GST on Liquidated Damages, Section 74 and Kailash Nath, Restraining a Bank Guarantee Call and the Change in Law Clause

This article is Part 4 of a four-part series on EPC contracts in India.

• • Part 1: Entity Structure and Mobilisation

• Part 2: Tax Architecture

• Part 3: Customs and the Project Imports Scheme

• Part 4: Commercial Risk (this article)

In brief

Liquidated damages, performance security and the change in law clause decide who bears the loss when an EPC project goes wrong. GST is not payable on liquidated damages paid as compensation for breach. Section 74 of the Contract Act awards reasonable compensation not exceeding the stipulated sum and requires that loss be shown to exist. A wrongful call on a performance bank guarantee is rarely restrained, so the protection must be built into the contract. Indian courts construe force majeure narrowly, which makes the change in law clause the contractor’s real protection against cost events.

This is Part 4 of a four-part analysis of EPC contracts in India. Part 1 covered entity structure and mobilisation, Part 2 the tax architecture, and Part 3 customs and the Project Imports Scheme. This Part covers the commercial risk architecture: the provisions that decide who bears the loss when the project does not go to plan.

Topics You Can Jump To:

Section III — Customs and the Project Imports Scheme

What is the Project Imports Scheme, and why does it matter for EPC? 

What is the registration trap in the Project Imports Scheme? 

Does construction equipment qualify under Heading 9801? 

How does Project Imports interact with EPCG and Advance Authorisation? 

Section IV — Commercial Risk: Liquidated Damages, Security and Change in Law

Is GST payable on liquidated damages under an EPC contract? 

Can liquidated damages be recovered without proof of loss? 

Can a wrongful call on a performance bank guarantee be restrained in India? 

Force majeure and change in law on Indian EPC projects

Checklist — Customs and Commercial Risk

Customs and Project Imports

Liquidated damages

Performance security

Change in law and force majeure

Frequently Asked Questions

About the Author

Services We Provide

 

Section IV: Commercial Risk, Liquidated Damages, Performance Security and Change in Law

The tax and customs structures determine what a project costs when it goes to plan. Liquidated damages, performance security and the change in law clause determine who bears the loss when it does not. These are the provisions that are negotiated hardest and drafted least carefully, and they are where a contractor with an immaculate tax position can still lose the project’s entire margin.

Is GST payable on liquidated damages under an EPC contract?

No. CBIC Circular No. 178/10/2022-GST dated 3 August 2022 confirms that liquidated damages paid as compensation for breach are not consideration for any supply. There is no agreement to tolerate an act. A contract is entered into for performance, not for breach. Field formations nonetheless continue to raise demands.

The question arises because Entry 5(e) of Schedule II to the CGST Act treats ‘agreeing to the obligation to refrain from an act, or to tolerate an act or a situation, or to do an act’ as a supply of services. For years, under service tax and then under GST, the revenue construed liquidated damages as consideration for the aggrieved party’s supposed agreement to tolerate the breach. Advance Ruling Authorities split, several holding liquidated damages taxable, and demands were raised across the infrastructure sector.

CBIC Circular No. 178/10/2022-GST (F. No. 190354/176/2022-TRU, dated 3 August 2022) closed the argument. Its reasoning is worth stating precisely, because it is the reasoning and not merely the conclusion that decides marginal cases. The Circular holds that an agreement to tolerate an act cannot be presumed to exist merely because money has flowed from one party to another. There must be an express or implied promise by the recipient of the money to tolerate something in return for it. Liquidated damages are not that. They are recovered to deter breach, not to permit it. A contract is entered into for its execution and not for its breach. Accordingly, liquidated damages are not consideration for a supply and no GST arises.

The distinction that decides borderline cases

The Circular draws a line between compensation for breach (not taxable) and payment for a facility made available (taxable). Late payment charges, early lease termination fees and loan prepayment penalties are taxable, because the recipient is genuinely supplying an accommodation: the right to pay late, to exit early, to prepay. The payer gets something it would not otherwise have had.

Liquidated damages for delayed completion are not that. The contractor is not buying the right to be late. It is compensating the owner for a breach the contract prohibits. The test to apply to any borderline payment on an EPC project is therefore: does the payment purchase an entitlement the payer did not have, or does it compensate for the loss of an entitlement the payee did have? The first is taxable. The second is not.

The Circular has not stopped the demands

In Aavanti Solar Energy (P) Ltd v. Joint Commissioner of Central Tax, Bengaluru (2024), the Karnataka High Court set aside a demand order that had been passed without considering Circular 178, and remitted the matter, emphasising that binding CBIC clarifications must be applied by the adjudicating authority. The Gujarat Authority for Advance Rulings reaffirmed the position in November 2025, holding that liquidated damages which the contract itself describes as a genuine pre-estimated loss cannot be consideration for tolerating anything.

For a foreign EPC contractor from whose invoices the Indian project owner has deducted liquidated damages, the position is clear and the answer to a GST notice is short: cite the Circular, cite the contract clause, and show that the payment compensates loss rather than purchasing tolerance. The drafting instruction that follows is to describe the sum in the contract as a genuine pre-estimate of loss and never as a penalty, a point that matters for a second, independent reason set out immediately below.

Can liquidated damages be recovered without proof of loss?

Not entirely. Section 74 of the Indian Contract Act awards reasonable compensation not exceeding the stipulated sum. Kailash Nath Associates v. DDA held that damage or loss is a sine qua non for Section 74: where loss can be proved, proof is not dispensed with. Only where loss is difficult or impossible to prove will the stipulated sum be awarded without it.

This is the harder of the two liquidated damages questions, and it cuts against the standard EPC assumption that the liquidated damages clause is self-executing. Section 74 of the Indian Contract Act 1872 provides that where a sum is named in the contract as payable on breach, the party complaining of the breach is entitled to reasonable compensation not exceeding the amount so named, whether or not actual damage or loss is proved to have been caused thereby.

In Kailash Nath Associates v. Delhi Development Authority, (2015) 4 SCC 136, the Supreme Court construed the phrase ‘whether or not actual damage or loss is proved to have been caused thereby’ to mean that where it is possible to prove actual damage or loss, such proof is not dispensed with. Since Section 74 awards reasonable compensation for damage or loss caused by breach, damage or loss caused is a sine qua non for the applicability of the section. Only where damage or loss is difficult or impossible to prove will the liquidated sum named in the contract, if a genuine pre-estimate, be awarded without proof.

Reconciling Kailash Nath with Saw Pipes

The relationship with ONGC v. Saw Pipes Ltd, (2003) 5 SCC 705 has generated a decade of litigation and a good deal of confusion, much of it produced by reading the Kailash Nath headnote rather than the judgment. The better view, and the one subsequent High Court authority supports, is that the two decisions are reconcilable and operate on different questions.

• Saw Pipes relaxes the requirement of mathematical precision in quantifying loss where the parties have pre-estimated it. The claimant need not prove the quantum to the rupee.
• Kailash Nath insists that some loss or injury must be shown to exist. The claimant cannot recover where the breach caused no harm at all.

Neither dispenses with the requirement that the breach caused harm. What is dispensed with, in the appropriate case, is the burden of proving the quantum, not the burden of showing that loss occurred. Practitioners who cite Saw Pipes for the proposition that liquidated damages are recoverable on proof of delay alone are overstating it, and practitioners who cite Kailash Nath for the proposition that quantum must always be strictly proved are overstating it in the other direction.

What this means for EPC drafting

• The liquidated damages cap is a ceiling, not an entitlement. A cap expressed at, say, 10% of contract price limits the owner’s recovery. It does not entitle the owner to that sum on proof of delay alone. The owner must still show that the delay caused loss.
• Characterise the clause deliberately. Recite in the contract that the sum is a genuine pre-estimate of loss arrived at by the parties, and where possible recite the basis of the estimate. A contract describing the sum as a ‘penalty’ invites the argument that it is unenforceable as such. A contract describing it as a ‘genuine pre-estimated loss’ was relied on by the Gujarat AAR in November 2025 for the GST question and supports the Section 74 position as well. The same drafting choice serves both regimes.
• Where loss is genuinely hard to quantify, say so in the contract. On a power project, the owner’s loss from delayed commissioning is a function of tariff, dispatch and power purchase agreement terms and is often genuinely difficult to compute. Reciting that difficulty strengthens the case that the Kailash Nath exception applies and the stipulated sum should be awarded without proof of quantum. This helps the owner, so a contractor should resist it.
• For the contractor, the mirror-image point. Where the owner has deducted liquidated damages and the contractor disputes the deduction, Section 74 is the contractor’s provision. The burden is on the owner to show loss, and a deduction made mechanically on the basis of the clause alone is vulnerable to challenge.

Can a wrongful call on a performance bank guarantee be restrained in India?

Rarely. A bank guarantee is an independent contract and the underlying dispute is irrelevant to it. Indian courts will restrain invocation only on egregious fraud vitiating the guarantee’s foundation, irretrievable injustice, or special equities. Standard Chartered Bank v. Heavy Engineering Corporation recognised special equities as a distinct third exception, but the threshold remains very high.

The performance bank guarantee, the advance payment guarantee and retention money are the mechanisms through which economic risk on an EPC project is actually allocated. For a foreign contractor, the wrongful call is the sharpest single commercial exposure: an owner facing a substantial claim can neutralise both the claim and the contractor’s balance sheet by calling the performance bond.

The autonomy principle

The Indian position begins from the autonomy of the guarantee. A bank guarantee is an independent contract between the bank and the beneficiary, absolute in nature. The existence of a dispute between the parties to the underlying contract is not a ground for injuncting enforcement. The bank is obliged to honour an unconditional and irrevocable guarantee once it is invoked in accordance with its terms, and it is not open to the bank to adjudicate whether the invocation was justified. So held the Supreme Court in Standard Chartered Bank v. Heavy Engineering Corporation Ltd., (2020) 13 SCC 574 : 2019 SCC OnLine SC 1638, following Hindustan Construction Co. Ltd v. State of Bihar, (1999) 8 SCC 436 and U.P. Cooperative Federation Ltd v. Singh Consultants and Engineers (P) Ltd, (1988) 1 SCC 174.

The exceptions, and the doctrinal difficulty

Two exceptions were long established: egregious fraud of a nature that vitiates the very foundation of the guarantee and of which the bank has notice; and irretrievable injustice or irreparable harm of such an exceptional character as to override both the express terms of the guarantee and the adverse effect an injunction would have on commercial dealings generally.

Standard Chartered appeared to recognise special equities as a third and independent exception, distinct from irretrievable injustice. That has caused genuine doctrinal difficulty, because special equities had previously been understood as a species of the irretrievable injustice genus, not a separate genus. After Standard Chartered, litigants began invoking broad notions of commercial hardship under the label.

The high-water mark was Halliburton Offshore Services Inc. v. Vedanta Ltd, where the Delhi High Court treated the COVID-19 pandemic as a special equity and injuncted invocation, a decision widely criticised as stretching the doctrine past breaking point. The Delhi High Court has since pulled back. In Director General, Project Varsha v. Navayuga-Van Oord JV, 2024 SCC OnLine Del 6459, it held that special equities are not a freestanding ground and must partake of the character of irretrievable injustice, and it set aside an arbitral tribunal’s order restraining invocation for stretching the doctrine too far.

What a contractor should actually expect

The position to plan against is that the exceptions are close to illusory in practice. Courts recite them and almost never find them satisfied. Neither economic hardship nor the pendency of the underlying dispute will do. Allegations that the owner has fabricated a default or misrepresented the contractor’s compliance are routinely dismissed absent unequivocal documentary proof of fraud, and a contractor in the middle of a live dispute rarely has that.

The one recognised fact pattern where relief has been granted is where the contractor has already obtained arbitral awards neutralising the beneficiary’s claims, such that invocation would amount to unjust enrichment and would negate the awards (Hindustan Construction Co. Ltd v. NHPC Ltd, 2023 SCC OnLine Del 819). That is a narrow window, and it opens only after the contractor has already won.

The drafting response

Because the judicial remedy is largely unavailable, the protection must be contractual and it must be built in at the outset. Four levers:

• Make the guarantee conditional where the owner will accept it. The autonomy principle applies with full force to an unconditional on-demand guarantee. A guarantee whose terms require the beneficiary to certify a specific, particularised default, with that certification a condition of a valid invocation, gives the contractor a foothold that an unconditional guarantee does not. Owners resist this. It is worth the negotiation.
• Draft the invocation mechanics tightly. The one exception courts do apply readily is where the guarantee is not invoked strictly in its own terms, or is invoked by a person not empowered to invoke it. A guarantee requiring a demand in a prescribed form, signed by a named office-holder, stating the specific breach and the amount attributable to it, creates real invocation risk for a careless beneficiary, and a real ground for injunction if the form is not followed.
• Cap and step down. Reduce the performance guarantee value at defined milestones, mechanical completion, provisional acceptance, rather than holding the full amount to final acceptance. Advance payment guarantees should amortise against certified progress, not sit at full value until the end of the project.
• Prefer a parent company guarantee where the balance sheet permits. A parent company guarantee is a guarantee of performance, not an on-demand instrument. It requires the beneficiary to establish the underlying breach before it can recover. Owners and lenders often prefer a bank guarantee for exactly that reason, but on a strong balance sheet the parent company guarantee is negotiable, and it removes the wrongful call exposure entirely.

Force majeure and change in law on Indian EPC projects

Indian courts construe force majeure narrowly. In Energy Watchdog v. CERC, the Supreme Court held that a rise in the price of coal did not excuse performance and that Section 56 of the Contract Act has no application where the contract itself provides for the contingency. Increased cost of performance is not force majeure.

Energy Watchdog v. Central Electricity Regulatory Commission, (2017) 14 SCC 80 is the governing authority and it is restrictive. The Supreme Court held that where a contract contains an express force majeure clause, the doctrine of frustration under Section 56 of the Contract Act has no application: the parties have allocated the risk themselves and the court will hold them to that allocation. On the facts, a steep rise in the price of Indonesian coal following a change in Indonesian law did not trigger the force majeure clause, because the contract had not made supply from any particular source a condition, and the generator’s difficulty was commercial hardship rather than impossibility.

Increased cost of performance is not force majeure. That proposition survives, and it is the one that matters on EPC projects, because the events that actually hurt an EPC contractor, commodity price movement, supply chain disruption, labour shortage, duty changes, are almost always cost events rather than impossibility events. A contractor that has priced its force majeure clause as protection against escalation has misread the Indian position.

The change in law clause is the real protection

The practical consequence is that the change in law clause, not the force majeure clause, is the contractor’s genuine protection on an Indian EPC project, and it must be drafted to reach the risks that actually materialise.

The solar Project Import withdrawal discussed in Part 3 of this series is the paradigm case. A customs notification, issued between bid and import, changed the landed cost of the equipment by a material margin. Whether that cost lands on the contractor or the owner is decided entirely by the change in law clause, and specifically by whether the definition of ‘law’ captures a customs notification amending a regulation made under Section 157 of the Customs Act. Many change in law clauses do not.

• Define ‘law’ widely. It should expressly include subordinate legislation, notifications, circulars and binding administrative orders, and changes in their judicial interpretation. A definition confined to ‘Acts of Parliament’ or ‘statutes’ will not capture the events that actually occur, because the events that actually occur are notifications.
• Cover tax and duty changes expressly. Changes in customs duty, GST rate, GST classification, and the withdrawal of a duty concession such as Project Imports should be named individually. A generic change in law clause frequently fails to capture a rate change, because on a narrow reading a rate change is not a change in ‘law’ at all.
• Set the relief mechanism, not merely the trigger. State whether relief is time, cost, or both; how the cost is computed; who certifies it; and what evidence is required. A change in law clause that establishes entitlement but not quantification produces a dispute rather than a remedy, and that dispute will be resolved under the contract’s dispute resolution machinery.

Checklist: Commercial Risk

A project-use reference for the material in Part 4. It is not a substitute for project-specific legal and tax advice.

Liquidated damages

• Describe the sum in the contract as a GENUINE PRE-ESTIMATE OF LOSS. Never use the word ‘penalty’
• Recite the basis of the pre-estimate in the contract where it can be articulated
• Where loss is genuinely difficult to quantify (delayed commissioning on a power project), the owner will want that difficulty recited. The contractor should resist it
• Understand that the LD cap is a ceiling, not an entitlement, the owner must still show loss (Section 74; Kailash Nath)
• Where the owner has deducted LD, challenge it: the burden is on the owner to show loss caused by the delay
• On a GST notice claiming tax on LD: cite CBIC Circular 178/10/2022-GST, cite the contract clause, show the payment compensates loss rather than purchasing tolerance
• Apply the test to any borderline payment: does it purchase an entitlement the payer did not have (taxable), or compensate for loss of an entitlement the payee did have (not taxable)?

Performance security

• Negotiate for a CONDITIONAL guarantee requiring the beneficiary to certify a specific, particularised default
• Draft invocation mechanics tightly: prescribed form, named signatory, specified breach, amount attributable to that breach
• Build in step-downs at mechanical completion and provisional acceptance. Do not hold full value to final acceptance
• Amortise advance payment guarantees against certified progress
• Explore a parent company guarantee in place of an on-demand bank guarantee where the balance sheet permits
• Do not plan on obtaining an injunction against a wrongful call. The exceptions are recited and almost never applied
• If a call is made, check first whether the invocation complies strictly with the guarantee’s own terms. This is the exception courts do apply

Change in law and force majeure

• Do not rely on force majeure for cost events. Energy Watchdog: increased cost of performance is not force majeure
• Define ‘law’ in the change in law clause to include subordinate legislation, notifications, circulars and binding administrative orders
• Name customs duty changes, GST rate changes, GST classification changes and withdrawal of duty concessions expressly
• Specify the relief mechanism, time, cost, or both, and the quantification method, the certifier, and the evidence required
• Diarise the notice period for a change in law claim. These clauses are usually condition-precedent

Frequently Asked Questions

• Is GST payable on liquidated damages deducted from an EPC contractor’s invoice?

No. CBIC Circular No. 178/10/2022-GST dated 3 August 2022 confirms that liquidated damages paid as compensation for breach of contract are not consideration for any supply. An agreement to tolerate an act cannot be presumed merely because money has flowed from one party to another. Liquidated damages are recovered to deter breach, not to permit it. Field formations continue to raise demands, and the Karnataka High Court set one aside in Aavanti Solar Energy (2024) for failing to apply the Circular.

• Can an owner recover liquidated damages without proving loss?

Not entirely. Section 74 of the Indian Contract Act awards reasonable compensation not exceeding the sum named. In Kailash Nath Associates v. Delhi Development Authority, (2015) 4 SCC 136, the Supreme Court held that damage or loss caused by the breach is a sine qua non for Section 74, and that where loss can be proved, proof is not dispensed with. Only where loss is difficult or impossible to prove will the stipulated sum be awarded without it. The liquidated damages cap is a ceiling, not an entitlement.

• Can an Indian court stop a project owner from wrongly calling a performance bank guarantee?

Rarely. A bank guarantee is an independent contract and the underlying dispute is irrelevant to it. Indian courts will restrain invocation only on egregious fraud vitiating the foundation of the guarantee, irretrievable injustice, or special equities. Standard Chartered Bank v. Heavy Engineering Corporation, (2020) 13 SCC 574, recognised special equities as a distinct third exception, but the threshold remains very high and neither commercial hardship nor a pending dispute will satisfy it. Protection must be built contractually.

• Is a rise in commodity prices a force majeure event under Indian law?

No. In Energy Watchdog v. Central Electricity Regulatory Commission, (2017) 14 SCC 80, the Supreme Court held that a steep rise in the price of imported coal did not trigger the force majeure clause, and that Section 56 of the Contract Act has no application where the contract itself provides for the contingency. Increased cost of performance is commercial hardship, not impossibility. On EPC projects, the change in law clause rather than the force majeure clause is the contractor’s real protection against cost events.

About the Author

Ravish is a dual-qualified lawyer and Solicitor admitted to practice in India and on the roll of the Solicitors Regulation Authority (England and Wales). He specialises in international arbitration and international taxation, and holds the Advanced Diploma in International Taxation (ADIT) from the Chartered Institute of Taxation (CIOT). His practice focuses on cross-border disputes, enforcement strategy, and complex tax-driven structuring.

 

Further details are available on his LinkedIn Profile: https://www.linkedin.com/in/adit-ravishbhatt/

 

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Disclaimer

This article provides general information only and is not legal, tax, or financial advice. India inbound structuring requires coordinated input from advisers in all relevant jurisdictions, and outcomes depend heavily on facts, residency, substance, and evolving laws. This Part 4 covers commercial risk; Parts 1 to 3 covered mobilisation, the tax architecture, and customs and the Project Imports Scheme. Readers should seek professional advice before acting on any material herein. R & D Law Chambers LLP assumes no responsibility for any reliance placed on this summary.