Representatives of a several industries, including pharmaceuticals, textiles, insurance, clean energy and farm equipment, have sought government intervention after the recently-announced cuts in goods and services tax (GST), posed a cashflow challenge.
While the tax rate cut—to come into effect on 22 September—is meant to boost demand for goods and services and spur industrial growth, it has also accentuated a system flaw. Mint takes a close look at what is coming in the way of businesses fully passing on the benefit of tax cuts to consumers.
How does duty inversion affect businesses?
GST is a tax on consumption, designed to be applied only on the margins of every stage of the supply chain. For it to effectively work, businesses need to be given credit for the taxes already paid on the raw materials and services used, so that this credit can be used to set off a part of the taxes they need to pay to the government on their sales. That way, when the consumer pays GST as a share of the final price of an item, the seller collects the full amount of taxes that went into that supply, including on his margin. Since taxes have already been paid for everything other than on the margin (the value addition at this stage), only this part needs to be paid to the government by the seller. Tax credits for paying part of the final output tax liability thus helps in making sure only the value added at each stage gets taxed.
However, for various reasons, including political sensitivity around taxation of certain mass use items and to ensure affordability, the rate of final tax on a product or service is kept low. An example is fertilizers that attracts 5% GST, although some of its components are taxed at 18% now.
Thus, the taxes paid by a business on raw materials used would be more than the tax outgo on the finished product or service. Businesses can seek refund of such excess taxes already paid on their operations, but it adds another procedural step and the delays in refund affect their working capital.
How does it affect competitiveness of businesses?
If delayed or denied, the accumulated input tax credit becomes a cost for businesses, who tend to recover it from their consumer by jacking up their sale price. The GST law allows refunds, so this is not a permanent cost but a temporary cash flow issue. If it is an intermediate stage of production, the increase in the base price on account of duty inversion leads to indirect cascading of taxes, affecting the competitiveness of an industry. This reduces the sector’s attractiveness for new investments, which goes against the government’s priority of promoting import substitution and making the country self-reliant. Correcting the inverted duty structure has, therefore, been on top of the GST Council’s agenda. While it has been corrected in several areas, the overall work remains unfinished.
Why do some tax refunds face delay?
In general, refund claims due to duty inversion are subject to strict assessments, while refunds to exporters are largely automated and are prioritised. Taxes going into items exported (zero rated supplies) are refunded to keep goods globally competitive.
Input tax credit has been a tricky area of taxation. Even before GST was introduced in 2017, input tax credit claims in the excise-VAT era have been an area of litigation because of non-compliance by sections of the industry and concerns around inflation of such claims. There have been numerous cases of fake invoicing without actual supply of goods or services. As per finance ministry estimates, one fourth of the ₹7 trillion GST evasion detected over five years ended FY25 was on input tax credit related frauds.
Do GST reforms accentuate duty inversion?
Representatives of several industries, including textiles and fabrics, insurance, tractor and fertilizers, have approached the government last week seeking a solution to duty inversion arising from the recent GST rate cuts.
Representatives of tractor manufacturers said that about ₹800-900 crore of taxes have been paid on the raw materials used in their inventory, which they will find difficult to recover from consumers after the revised rates on tractors come into effect later this month.
To be sure, the GST Council not only reduced the tax rate on tractors from 28% to 18% and from 12% to 5%, depending on the engine capacity, it also lowered the rate on certain parts such as tyres to resolve or minimize duty inversion.
In the case of health and life insurance, since the final service will now be exempt, service providers will not get refunds on their input taxes. However, they can claim input tax refunds on their other insurance services that are not exempt.
In the case of micro fertilizers, the accumulated input tax credit estimated by the industry is ₹400 crore.
Why is it not easy to resolve duty inversion?
The same class of raw material or service is used in multiple industries. Therefore, any revision of tax rates has to be carefully calibrated since it can have unintended consequences in other sectors.
Tax authorities look carefully into which are the large downstream consumers of a raw material or service and the final tax rate applicable on them before making rate revisions. Also, it is often not possible to set the final tax rate on goods and services purely on economic rationale to minimize duty inversion, as there are socioeconomic and political sensitivities involved.
