SynopsisThe GST was supposed to streamline business operations, but a by-product of the indirect tax regime is hurting the competitiveness of exporters. What is worse is that there is no solution in sight.
Complex, arbitrary and cumbersome — that is how several sections of industry describe the Indian taxation framework. The government wants to make India a manufacturing hub, but the taxation maze makes it challenging for manufacturers to function smoothly, they point out.
Making the system more complicated, sometimes even crippling, for businesses is inverted duty structure (IDS) — a situation where the tax rate on the raw materials used to manufacture a product is higher than the tax rate on the finished merchandise.
The situation has manifold consequences for domestic manufacturers and exporters as IDS leads to a spike in the price of the product, making it uncompetitive.
“In the textile and apparel sector, IDS gravely affects us as our input tax credits accumulate a lot,” says Sudhir Sekhri, Chairman of Trend Setters Group, a Delhi-based apparel firm. “The government says the surplus tax paid will be refunded, but that is not happening. It was a major issue during the earlier tax regime too. The GST framework has not made our life any better regarding this issue as the problem continues to exist.”
Many firms who are part of a supply chain of an exported product feel the IDS pinch. It is a bigger worry for MSME exporters, who are hugely dependent on value chain intermediaries for raw materials. Unsurprisingly, several sectors have repeatedly asked the government to fix this issue.
On May 28, the GST Council deliberated on ways to correct the IDS issue in fertilisers, steel utensils, solar modules, tractors, tyres, electrical transformers, pharma, textiles, fabrics and railway locomotives, among others. However, no decision seems to have been taken yet.
The Council gave priority to discussing issues such as rate cuts, says Sandeep Jhunjhunwala, Partner at Nangia Andersen LLP. “The only option now with businesses is to file representation with the GST Council or knock on the door of courts.”
The obvious question is, if IDS is really so troublesome, why has the government not been able to resolve it? Because there aren’t any easy solutions, experts say. It involves dealing with the complex manufacturing value chain, where each raw material is a part of a bigger chain. Disrupting such an integrated system can create havoc.
The issue of IDS has been on the agenda of several GST Council meetings, says a finance ministry official on condition of anonymity. “However, because of the devastating effects of the pandemic, especially the second wave, the GST Council, in all its wisdom, including the FMs of various states, have decided that this is probably not the right time to tinker with the GST rate. There certainly is a consensus and an in-principle agreement across all members of the Council that this is one issue the Council will have to address at some point in the future,” the official adds.
Experts say the problem requires delicate handling.
Agneshwar Sen, Associate Partner-Tax and Economic Policy Group, EY India, says any raw material may be used to make more than one finished product and it is not feasible to tax all the finished products at a uniform rate. “There will always be some raw materials that have a higher duty or tax than the finished product it goes into.”
MS Mani, Senior Director, Deloitte India, points out that the output of one industry is often the input for another. “The IDS challenge we see is because while output is taxed at a lower rate, the input mostly remains taxed at 18%. So, each time we try to bring changes to eliminate IDS in a particular sector, it causes difficulty in another,” he says.
Practically, there are only two ways to deal with the issue — either reduce the duty on raw materials or increase the duty on finished products. Most manufacturers will oppose any move to hike the duty on their finished products. It will make products costlier and add to the financial burden of smaller players. “Suppose the government reduces tax on the raw material in one industry, it will lead to a cascading effect as several other industries also use the same product. Consequently, all industries that were making that raw material will now start having a problem,” says Mani.
Besides, it can also affect the government’s tax revenue.
IDS and Trade Outreach
Apart from being a problem area for manufacturers, IDS’ refund framework seems to favour a domestic seller instead of an exporter, experts say.
iStockInverted duty structure is particularly troublesome for exporters.Under the GST framework, an exporter can file for tax refund in two ways: On payment of tax on exports, or by not paying tax on goods exported under bond or letter of undertaking route but claiming refund of unutilised input tax credit. Another form of refund is the inverted duty structure wherein a registered beneficiary who accumulates input tax credit on account of an IDS (18% paid on inputs but 12% payable on outward supplies) can file for a refund of the rate differential (6%, in this case).
Exporters qualifying for IDS refund now face a peculiar situation. They can either file for a refund on GST paid on exports or file for refunds on account of inverted duty structure. The law restricts exporters from claiming both. So, in a situation wherein the inputs remain taxed at 18% and GST paid on exports at 12%, the exporter will be entitled to a refund of 12%. “However, the issue here is his inputs have already been taxed at 18%, so he is bound to accumulate the remaining 6%. Ideally, he should get a refund on this 6% too — as a case of an IDS — but he does not receive that as he opted for filing refunds based on his exports of finished goods, and not on the inputs used,” says Jhunjhunwala.
While the law was designed to stop exporters from getting double benefits, the drafting of the law appears to have unintentionally excluded genuine exporters who qualify for both, adds Jhunjhunwala.
Then there are the troubles caused by foreign trade agreements (FTAs). Through such pacts, India gives signatory countries preferential tariff on certain finished goods. However, a domestic manufacturer of the product would be at a disadvantage as it would have to import raw materials by paying non-preferential rates. Indian companies get burdened by higher manufacturing costs, while manufacturers in FTA countries benefit from the tariff advantage.
When India signed the Information Technology Agreement (ITA-1) in 1997, it created an inverted duty structure where components were taxed higher than the final product. As a result, it became costlier for domestic manufacturers to procure components to manufacture in India and it became cheaper to import final products, like mobile phones. There was a similar impact due to FTAs signed with ASEAN and S Korea. This led to the collapse of the Indian electronic industry.
iStockSeveral FTAs that India signed created inverted duty structure, which led to the near collapse of electronic manufacturing in the country.Today, this is clearly visible in chemicals, which remain a critical input for many industries. Extensive forward and backward linkages also marked the sector.
IDS has become a serious problem in the sector because of unfavourable FTAs like the Comprehensive Economic Cooperation Agreement, says SG Mokashi, Chairman of Basic Chemicals, Cosmetics & Dyes Export Promotion Council (CHEMEXCIL). There are several instances of inputs attracting higher basic customs duty than the finished product under certain FTAs. “A good example is acetic acid, which is imported at 5% duty under the India-Singapore CECA. But the finished products made from acetic acid, like ethyl acetate, are imported at NIL duty, causing inverted duty issues,” he explains.
The oleo-chemical industry also faces an inverted duty anomaly as inputs like palm fatty acid distillate and crude palm stearin are imported at 7.5% duty. But finished products like saturated fatty alcohols are imported at NIL duty under the ASEAN FTA. This seriously affects the local industry, adds the CHEMEXCIL chief.
Terming IDS’ lingering issues “self-defeating” for exporters, Sekhri of Trend Setters says that under the special bilateral agreement that India has with Bangladesh, massive duty-free imports are being carried out in the garments sector. This hurts the industry’s attempt to be self-reliant and the nation’s exports.
Stifling Industry’s Growth
A Sakthivel, the Chairman of Apparel Export Promotion Council, says IDS remains a bottleneck for the apparel industry. Inputs into the man-made fabric segment (fibre and yarn) attract a GST of 18% and 12%, whereas the GST on apparel is 5% and 12%. This creates a tax structure where the rate on inputs is higher than that on the output, he says. “This increases the effective rate of taxation of man-made fabrics and garments and violates the principle of fibre neutrality. The inverted tax structure also blocks the working capital for businesses due to input tax credit accumulation.”
The apparel exporting industry is labour intensive, with a wage bill that could be about 30% of the product’s cost. The sector works on low margins of 4-5%, claims Sakthivel, also the president of the Federation of Indian Export Organisations. Hence, any added pressure will compound the miseries of the players; most of them have been battered by the pandemic’s fallout.
iStockGST on apparel is 5% and 12%, while inputs like fibre and yarn attract a GST of 18% and 12%.Another major export sector that has similar issues is engineering exports, which account for over 25% of India’s merchandise exports, claim the Engineering Export Promotion Council.
Chairman of the council, Mahesh Desai, says IDS is especially a cause of concern for the intermediate companies. These are mostly MSME exporters. Desai, however, adds that in Budget 2020-21, the government addressed many of the sector’s inverted duty concerns.
The Bottom Line
As IDS is ingrained in the value chain, it is an issue for all types of industries globally. So how are others dealing with similar cases?
China, called the factory of the world, hugely incentivises its manufacturers through taxation support. EY’s Mani says China has a value-added tax system where input tax credits are highly restricted.
In India, claim industry observers, policymakers struggle to come up with a pro-manufacturing tax regime. Nothing else explains why a significant share of the manufacturing community still thinks of the GST — launched in 2017 — as a work in progress. This is certainly a far cry from the aim of the “one nation, one tax framework” rolled out to subsume multiple overlapping taxes that plagued industries.
Despite IDS’ lingering issues, experts say the government has taken several steps to ease the pressure on manufacturers. “When GST was introduced, IDS was applicable to quite a few products. Over four years, the GST Council has corrected it in most of the cases. In cases where it remains unaddressed, it is not because of a lack of will by the GST Council, but due to a genuine difficulty,” says Mani.
There are certainly no short-term fixes for the IDS problems. The GST Council will have to take into account multiple factors to curb its ill effects. This can only be done by closely studying each input’s interplay with the larger value chain. The government can at best speed up its efforts to solve the issue.
(Editing by Ram Mohan. Illustrations by Mohammad Arshad)
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