Proposals for the introduction of a goods and services tax lack clarity and are riddled with inconsistencies

Shivam Mehta and Kapil Kumar Sharma explain

India’s broad based tax regime aims to cover as many people and enterprises as possible. As a result the country enjoys reasonable rates of taxes and duties. In fact, when compared with other economies of a similar size, India has one of the lowest rates of income tax in the world.

Offsetting this however, is the complexity of the Indian system, which is dominated by multiple laws and federal and state tax credit chains that are not inter-usable. The multiplicity of laws makes the system opaque and unpredictable, especially for foreign enterprises, many of which are used to having a single tax authority, a unified rate and predictable outcomes.

The move from a federal sales tax to a goods and services tax (GST), which was first proposed in the union budget of 2007-08, is expected to iron out these deficiencies in the country’s tax regime. The GST will replace the multiple indirect taxes that are currently levied – such as manufacturing tax (excise), service tax, federal sales tax, state value added tax, etc. In doing so it is expected to trigger an expansion of the tax base that will result in increased tax revenues. However, uncertainty prevails over many elements of the GST regime, including the exact date of its implementation, which has already been pushed back to 1 April 2012.

Plans for a GST

As the name suggests, a GST is a single unified tax on supplies of goods and services that makes no distinction between either type of transaction. It can be viewed as a destination-based consumption tax that is levied at the business location of the recipient of the goods or services being supplied. Since the introduction of a value added tax in France in the 1950s, the Organization for Economic Co-operation and Development estimates 150 countries have implemented some form of a GST.

Detailed plans for the implementation of a GST in India were set out in the union budget of 6 July 2009. The plans were for a GST with a dual structure: a federal or central GST (CGST) and state GST (SGST), which would be levied by the federal and state governments respectively. Then on 10 November 2009, the Empowered Committee of State Finance Ministers released a discussion paper highlighting key elements of the GST model. However, in certain cases, this discussion paper raises more questions than it answers.

Inter-state transactions

While the determining principles on what constitutes inter-state supplies are still to be formulated, it is expected that introducing a GST will lead to the creation of a common market within India.

This will be triggered by the merger of federal and state tax credit chains that will result from an integrated GST (IGST) on supplies of goods and services between states. At present the federal and state tax credit chains run parallel to each other and some credits, like those on federal sales taxes, are not part of the supply chain. As a result there are distortions in competition in inter-state trade. But with a GST, all tax credits will be available more widely and flow more freely.

Under current proposals, the selling dealer in the originating state would charge and collect IGST and pay this to the federal government. The selling dealer would also be entitled to offset IGST, CGST and/or SGST credit against IGST payable on its inter-state sales. The purchasing dealer, meanwhile, would be entitled to use the IGST input credit to offset against any IGST, CGST or SGST for which it is liable.

Interestingly, the November 2009 discussion paper does not address the modalities of transfer of funds from the centre to the destination state in cases when inter-state supplies are made to an end-customer or a buyer that cannot accept tax credit. This happens when the buyer does not meet the minimum turnover criteria necessary under the current regime and in these cases the selling dealer may be required to identify the nature of the buyer and also the states to be credited with IGST.

The treatment of transfer of stocks of goods from one state to another is also not addressed in the discussion paper. While it is possible that these transactions may remain tax free, exempting stock transfers would lead to an accumulation of input credit in the state from which the goods are transferred.

Alternatively, transferred stock may be deemed to be supply, making the selling dealer liable for IGST on such transfers. Classifying stock transfers as supply would have administrative and financial advantages and IGST charged on stock transfers would be available as credit in the destination state.

Different treatment for goods and services

In European VAT legislation, there is little distinction between goods and services as the rates for taxation are the same. However, under the existing regime in India, the question as to whether a taxable transaction involves goods or a service continues to confuse the courts. Many cases have been brought – sometimes successfully – in which it has been argued that a taxable product classified as a service and subjected to service tax is also amenable to tax as goods. This can result in double taxation. GST has the potential to eliminate the distinction between goods and services by imposing a single unified tax on both.

But even when the distinction between goods and services is removed, the multiple taxation of a single transaction remains a possibility if there is any confusion or ambiguity about the state from which the goods or service originated. It is therefore essential that the “situs of supply” rules for the new tax are drafted with utmost care.

Seamless flow of credit

Under the current regime, Indian courts occasionally face the issue of availability of tax credits on goods and services used in taxable business. Revenue authorities sometimes attempt to disallow credits on goods and services by challenging the connection with taxable business in the light of restricted definitions under the current credit rules.

Now, with the country on the verge of a large and important indirect tax reform – one that aims to facilitate the seamless flow of tax credit – it is important that restrictive interpretations relating to such credits should not find their way into the new legislation. For the credit chain to be seamless, tax credits should be allowed on anything used in, or in relation to, a taxable business. In an ideal GST regime, an indirect tax borne by a supplier should not become a cost in the supply chain.

The discussion paper proposes that under the GST regime tax exemptions and remissions that relate to industrial incentives that prevail under the federal excise laws be converted into cash refund schemes. In other words, industries that enjoy area-based exemptions as part of special industrial area schemes will be required to pay taxes, but will receive refunds from federal and state governments. However, it remains to be seen whether tax reimbursements will be granted according to actual taxes paid after the adjustment of credits or according to the percentage of value addition prescribed for different products.

Sector-specific concerns

Current and international tax treatments proposed under GST for some of the major sectors of the economy are discussed below:

Financial services: The financial services sector contributes a great deal to the taxes of an economy. However, the services provided by this sector are intangible. In addition, determining the service element or the place of consumption of a typical financial transaction based on its various attributes – principal amount, interest element, service element, etc – can be relatively complex. As such, the applicability of VAT or GST on financial services has been a matter of concern. Internationally, such transactions are often given the status of exempted services.

In India however, the current taxation practice is to make the provision of services by banks and other financial institutions liable to service tax. As the proposal for the inclusion of financial services within the GST tax net was omitted from the discussion paper, the final decision regarding the taxability of financial services remains unclear.

Insurance: Internationally, many countries treat insurance services in the same way as financial services and exempt them from VAT or GST as it is complicated to include them within this net. In the current Indian tax regime, however, service tax is levied on the gross premium charged for insurance services, with separate classifications for life insurance and general insurance. There is also a separate taxable category covering services provided by insurance intermediaries such as surveyors and agents.

However, under the proposed GST regime there is little clarity about the taxability of insurance services or the classification of life insurance services and general insurance services. While including insurance services within the GST net may raise issues such as the determination of the situs of these services, other matters of great concern to the sector are the treatment of reinsurance transactions and administrative problems.

Real estate: The diverse nature of real estate services – construction, repair and maintenance, lease and license services, real estate consultancy, etc. – generally require them to be treated as separate classifications. For instance, while new construction and the repair and maintenance of existing structures are subject to VAT under European legislation, leases and sales of residential or commercial real property are, in principle, exempt.

The current Indian legislation regarding the taxation of the leasing and licensing of land, commercial buildings, construction services (both residential and commercial), agent services, etc., is not in line with laws in other countries. In addition, there is uncertainty over the taxability of such services under the proposed GST regime.

Health services: In most countries, health and medical care services are either treated as zero-rated or exempt from the scope of VAT upon fulfilment of certain conditions. In India, medical services were similarly exempted from the indirect tax net until recent amendments imposed taxes on services provided to business entities and insurance companies. Under the proposed GST regime, the final position on taxability of medical services is still to be outlined. While there is concern that providing an exemption for medical services may break the credit chain and cause knock-on effects, including common medical services within the GST tax net is likely to attract resistance from the general public.

Petroleum: Developments within the petroleum sector act as a catalyst for changes within a number of other related sectors. Therefore, any alterations to the taxation of petroleum have to be thought through with great care. There are two reasons to include petroleum within the GST net: first, excluding it would affect the seamless flow of credit that GST promises, and second, by not including it, many of the current problems that it faces, such as multi-level taxation, determining place of supply of oil, and apportionment of credit, would continue.

Lack of clarity

Introducing a GST is indeed a positive move and it will seek to do away with the cascading effect under the existing tax regime. However, there is a lack of clarity, guidance and predictability with regards to key elements of the proposed structure in the discussion paper released by thegovernment.

These issues require thorough examination before the any tax legislation is put into force.

Shivam Mehta and Kapil Kumar Sharma are senior associates at Lakshmikumaran & Sridharan. The article was written with the assistance of V Lakshmikumaran, the firm’s managing partner.