After an intense debate of 11 long years from the time when the vision of “one nation, one tax” was first mooted in 2005, the Indian Parliament in early August 2016 finally approved the constitutional amendment required for the implementation of the Goods and Services Tax (GST).
“The key to the successful implementation of the GST will be cooperation — between the Centre and the States, among the States, and between the governments and the businesses.“
Satya Poddar, Tax Partner — Policy Advisory Group, Ernst and Young India
The GST is the largest-ever tax reform in the fiscal history of India. It charts a new course for fiscal federalism in India that focuses on cooperation instead of self-interests.
Good riddance to the legacy system
The spirit of cooperative federalism requires both the Union and the State governments to sacrifice their fiscal autonomy in favor of a collective decision-making process. The giving up of the fiscal autonomy is unprecedented and reflects that the modern economy of today calls for increasing cooperation among the economic players for the common good, instead of focusing on individual gains.
The current taxation system in India provides truncated taxation powers to the central government (the Centre) and the States and is not in tune with the modern businesses and the complex supply chains. The patchwork of taxes has led to balkanization of the common market and fragmentation of the supply chains.
The differential taxes in different States give rise to arbitrage opportunities. Taxes such as central sales tax (an origin-based tax) and entry tax being non-creditable further add to the costs of businesses.
To add to the woes, India has approximately 600 check posts. Goods carriage vehicles in India barely travel 280 km per day against a world average of 400 km per day. The World Bank has observed that 60% of truck drivers’ time is spent off-road, negotiating at check posts and at toll plazas.
The GST overcomes these gaps. While the States will get the power to tax both goods and services, the Centre will be able to levy taxes beyond the manufacturing point, across the full supply chain. At the same time, the tax provisions that restricted inter-State movement of goods within the country will now be dispensed with.
These provisions are absolutely fundamental to modernizing the tax system and making it simple and efficient. GST will be supply chain neutral and will obviate the need for bundling or unbundling of goods and services for taxation purposes.
Basic framework for GST design
The Constitution envisages certain key guiding principles for the GST design to be recommended by the GST Council:
- The tax will be levied concurrently by both the national and subnational governments (States).
- It will apply to both goods and services and any mixture of the two.
- The tax will apply to the full supply chain, i.e., to all transactions in the economy whether local or inter-State, manufacturing level or other points in distribution, and by way of sale or lease or any other arrangement.
- The tax will apply only on a destination basis and not at the place of origin.
- No tax can apply to impede the free flow of goods and services in the common market of India.
Long road ahead
A GST type of tax has been implemented in more than 150 countries in the world, but none meets the specifications for the model envisaged for India. What is proposed for India is not a single national tax but a set of 38 taxes, i.e., a GST for each of the 29 States and seven federally administered Union territories, a federal GST and an integrated GST on inter-State supplies, all fully harmonized to look like a single tax.
The task of designing the GST is assigned to the GST Council, a collective forum of the States and the Union governments. The GST Council’s decisions will require three-quarter majority and the Union government will have weightage of one-third of the votes.
The GST Council will decide very important aspects of the tax, including the base, rates, allocation of tax base among the States, administrative architecture and compliance procedures. Each of these design features can be a potential source of endless debates and controversies in a multiparty democracy such as India.
The constitutional amendment strikes a delicate balance between the demands of the fiscal autonomy of the States and the need for harmonization of 38 different taxes. The Centre and the States retain the power to design taxes as they consider appropriate within the defined framework.
The GST Council’s decision will not be binding on them and will only be recommendatory. What happens when States deviate from the collective decisions?
It is in this context that the role of the dispute resolution mechanism becomes crucial. It is not clear at this stage how the mechanism will function and whether the decisions of the dispute resolution authority will be binding.
Spurred by the fear of letting go of their exclusive powers, the States have insisted on the exclusion of large chunks of the economy (such as petroleum, alcohol, electricity and real estate) from the GST base. This is unfortunate because ideally there should have been no exclusions from the GST base, and the States would have continued to have the autonomy to levy supplementary taxes on these sectors.
The States have also retained the autonomy to set the tax rates under GST within a narrow band. Finally, the States have been given assurance of compensation for any loss in revenues for a five-year period.
Model GST law released
The Union government has released the model GST law for stakeholders’ comments. The model law is a product of intense debates and controversies in the drafting committee of Centre and State officials.
Many provisions of the law will need to be reviewed as they do not bode well for the ease of doing business that the shift to GST seeks to bring about.
Despite the fact that GST in India will be a set of 38 different taxes, the governments have aspired for full harmonization of virtually all aspects of the Centre and State taxes, including the tax base and registration, reporting, payment, and refund rules and procedures.
This is indeed the most unique and essential feature of the model law. It does not exist anywhere else in the world, and without it the GST reforms would come to naught.
While consensus on full harmonization is an outstanding achievement, it has not been easy and the Centre has had to concede to virtually all of the demands of the States. As a result, some of the provisions are harsh:
- Taxable supplies have been defined expansively to catch any inter-State activities between two arms of the same person
- Complex valuation rules have been prescribed for supplies without consideration
- Credits will still be denied for construction inputs
- Credits will be delayed until tax is actually paid by the supplier
- Refunds of excess credits are subject to discretionary approval of officials, and harsh penalties and punishment prescribed for gaps in compliance
The States have insisted that dealers register for GST in each State from where they supply goods and services, and remain subject to their physical control and monitoring, much like under the current value-added tax. Each registration will be treated as a separate person. This means that they would need to file separate returns for each State where they are registered, and prepare and maintain financial accounts state-wise. Their output tax collections and input tax credit claims need to be segregated for each registration and each tax, and cannot be pooled. The model law embargoes any refund of the credit balance, except where it is on account of exports or inverted duty structure (inputs taxed at a rate higher than outputs).
The worst impacted would be those in the service sector with pan India operations, e.g., telecom operators, national airlines and financial institutions. Their annual tax compliance steps could go up from less than 20 (2 semiannual returns and 12 monthly payments) to as many as 1,600.
The most challenging part of the model law is the valuation rules for taxation of self-supplies of goods and services between two arms of the same legal entity, the so-called “supplies without consideration.” The model law defines supplies to include any inter-State movement of goods, or inter-office activities or functions within an organization.
The head office interacting with its production plant or distribution center in another State will now be considered to be rendering a service which would need to be valued and recorded in the books of account and then tax remitted on it. The same would apply to the marketing or business development support provided by a group in one State to fellow team members in another State.
This is the biggest question. The rules are similar to those for transfer pricing and customs valuation for international transactions.
They will create inter-State fiscal frontiers, impeding free flow of goods and services within the common market of India. In the rest of the world, such activities within the domestic market are neither recognized nor made subject to tax. The tax is limited to transactions between two legal entities made for a consideration. Valuation rules are needed only in select cases such as for fringe benefits to the employees.
Consultations begun for early implementation
The government is making all-out efforts for an early rollout of the GST. In its road map for GST implementation, the Ministry of Finance envisages development of front-end and back-end processes of the GST Network, the organization set up to provide the information technology (IT) backbone for GST by the end of December 2016.
It is focusing on the training of almost 60,000 officials of Centre and State governments on GST laws and IT framework. At the time of writing this article, both the Ministry of Finance and the Empowered Committee of State Finance Ministers are holding consultations with trade and businesses to understand their concerns.
Industry, on its part, needs to engage constructively with the government and prepare for GST. The key to the successful implementation of the GST will be cooperation — between the Centre and the States, among the States, and between the governments and the businesses. One hopes that all the stakeholders recognize this aspect for the larger good and help India achieve its potential economic growth.
This article is included in issue 18 of EY´s Global tax policy and controversy briefing.