The Authority for Advance Rulings, Karnataka in the case of M/s. Enzyme Business Center vide Order No.- KAR ADRG 33/2023 dated 16.11.2023, has held that the damages received by the applicant from the tenant towards the termination of sub-lease before the agreed upon lock-in period as per the sub-lease deed agreements tantamount to supply as per Section 7 of Central GST Act, 2017 and the amount received towards damages as per the settlement agreement is to be construed as Consideration for the above supply. 

In this case, the applicant is engaged into sub-letting of commercial property on rental basis. They have entered into lease agreement with two different landlords and has obtained two premises for lease, which the applicant further  sub let to third parties (i.e. Clients). The Clients of the applicant stated their incapability to continue the sub-letting agreement and the applicant agreed upon for the early termination of the contract subject to payment of damages by the Client.

The Applicant here sought advance ruling as to whether damages amount received towards the termination of sub-lease before the agreed upon lock-in period as per the sub-lease deed agreements would tantamount to supply as per Section 7 of Central GST Act, 2017. 

The Applicant submitted that the payment of damages is for the contract violation as per the agreement duly agreed upon and the same is not considered as a Supply under GST. Further, the applicant has relied upon CBIC circular No. 178/ 10/2022 stating that damages are monetary compensation loss due to non-occupancy of the rental property and no GST is applicable in this regard.

The Authority for Advance Ruling (AAR) observed the terms of the sub-lease agreement, which states that “the amount which was received by the applicant from their client, was a part of the terms and condition of the lease agreement signed between the applicant and their client”. This means that, while entering into the agreement, the client was aware about the terms and conditions of the contract that, in case of breach of agreement, i.e, in case, of early termination, they shall be liable to pay the rental till the end of lock-in period as a settlement for exit from the contract. Thus the Applicant has received money on account of non fulfillment of conditions as stipulated in the lease agreement.

Further, the AAR in terms of the provisions of Section 7 of the CGST Act, noted that the payment of amount is for an act of tolerance in the sense that, when there is breach of the contract, the other party is put to certain hardships, which he tolerates in return of the payment received by his client. The same can be understood as consideration received by the Applicant for “agreeing to the obligation to refrain from an act, or to tolerate an act or a situation” of their client of not completing the lock-in period, which he had agreed in terms of contractual obligations. Therefore, this activity constitutes supply in terms of Section 7(1) of CGST Act, 2017.

Also, the AAR in view of the CBIC circular No. 178/ 10/2022, stated that it is mentioned that amounts paid for early termination of lease as contemplated by the contract as part of commercial terms agreed to by the parties, constitute consideration for the supply of a facility, namely, early termination of a lease agreement. Therefore, such payments, even though they may be referred to as fine or penalty, are actually payments that amount to consideration for supply, and are subject to GST, in cases where such supply is taxable. Since these supplies are ancillary to the principal supply for which the contract is signed, they shall be eligible to be assessed as the principal supply.

Therefore, in the present case, the principal supply is sub letting of a commercial property which is a taxable supply of service and is classified under chapter heading 9972 – Real Estate Services and same would be liable to GST at 18% (9% CGST and 9% SGST).