In a major reform to promote fair lending practices, the Reserve Bank of India (RBI) has changed the way banks and NBFCs impose penalties on loan defaulters. As per RBI’s circular dated 18th August 2023, all Regulated Entities (REs), including banks and Non-Banking Financial Companies (NBFCs), are directed to stop charging penal interest and instead levy penal charges for breaches of loan agreements. This change became effective from 1st January 2024.

But this shift raised a crucial question — Are these penal charges subject to GST? Let’s understand the full picture.

What Did the RBI Actually Say?

Earlier, if a borrower defaulted on an EMI or violated key loan conditions, banks would impose penal interest — extra interest over and above the regular rate.

With RBI’s new rule:

  • Penal interest is discontinued

  • Penal charges (fixed fees) are now to be levied instead

  • Applies to loan accounts, excluding:

    • Credit cards

    • External commercial borrowings

    • Trade credits

    • Structured obligations

The RBI made this change to bring transparency, ensure fair pricing, and encourage credit discipline.

Why This Change Matters

The RBI noticed that different lenders had varying practices when it came to penal interest. Some even misused it by disguising regular interest as penalties.

To fix this:

  • RBI made a clear distinction between interest and penal charges

  • Penal charges are meant to deter misconduct, not to earn extra revenue

  • This also allows borrowers to understand penalties better

The GST Confusion: Are Penal Charges Taxable?

After this announcement, many banks, NBFCs, and tax professionals raised a common concern — will these penal charges attract 18% GST?

Some GST officers initially believed that penal charges could be taxed as a supply of service for “tolerating an act,” which is a taxable event under the GST Act.

If this interpretation were correct, borrowers would have to pay extra GST on top of the penalty — making defaults even costlier.

What the Earlier GST Circular Says

To address similar confusion in the past, the CBIC (Central Board of Indirect Taxes and Customs) had issued a clarification through Circular No. 178/10/2022-GST dated 3rd August 2022.

According to this:

  • Payments like liquidated damages or penalties for breach of contract are not a separate supply

  • These are not payments made for “tolerating an act”

  • Such penalties are simply a consequence of non-performance, not a service

Final GST Clarification: No GST on Penal Charges

In line with the above logic, the CBIC has now clarified that:

✔️ Penal charges imposed by REs (as per RBI’s new rule) are not taxable under GST
✔️ These charges are similar to liquidated damages, and do not count as supply of service
✔️ Therefore, no GST is applicable on such charges

This decision was also backed by the 55th GST Council, which clearly stated that these penal charges should not be subject to GST.

What This Means for Borrowers and Banks

✅ No extra tax burden on borrowers for loan defaults
✅ Clear distinction between interest income and penalty fees
✅ Banks and NBFCs can now apply penal charges without worrying about GST compliance issues
✅ Greater transparency and fairness in lending

Conclusion

RBI’s directive and the GST clarification together create a more transparent and borrower-friendly lending ecosystem. By removing GST on penal charges, borrowers are protected from double punishment — first for defaulting, and then again through tax.

This is a welcome move for both the financial sector and the common borrower, ensuring fair practices and simplified tax treatment.

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