Businesses dealing in exports often face a practical issue: a foreign customer places an order, the Indian supplier starts work and incurs costs, and then the customer cancels the order midway. The customer may agree to reimburse the costs or pay compensation. The key GST question is whether this reimbursement is taxable and, if so, whether it can be treated as export of service.
In this article, we examine the GST implications of such reimbursements with reference to the concepts of “supply”, “tolerating an act”, liquidated damages and export of services under the CGST and IGST law.
1. Typical Fact Pattern
Consider an Indian supplier (Mr. X) who receives an export order from a foreign client. On the strength of this order, he begins preparatory activities – procuring inputs, incurring labour and other business expenses in the normal course. Before any goods are exported or any service is fully performed, the foreign client unilaterally cancels the order. The client then reimburses Mr. X for expenses already incurred or pays a lump‑sum compensation for cancellation.
The amount paid is described as reimbursement/compensation for cancellation of the contract, and not as consideration for any specific service rendered to the foreign client. The central issue is whether this amount can be treated as consideration for a “supply” under GST.
2. When Does a Receipt Become “Consideration for Supply”?
Section 7(1)(a) of the CGST Act defines “supply” very broadly to include all forms of supply of goods or services or both, made for a consideration in the course or furtherance of business. For GST to apply, two conditions must generally co‑exist: there must be a supply of goods or services, and there must be a direct and proximate nexus between that supply and the consideration received.
In other words, the real test is not whether money is received, but why it is received. If the payment is in return for a positive act or service agreed between the parties, GST may apply. If the payment is merely compensatory in nature, it is not automatically taxable.
3. Reimbursements Under GST – Different Possibilities
Reimbursements are not treated in a uniform manner under GST; their taxability depends on the underlying arrangement between the parties. Broadly, three situations can arise.
(a) Reimbursement as Part of the Price of a Taxable Supply
If a supplier incurs expenses in his own capacity (for example travel, logistics, third‑party charges) and then recovers the same from the client as part of his commercial charges, such reimbursement generally forms part of the value of supply. In such cases: the supplier is providing a taxable service or goods, the reimbursement is integrally linked to that supply, and GST is payable on the total amount charged, including reimbursement.
Here, what is reimbursed (type of expense) is less important than the fact that the payment is part of the agreed consideration for the core supply.
(b) Reimbursement in “Pure Agent” Capacity (Rule 33)
Rule 33 of the CGST Rules provides a specific carve‑out where the supplier acts as a “pure agent” of the recipient. If the prescribed conditions are satisfied – such as incurring expenses on behalf of the recipient, the recipient being legally liable for those expenses, the amounts being separately indicated in the invoice, and the supplier recovering exactly the same amount – then such reimbursements are excluded from the taxable value.
Even in this scenario, there is an underlying supply between the parties; only the pure‑agent portion is kept outside valuation. This concept typically does not apply where the payment itself is only for cancellation of a contract and there is no completed underlying supply.
(c) Reimbursement as Compensation / Liquidated Damages
Another way to look at a cancellation‑related payment is to treat it as compensation or liquidated damages for breach of contract. Schedule II, paragraph 5(e) covers situations where a person agrees to refrain from an act, to tolerate an act or a situation, or to do an act, and treats them as supply of services.
For some time, tax authorities attempted to bring liquidated damages and penalties within GST on the argument that the aggrieved party is “tolerating” the breach in exchange for consideration. However, CBIC Circular No. 178/10/2022‑GST dated 03.08.2022 clarified that liquidated damages, compensation or penalty for breach or non‑performance of contract are not taxable merely because they relate to a breach. There must be a clear and independent contractual obligation to tolerate an act for consideration; mere acceptance of damages due to breach does not, by itself, amount to agreeing to tolerate.
4. Applying These Principles to Cancellation of an Export Order
In the typical fact pattern described earlier, the following aspects are relevant:
- There is no express contractual clause under which the Indian supplier agrees, for a price, to tolerate cancellation of the contract.
- The foreign client unilaterally cancels the order; the supplier has not promised to “allow” such cancellation in return for a fee.
- The amount received by the supplier is meant to make him whole for costs already incurred and/or for business loss suffered, and not to remunerate any positive service rendered to the client.
Given these facts, the payment received does not fit into the category of consideration for “tolerating an act” under Schedule II. It is compensatory in nature. Consequently, there is no supply of goods or services linked to this payment, and the amount is not liable to GST.
5. Can Such Receipt Be Treated as “Export of Service”?
For a transaction to qualify as export of services under Section 2(6) of the IGST Act, five cumulative conditions must be satisfied: the supplier of service must be in India, the recipient must be outside India, the place of supply must be outside India, payment must be received in convertible foreign exchange/ permitted INR, and the supplier and recipient must not be mere establishments of the same person.
In a cancellation scenario, the primary difficulty is that there is no completed or identifiable “service” supplied to the foreign client in respect of which the payment is made. The order is cancelled midway, and the amount received is not consideration for an export service but compensation for costs and loss. Since the very condition of supply of service is not met, the payment cannot be characterised as export of service, even if it is received from a person located outside India in foreign currency.
6. Practical View and Compliance Aspects
Based on the statutory definition of supply, the valuation rules and the CBIC circular on liquidated damages, a strong view is possible that reimbursement/compensation received solely on account of cancellation of an export order, where no taxable supply has taken place and there is no separate agreement to tolerate the cancellation, is not liable to GST.
From a compliance perspective, such amounts would generally not form part of taxable turnover and need not be reported as outward supplies, provided that the contractual documents, correspondence and accounting entries clearly establish the compensatory nature of the payment and absence of any underlying supply. Taxpayers should retain adequate documentation to support this position in case of scrutiny.
FCA, CWM (AAFM-US), CBV, CIFRS, R-ID, B.COM (H), RV* (IBBI)
Practising Chartered Accountant in Delhi NCR Since 2011. He can be contacted at ankitgulgulia@gmail.com or +91-9811653975.