Explained | What is the inverted duty structure and why is the GST Council talking about it?

Why is it a problem?

Taxpayers who face an inverted duty structure will always have Input Tax Credit (ITC) in their GST electronic credit ledger even after paying off the output tax liability. This creates working capital issues for the taxpayers, as crucial resources remain blocked in the form of ITC. While the GST law provides the option to claim the unutilized ITC as a refund, there are other complications.

From the government's standpoint, because of the current anomaly, many administrative-level issues have cropped up. A complicated refund process under GST creates additional compliance requirements and finally leads to more cost of compliance. This way, the inverted duty structure has caused refund-related issues under the GST regime.

Why do businesses want to see it gone?

Businesses paying taxes under this structure continue to have Input Tax Credit in their ledger even after paying off the output tax liability, leading to crucial working capital remaining stuck in the form of credit.

There is confusion about central laws not providing for any refund of credit accumulation on account of differential tax rates, particularly when the rate of tax on inputs is more than rate of tax on output.

Services sectors such as hotels and hospitality have pointed out to Section 54(3) of the CGST Act, which states that unutilized ITC can be claimed, but the tax department does not consider the unutilized ITC on services while calculating “Net ITC” as per Rule 89(5) of CGST Rules. Hence, there is confusion on whether a taxpayer is eligible to claim a refund of unutilised ITC on input services or not.

How feasible is the inverted duty structure in the context of trade policy?

Experts broadly agree that the structure currently raises the cost of procuring input goods, which makes manufacturing more expensive, and higher costs ultimately makes businesses less competitive in the cutthroat world of global export orders.

Industry bodies like the Confederation of Indian Industry (CII) have pointed out that to maintain the razor thin profit margins as well as consistently secure global buyers, businesses need a regime where lower or minimal duties on intermediates and raw materials is a must.

Higher duties on finished goods would counterbalance this and stop the market being flooded with foreign-manufactured items, as has been the case in India in most sectors. The current system also incentivizes the export of raw materials and not value-added products, something that the Centre has been trying to change for the past five years.

Why has the issue gained prominence now?

Domestic industry has stepped up its opposition to the current structure since mid-2020 when volatility hit global commodity prices. Currently, commodity prices have risen to record highs and domestic user industries say the need to address high import duties for raw materials is needed quickly.

A sudden price rise over the past three months of key input materials such as steel, chemicals and plastics have raised the cost of manufacturing. After a disastrous year when most of India's exports faced a slowdown owing to the COVID-19 pandemic, exporters say higher costs have hit them even as they continue to suffer a liquidity crisis.

Crucially, this has come at the inopportune time when major markets like the US, UK and the European Union are opening and placing a lot of export orders. Companies, both big and small are desperate to secure these orders, which will decide their fate for the next financial year but are hampered by the lack of funds to buy costly imports needed to fulfil those orders.

What has been the state of discussions on it till now?

The issue had been discussed in detail earlier at the GST Council as well, with refund problems related to inverted duty structures coming up before the Council several times.

The Centre is not keen on reducing GST rates on inputs as it would lead to substantial loss of revenue. Another important step for the Centre to reform the structure is to raise taxes on final products. But experts have also said that it is not fair to increase the GST rates on the outputs, which may create further burden for small entities and the final consumers.

Since last year, states with large unorganized MSME (Micro, Small and Medium Enterprises) sectors such as West Bengal and Punjab, had written to the Finance Minister saying that hiking tax rates would not bode well for the economy, especially during the COVID-19 pandemic.