Karnataka High Court Rules: No GST on Liquidated Damages, Orders ₹5 Crore Refund

Karnataka High Court Rules: No GST on Liquidated Damages, Orders ₹5 Crore Refund

Court Says Damages Are Compensation, Not Service

Businesses Welcome Clarity on GST Disputes

By Our Legal Correspondent

New Delhi: December 31, 2025:

In a landmark judgment, the Karnataka High Court has held that liquidated damages paid for breach of contract are not liable to Goods and Services Tax (GST). The ruling comes as a major relief to businesses across India, as it settles a long-standing dispute on whether damages should be treated as a taxable supply of service. The Court also ordered the refund of ₹5 crore paid under protest by the petitioner, setting a precedent for similar cases.

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Background of the Case

• The case involved Aavanti Solar Energy Pvt. Ltd., which had paid GST on liquidated damages under protest.
• The tax authorities had demanded GST, arguing that damages fall under “tolerating an act” as per Para 5(e) of Schedule II of the CGST Act, 2017.
• The company challenged the demand, stating that damages are compensatory in nature and do not amount to a supply of service.
• The High Court agreed with the company, ruling that GST cannot be levied on damages for breach of contract.

Court’s Observations

• Damages are not consideration: The Court clarified that liquidated damages are meant to compensate the aggrieved party, not to provide any service.
• Schedule II inapplicable: Para 5(e) of Schedule II, which treats “agreeing to tolerate an act” as a supply of service, does not apply to breach of contract situations.
• Refund ordered: The Court directed the tax department to refund ₹5 crore collected under protest.

Why This Ruling Matters

1. Clarity for Businesses: Many companies face disputes over GST on damages, penalties, and compensation clauses in contracts. This ruling provides legal clarity.
2. Financial Relief: Businesses that paid GST under protest may now seek refunds.
3. Legal Precedent: The judgment strengthens the argument that compensation is not a taxable supply.
4. Impact on Contracts: Companies may now draft contracts with greater confidence, knowing that damages clauses will not attract GST.

Industry Reactions

• Tax Experts: Professionals welcomed the ruling, saying it aligns with the principle that GST applies only to supply of goods or services, not compensation.
• Businesses: Corporates across sectors, especially infrastructure and energy, see this as a relief from unnecessary tax burdens.
• Legal Analysts: They note that this judgment may influence similar cases pending across India.

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Comparison Table

Wider Legal Context

• Other High Courts: Similar rulings have been delivered in different states, but Karnataka HC’s decision adds weight to the argument against taxing damages.
• Supreme Court Outlook: If challenged, the matter may reach the Supreme Court, which could settle the issue nationally.
• Government Circulars: The Court noted that authorities had ignored key circulars clarifying that damages are not taxable.

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Implications for Businesses

• Contract Drafting: Companies should clearly define damages as compensation in contracts.
• Tax Planning: Firms can avoid unnecessary GST payments on damages.
• Litigation Strategy: Businesses facing demands can rely on this judgment as precedent.

Conclusion

The Karnataka High Court’s ruling marks a significant step in clarifying India’s GST framework. By holding that liquidated damages are not taxable, the Court has protected businesses from unjust tax demands and reinforced the principle that GST applies only to actual supply of goods and services. The refund of ₹5 crore underscores the seriousness of the issue and sets a precedent for future disputes.

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