST Act, 2017, interest, late fee or penalty charged for the delayed payment of any consideration is to be added in the taxable value and therefore, GST is applicable on recovery of late payment charges.

6. Cancellation charges – We often experience cancellation charges against hotel accommodation booking, entertainment event, travelling etc. The supplier may allow cancelation of supply on payment of cancellation fee as per commercial terms of the contract. Cancellation fee can be considered as the charges for the costs involved in making arrangements for the intended supply. Cancellation charges is a facility granted by supplier naturally bundled with the main supply and accordingly, GST will be appliable at the same rate as applicable to the main supply.

The above are just few examples and therefore, applicability of GST on any recovery against any loss or damage is to be studied based on the below two grounds:

1. Whether recovery / deduction / payment is against independent contract envisaging tolerating an act or situation or refraining from doing any act or situation or simply doing an act and not a part of the original contract..?
2. Whether recovery / deduction / payment is naturally bundled to the main supply..? (Considering the clarifications and examples, this I feel the most challenging aspect in order to decide the applicability).

To conclude –

1. GST is applicable – if the answer to question no. 1 and 2 is positive; and
2. GST is not applicable – if the answer to question no. 1 and 2 is negative.

Whether this Circular has clarified the doubts or added more confusion is a separate aspect. However, clarification with regard to the first few transactions discussed above are in favour of the assessee and therefore, assessees can straight a way follow this without going into deep analysis with regard to the transactions that are specifically mentioned in the Circular.