India: Indirect tax system on the verge of change

September 30, 2011

The indirect tax regime in India involves multiple levies for different transactions. They can be broadly categorized as follows — the federal levy (such as central excise duty, service tax, customs duty and central sales tax), the levy by the States and municipal bodies (such as VAT) and other local taxes (such as octroi, cess, entertainment tax, etc.).

Not surprisingly, the current system is complex and imposes additional compliance burdens on companies that operate in India or that are looking to expand into India. However, this system is set to undergo a major reform with the introduction of a GST.

The current indirect tax structure in India

The indirect taxes that are currently levied in India are structured as follows:

Federal levies

Customs duty: Customs duty is a federal levy applied to goods imported into India. It comprises multiple duties as follows:

  • Basic customs duty (BCD) (with a generic rate of 10%)
  • Additional customs duty (ACD) charged in lieu of excise duty (with a generic rate of 10.30%)
  • Education cess (EC) and secondary and higher education cess (SHEC) charged at 3% on BCD and ACD
  • Special additional customs duty (SACD) charged in lieu of VAT at a rate of 4%

ACD paid on the importation of goods is typically allowed as a credit against the importer’s output excise or service tax liability, subject to certain conditions.

Similarly, SACD paid on the importation of goods is allowed as credit for a manufacturer against the output excise or service tax liability.

However, BCD paid on importation of goods is a cost to the importer. In addition, while the importation of certain notified goods by a trader is exempt from payment of SACD, in the case of the importation of other goods, the trader can claim a refund of SACD paid at the time of import.

The refund is subject to conditions that include the requirement that the tax on the sale of the said relevant goods is paid by the trader.

The Customs Tariff in India is aligned with the international Harmonized System of Nomenclature (HSN). The customs’ duty rate payable depends on the HSN code of the imported goods.

The generic customs’ duty is 26.85%. However, there are goods that attract a lower rate of customs’ duty on importation into India, such as pharmaceuticals and medicines.

Central excise duty — Central excise duty is a federal levy charged on the manufacture of excisable goods in India.

The classification of manufactured goods in the Central Excise Tariff determines the rate of central excise duty.

The generic rate of excise duty is 10.3% (including EC and SHEC). Specified luxury items, such as motor vehicles and cigarettes, attract a higher rate of central excise duty.

Excise duty paid on procuring manufacturing inputs is available as a credit to offset against the manufacturer’s output excise or service tax liability, subject to certain conditions.

Whether a process, including packing or repacking, etc. amounts to “manufacture” of the goods has been the subject of interpretation by India’s highest court, the Supreme Court, and there are many landmark decisions on this particular issue.

Service tax — Service tax, which is a federal levy, applies to the provision of specified taxable services.

Currently, the service tax rate is 10.3% and more than 100 categories of services are under the service tax net.

Service tax is primarily payable by the service provider. However, in certain cases, a reverse charge applies.

This provision includes services provided from outside India to a service recipient located in India, in which case the service tax is payable by the service recipient in India.

Central sales tax (CST) — CST is a federal levy but the revenue is collected by the states. CST is levied on the sale of goods from one state to another (i.e., on the inter-state movement of goods).

Generally, the rate of CST should be the applicable state VAT rate. However, subject to the fulfillment of certain conditions, CST is presently levied at a concessionary rate of 2%.

The government proposes phasing out this levy after the introduction of the GST.

State levies

VAT — VAT is a state levy that applies to the sale of goods within the state (i.e., to intra-state sales). Every state has its own VAT legislation and independent tariff for fixing the rate applicable to goods.

The rate of VAT varies between 0%, 4% to 5%, and 12.5% to 15% depending on the goods and the individual state VAT legislation.

Entry tax — Entry tax is a state levy that applies to the entry of goods into specified states for sale, use or consumption. Entry tax rates vary from 0% to 15% depending on the goods and the state concerned.

Generally, entry tax rates are 1% or 2% or they may be equivalent to VAT rates. Credit for entry tax may be allowed to set-off against VAT chargeable, subject to statespecific provisions.

Recently, the constitutional basis for entry tax has been called into question in several court cases and the courts have held that the entry tax provisions in certain states are unconstitutional if they are non-compensatory in nature.

However, absolute clarity is yet to emerge on this issue.

Municipal levy

Octroi — Octroi, which is a municipal levy, applies to the entry of goods into the municipal limits of specified cities for sale, use or consumption (currently it applies to the entry of goods into select municipal limits in the state of Maharashtra (i.e., the cities of Mumbai, Pune, Nagpur). Octroi rates vary from 3% to 7% depending on the goods and individual cities concerned.

In general, Octroi is not available for set-off against sales taxes and is, therefore, an additional cost.

The federal levies (comprising of central excise, customs and service tax) have contributed approximately US$66,6671 million in financial year 2009–2010 to the Government exchequer, which has since increased to approximately US$73,3331 million in financial years 2010–2011.

This is expected to rise further by around 7% to10% in financial years 2011–2012.

Indirect taxes continue to be an important source of revenue for the government of India, in addition to direct taxes, and they contribute approximately 50% of the total revenue received by the center from different taxes.

Time for reform? The need for a General Sales Tax in India

The present indirect tax model in India with its multiple levies requires businesses to ensure compliance with a number of varied statutory requirements, such as return filing, maintenance of records and documents for availing credit/refunds of taxes paid, under different statutes.

VAT compliance obligations, for example, vary from state to state. This results in a number of difficulties, which have led to avoidable disputes and litigation. For example, businesses may have different tax positions for similar activities.

Long-standing unresolved issues include ambiguity about whether to levy service tax or VAT on transactions involving intangibles, and tax cascading both at the center and state level, due to the unavailability of tax credits for inputs and purchased services.

Furthermore, at present, SACD credit is available only to manufacturers and not to service providers.

These issues have led to an awareness of the need to simplify the operational aspects of the present complex indirect tax model. The foundation stone for change was laid by the government when it introduced the VAT in 2005.

To further simplify the indirect tax model in India and to broaden the tax base, the government is now proactively working out the roadmap for implementing a new tax, a national-level General Sales Tax (GST).

GST seeks to subsume indirect taxes such as central excise duty and service tax at the central level and VAT and identified local levies at the state level.

Under the GST proposal, basic customs duty (BCD) would continue to be levied on imports and it would not be subsumed into GST.

The introduction of GST is an attempt by the central government to unify the various states into a common market by replacing a complex regime of central, state and local taxes.

As such, GST is expected to result in a simplified tax system and possibly in the uniform pricing of products across the country.

Milestones in progress toward GST

The Empowered Committee (EC) of State Finance Ministers has been working with the central government since 2006–2007 to prepare a roadmap for introducing a national level GST.

In November 2009, the EC presented the First Discussion Paper (FDP), which proposed a dual GST model through multiple statutes, one for Central GST (CGST) and State GST (SGST), with the GST rate being split into CGST and SGST.

It was proposed that this dual GST model would implement unvarying tax rates throughout the country.

It would remove the cascading effects of Cenvat and service tax by allowing set-off of the tax in a hierarchy of producer/manufacturer/service provider to the retailer/end user level.

It was also proposed that certain sectors such as petroleum products, natural gas, electricity and real property, should be outside the scope of GST under the dual GST model.

The Task Force of Finance Commission on GST has also provided its views on the proposed GST model.

Furthermore, the Finance Minister has proposed the following GST rate structure:

  • For the first year of implementation, a combined GST rate will apply to goods with rates ranging from 12% (lower rate) to 20% (standard rate) and 16% for services
  • For the second year, depending on revenue collections etc., the combined GST rate on goods may be reduced to range from 12% (lower rate) to 18% (standard rate) and be retained at 16% for services
  • From the third year onward, again depending on revenue buoyancy, the combined GST rate on goods may converge to a single rate of 16%, with the GST on services retained at 16%

Issues to be resolved by the Central Government

The dual GST model can come into operation only after suitable amendments have been made to the existing provisions of the Constitution of India.

Presently, the center can impose taxes on manufactured goods and services while states can only tax sales of goods. At present, the States do not have the power to levy taxes on services.

The first step, therefore, required facilitating a Constitutional Amendment Bill (CAB) to allow the center and states to levy tax simultaneously on goods and services.

This amendment to the Constitution requires the consensus of the states because they will be important stakeholders in the implementation of the proposed GST law.

However, certain states have expressed their apprehension that if GST is implemented, they would lose the revenue presently generated from the state levies and all the power and control to levy tax would vest with the center.

As a result, certain states have been opposing implementation of GST and have been demanding more revenue share and power from the center for example, to increase or decrease of the rate of GST.

Furthermore, several aspects continue to be issues debated by experts and stakeholders alike, such as the infrastructure of the government department needed to handle the increased tax base of taxable persons, the exemption threshold for small businesses and the sectors to be kept outside the scope of GST.

These issues need to be positively resolved by the center before the introduction of GST.

Tracking GST developments The CAB was tabled before the Parliament of India on 22 March 2011 by the Finance Minister of India. This move is seen as a positive step toward implementing GST in India as early as possible.

The CAB needs to be passed by a two-thirds majority in both Houses of Parliament.

Subsequently it needs to be ratified by at least 50% of the state legislative assemblies before it can legally amend the present provisions of the Constitution.

After ratification of the CAB, the center and state assemblies will have to pass the GST legislation.

Meanwhile, as part of the ongoing process, the CAB has been referred to the Standing Committee on Finance of Parliament for a detailed examination of the suggested amendments and to report on its findings.

The Standing Committee has invited suggestions and views from various individuals, experts, institutions and organizations on aspects of the new tax, such as identifying the negative list of goods and services that would not attract the levy (under the proposed law, GST will be levied on all goods and services except for the ones mentioned on the negative list).

Changes to the Finance Bill 2011-2012 for introducing GST

In parallel with these changes, the government of India is taking other positive and concrete steps toward the introduction of GST and to ensure a smooth transition from the present system.

For example, effective steps have been taken to establish a strong IT infrastructure.

The National Securities Depository Limited (NSDL) has been selected as technology partner for creating the National Information Utility that would establish and operate the IT backbone for GST. NSDL is in the process of setting up a pilot portal in collaboration with 11 states prior to rolling it out across the country.

In addition, as a move toward broadening the tax base for GST, the recently announced annual budget has reduced the number of exemptions to the central excise duty.

The government has levied a nominal rate of excise duty of 1% on around 130 specified items, mostly consumer products. The basic rate of central excise and service tax has been maintained at 10.3% to stay on course toward GST.

Yes to GST — but when?

The introduction of a new GST has been long-awaited both in India and abroad. But the burning question is — what is the expected time line for its implementation?

The government has expressed its intention to introduce a national-level GST by 1 April 2012.

However, the implementation has been delayed in the past and this may not be a firm date.

Given the various procedural and legal issues involved, the need for agreement between the state governments and the complex tax issues that the proposed GST law will need to address, it is only natural that there will be a lot of deliberation and discussion.

This process could be time-consuming and impact the introduction of the levy. We believe that GST would benefit the country at large and the stakeholders should demonstrate the will required to put the new tax in place as soon as possible.

This article was first published in the Ernst & Young Indirect Tax Briefing which can be accessed using the link below:

Endnotes 

  1. We have computed figuring that the USD rate applicable is Rs. 45 per USD.
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