GST in the Aftermath of Demonetization

Trust Bloomberg Tax's Premier International Tax offering for the news and guidance to navigate the complex tax treaty networks and business regulations.

Dinesh Agrawal

Dinesh Kumar Agrawal C.A. Khaitan & Co., Mumbai

Dinesh Kumar Agrawal C.A. is Executive Director, Khaitan & Co., Mumbai

Demonetization of high value currency notes in an attempt to tackle the problem of “black money” has had a profound impact on the Indian economy but has been generally welcomed by the population. Delay in the GST rollout now has the potential to derail the benefits.

Demonetization of high value currency notes by the Narendra Modi-led Indian Government has had a profound impact on the Indian economy and almost every Indian resident. Currency notes of 500 rupees and 1000 rupees worth 15.4 trillion rupees (about 86 percent of the value of currency in circulation) were demonetized from midnight on November 8, 2016. The Modi Government took this extreme step, supposedly, to tackle the menace of “black money”, and to reduce cash transactions, which are directly related to corruption in the economy. It is estimated that the size of India's black money economy is between 23–26 percent of GDP. It is also estimated that approximately 68 percent of transactions in India are cash-based. Tax evasion and corruption thrives on such a cash-based economy.

I. The Current Indirect Tax System

One of the major contributors of black money in the Indian economy is the current fractured indirect tax system. Presently, the indirect tax system is complicated and multilayered, with multiple transaction tax on goods and services. In the existing framework, the Central Government levies excise duty on manufacture of goods, service tax on provision of services, whereas the State Government levies Value Added Tax and Central Sales Tax respectively on intra-state and inter-state sale of goods, and luxury tax and entertainment tax on luxuries and entertainments. Different taxable events and taxable values under different tax enactments, coupled with multitudes of exemptions administered by multiple tax authorities, makes it easy for businesses to evade tax. Clandestine removal of goods from factories necessitates further transactions in cash to avoid detection by tax authorities. The cost of tax evasion is insignificant, as the risk of getting caught is low.

II. The GST Regime

In the Goods and Services Tax (“GST”) regime, the distinction between various economic activities such as manufacture, service and trade is eliminated by subsuming most of the indirect taxes levied on goods and services under a single destination-based tax. GST will be levied on supply of goods and services throughout the supply chain until it reaches the ultimate consumer. The taxable event is “supply” and tax would be charged on most of the dealers with threshold turnover of two million rupees (one million rupees in the case of dealers located in the north-east states). Set-off of the tax paid on inward supply would be allowed against tax payable on outward supplies. Thus, businesses will act as a pass-through and the tax burden would be borne only by the ultimate consumers.

Indian polity is based on federalism, where both Central Government and State Government require fiscal resources: the GST regime has been designed to provide fiscal resources to both Central Government and State Government. GST comprising of Central GST (CGST) and State GST (SGST) would be levied on intra-state supply, whereas Integrated GST (“IGST”) would be levied on inter-state supply or import of services. CGST and SGST would be levied on the same tax base. Insofar as import of goods is concerned, countervailing duties like additional duty of customs and additional customs duty (CVD+SAD) would be replaced by IGST. Suppliers would be allowed to use credit of input CGST against output CGST or IGST, input SGST against output SGST or IGST and input IGST against output IGST, CGST or SGST. Taxes would move along with goods and services in the supply chain to ensure credit utilization.

The Reserve Bank of India stated that demonetization is expected to significantly transform the domestic economy in due course in terms of greater intermediation, efficiency gains, accountability and transparency, through increasing adoption of digital modes of payment, notwithstanding the short-term disruptions in certain segments of the economy and public hardship. 1

Intermediation, transparency and self-monitoring through a digital platform are the hallmarks of GST, which would curb the black economy and corruption. GST administration is entirely digital: an electronic platform is developed and maintained by GST Network, an independent non-government company. Dealers are required to electronically file tax returns comprising of transaction-wise outward supplies and inward supplies. All supplies to GST dealers irrespective of monetary value, and inter-state supplies of 200,000 rupees or more to non-GST dealers, are required to be reported. The electronic platform allows matching of inward supply against outward supply; thus, misreporting of transactions can be easily detected. Input tax credit would be electronically matched with the supplier's return. As there is seamless credit across the supply chain, there is little incentive for businesses to evade tax and, because of the universal electronic platform, the risk of getting caught is also high. GST creates audit trails that would curb evasion, widen the tax base and boost tax collection. Thus, it is expected that a transparent self-monitored GST regime will help in the emergence of a clean Indian economy.

Undoubtedly, GST will supplement demonetization in curbing black money. As all business-to-business transactions and most high value business-to-consumer transactions would be reported, the appeal of cash transactions would be greatly reduced. Presently, cash transactions are encouraged in evasion of both direct and indirect taxes, as persons can evade indirect tax, and also suppress their consumption leading to under-reporting of income for direct tax. The Modi Government has pinned great hopes on GST to rout the parallel economy powered by black money, which has been temporarily exterminated by demonetization.

III. Effects of Demonetization and GST

Demonetization has resulted in a temporary cash crunch across India, rural India being worst affected. This situation is yet to ease. Shrinkage of demand has resulted in reduction of industrial production; tiny and small scale units depending entirely on cash transactions have closed down. It is expected that GDP growth would fall by a half to one percent. In its first projection on India post-demonetization, the World Bank has lowered the country's GDP growth estimate for this fiscal year to 7 percent, from its earlier estimate of 7.6 per cent, made in June last year. 2 Presumably, the state's tax revenues will be hit: however, on the other hand, demonetization has also shown a temporary buoyancy in tax revenue, as many traders outside the tax net are forced to account for their actual turnover to account for cash deposits in banks. The real impact of demonetization on states' tax revenue is yet to be computed.

Empirical evidence suggests that the rollout of GST would also disrupt the economy in the short run. The concerns of some states were voiced by Amit Mitra, chairman of the Empowered Committee of Ministers on GST, who stated that GST needs to be deferred so the economy is not hit by another disruption after demonetization. 3 States also raised the demand for higher compensation for loss of revenue. However, the Modi Government is in no mood to defer the rollout of GST, as it may wipe out the gains of demonetization. The government worked very hard with all stakeholders to bring in workable changes in the Model GST Law that was announced in July this year (First Draft): the revised GST law was released on November 26, 2016 (Second Draft) for vetting by the GST Council.

The Second Draft has incorporated a number of suggestions made by the industry and commerce: significant among them are provisions related to scope of supply, input tax credit, and place and time of supply. Doubts regarding ab initio exemption on exports and supply to special economic zones have been put to rest.

One of the contentious proposals in the Second Draft relates to anti-profiteering measures. The provision has given power to the authorities to examine and identify if the implementation of GST has resulted in reduction of the price of goods or services supplied by the assessee due to the availability of input tax credit or reduction in the tax rate, and if so, whether this advantage has been passed on to the ultimate consumer. If assessees are not compliant, the authorities have the power to penalize the uncooperative businesses. Prima facie, the provision has been introduced with the noblest of intentions to ensure a reduction in prices, but it may lead to hardship and harassment for business. In a market economy, market dynamics decide the price of goods and services. At best, anti-profiteering could be a temporary measure with clear rules and regulations.

Before demonetization, the GST Council has approved GST rates of 5 percent, 12 percent, 18 percent and 28 percent, in addition to a cess over the peak rate on demerit and luxury goods. The Council also agreed for a corpus of 550 billion rupees to compensate States. Now, discussions are under way to allocate goods and services to a tax slab, and businesses are in overdrive to justify a lower tax rate: the leather, textile, apparel and footwear industry, and the tourism sector are seeking a lower tax rate of 5 percent. As a precursor to GST, a large number of existing exemptions are likely to be withdrawn in a phased manner.

IV. Potential Issues

Post-demonetization, dual control of taxpayers, and territorial jurisdiction under GST were the most problematic issues. For GST to succeed, compliance must be easy and taxpayers must not face undue harassment, having to deal with two administrative bureaucracies for the same tax. It was agreed at the start that a taxpayer would be under the control of a single tax authority by cross empowerment under Central and State laws and would not be subjected to dual control. The tussle between the Centre and the States was about who would gain how much control over the taxpayer base of VAT, excise and service tax after the GST rollout. After much sparring, the Centre gave in to the demands of the State. The GST Council agreed that States will oversee administration of 90 percent of economic entities with a turnover under 15 million rupees, with the remaining 10 percent under the Centre's purview. For entities with a turnover of over 15 million rupees, the Centre and the States will share control equally. The States will also be empowered to share control equally under the IIGST. It is interesting to note that control over taxpayers has no direct impact on the tax revenue to Centre and State; therefore, in the public perception, the sparring over control of taxpayers is pretty much related to power and privileges (read illegal gratification) rather than for the benefit to the exchequer. In fact, concession to the States has unnerved Central tax officers over perceptible loss of power. Sensibly, the Centre also yielded to States' demand for taxation powers in littoral waters.

Political rapprochement shows the sincerity of the Modi Government to roll out GST as early as possible: the States and the Centre must swiftly tie up all loose ends to ensure rollout by July 1, 2017. Demonetization has caused considerable hardship and stress to the public as well as to the economy; nevertheless the public has generally welcomed it, believing in the honorable intention of the government to rein in the black economy. Delayed GST rollout has the potential to derail the benefits of demonetization.

Dinesh Kumar Agrawal C.A. is Executive Director at Khaitan & Co., Mumbai. He specializes in customs, central excise, service tax, foreign trade policy, trade-related foreign exchange laws and VAT laws and procedures. He may be contacted at: dinesh.agrawal@khaitanco.com

NOTES

1 The Financial Stability Report published in December 2016.

2 Economic Times, January 11, 2017.

3 Business Standard, December 9, 2016.

Copyright © 2017 The Bureau of National Affairs, Inc. All Rights Reserved.

Request International Tax