Indirect Taxes in India: Time for Reform?

Editor: Mary Van Leuven, J.D., LL.M.

Foreign Income & Taxpayers

In January 2015, President Barack Obama traveled to India for a three-day state visit and was a guest of the government for India’s Republic Day celebrations. The president’s trip symbolizes the increasingly important role the subcontinent plays in the global economy.

In recent years, India has experienced rapid economic growth due in part to a liberalization process that started in 1991. Since then, India has become one of the world’s most attractive investment destinations. But, despite India’s progress, it still has a complex indirect tax system with separate, sometimes overlapping, taxes administered by various federal, state, and local jurisdictions. Understanding that a complex tax regime is an obstacle to economic growth, India has been debating a fundamental reform of its indirect tax system. In December 2014, the newly elected government of Prime Minister Narendra Modi introduced to the Parliament a long-expected proposal for a constitutional amendment necessary to implement a more integrated federal-state indirect tax system. This item provides an overview of the current indirect tax system in India before highlighting the proposed changes, which, if adopted, would become effective in April 2016.

Overview of the Indian Indirect Tax System

The Indian indirect tax system can be broadly divided into two categories: federal taxes and state taxes. Federal taxes are imposed on manufacturing activities (central excise duty (CENVAT)) and sales of services (service tax); state taxes are imposed on the sale of goods within a state (a value-added tax (VAT)). Additionally, taxpayers may be subject to other indirect taxes, such as octroi (an entry tax on goods brought into a state for use) and luxury taxes. Thus, depending on its activities and location, a taxpayer may be subject to several indirect tax regimes.

Federal Taxes

Central excise duty (CENVAT) on manufacturing: CENVAT, commonly known as the “excise duty,” is a federal tax levied on the manufacture and production of goods. Any person who is engaged in the manufacture or production of “excisable goods” is subject to the excise duty. Only goods identified in the law are subject to excise duty. These goods may include any article, material, or substance that is capable of being bought and sold for a consideration—such goods are deemed to be marketable. Manufacturing or processing is any process incidental or ancillary to the completion of a manufactured product, including packing, labeling, and applying a treatment to the product to make it marketable.

The excise duty is based on either the transaction value or the maximum retail price. Liability for the excise duty is imposed on the manufacturer, which may or may not be the owner of the goods. The manufacturer includes any person under whose direction, control, and supervision the manufacturing activity is carried out. The excise duty is charged and collected at every stage of the manufacturing process, including the purchase of raw materials and the movement of goods from the factory, which may be pursuant to a sale to a buyer or otherwise.

The general excise duty rate is 12%. Two small education-related surcharges bring the effective general excise duty payable on a product to 12.36%. However, the rate may vary for certain goods depending on the tariff classification. Every person who manufactures or produces excisable goods must register for excise duty for each manufacturing premises and file monthly returns.

Service tax: Service tax is a federal tax levied on the sale of services in India (except for the states of Jammu and Kashmir). “Service” is defined as any activity performed by a person for consideration; however, the term does not include activities that constitute only transfers of title to goods or immovable property, transactions in money or actionable claims, or services provided in the course of employment. Certain activities and transactions are classified as “declared services” and thus classified as services for the purpose of the tax (e.g., supply of food, financial lease, hire, purchase, etc.). Certain activities are not subject to service tax because either the activities are not considered services (i.e., those identified in the “negative list”) or they are exempt (e.g., gambling, entertainment, advertising, specified services provided by charitable institutions, and health care services, among others).

The sale of a service is generally sourced to where the recipient is established. Services received in India from nonresident service providers are subject to the service tax; services provided to a recipient located outside India are generally not subject to the service tax. A service will be treated as an export of service and thus entitled to input tax recovery (discussed below) only if (1) the service provider is located in India; (2) the recipient of the service is located outside India; (3) the service is provided outside India; (4) the payment is received in convertible foreign exchange; and (5) the service provider and service recipient are not merely establishments of the same legal person.

Liability for the service tax generally rests with the service provider. However, for taxable services from a foreign vendor, the domestic taxpayer is required to self-assess the service tax. Self-assessment also applies to certain domestic activities, such as legal services. A partial self-assessment mechanism applies to certain listed transactions.

Like the excise duty, the effective service tax rate is 12.36%. Service providers with gross receipts above INR 1 million ($16,000) must register for service tax, remit taxes charged on a monthly basis, and file a service tax return on a semiannual basis. Businesses with several offices across India can opt for centralized registration.

Input tax credits for federal indirect taxes (CENVAT credit): Certain manufacturers and service providers are eligible to claim a credit (called the CENVAT credit) for excise duty paid on specified inputs and capital goods used in the manufacturing process as well as service tax paid on purchased services. The CENVAT credit is available only for eligible expenditures. For instance, excise duty or service tax paid on expenditures linked to exempt sales are generally not creditable. The total CENVAT credit on eligible expenditures (goods or services) must be used for payment of excise duty or services tax liabilities. Taxpayers with excess CENVAT credits may request a refund.

State Taxes

Intrastate sales: Similar to sales tax in the United States, each state in India has its own VAT law and administers it separately from the other states and the federal government. VAT applies to the intrastate sale of goods by a taxpayer, also known as a dealer. Unlike most VAT jurisdictions, VAT does not apply to goods being imported into India. Although each state has its own VAT legislation, the definitions of “goods” and “dealer” are relatively uniform across the country.

Goods are generally defined as movable property, including intangibles and incorporeal articles, but excluding newspapers, actionable claims, stocks, shares, and securities. A dealer is any person who carries on, whether regularly or otherwise, the business of buying, selling, supplying, or distributing goods, directly or indirectly, for cash or for deferred payment, or for valuable consideration. A sale is defined as the transfer of property in goods for valuable consideration.

Although the VAT rates vary across states, the rates generally can be summarized as follows: 0% on goods of basic necessity, such as food and the export of goods from India; 1% on gold and silver ornaments; 5% on declared goods and machinery; 12.5% to 15% on all other goods; and 20% or more on fuel, diesel, cigarettes, and lottery tickets.

Dealers with gross receipts above INR 0.5 million ($8,000) per year (for some states, the threshold is lower) must register for VAT. A simplified compliance regime is available for dealers with gross receipts between INR 0.5 million ($8,000) and INR 5 million ($80,000). These small dealers do not charge and collect VAT; instead they pay VAT based on a small percentage of their gross receipts. In addition, they are not entitled to any input tax credit. The simplified compliance regime, however, is not available to dealers with interstate transactions, imports, exports, or stock transfers.

Interstate sales: Interstate sales of goods are subject to the federal central sales tax (CST), which is administered and collected by the state tax authorities. CST is payable in the state from which the goods are shipped and is levied at a concessional rate of 2% when a statutory declaration called the C-form is issued. For the concessional rate to apply, the purchasing dealer must issue the C-form. The C-form can be issued for the following purchases: (1) resale; (2) use in manufacture or in processing for sale; (3) use in telecommunications networks; (4) use in mining; (5) use in power generation and distribution; and (6) containers and packing materials. Failure to obtain the C-form results in VAT liability at the rate prevailing in the vendor’s state.

Input tax credit: Taxpayers are allowed to credit VAT paid on expenditures against VAT collected. However, VAT is not creditable on the following: (1) interstate purchases; (2) goods purchased from a dealer who is paying VAT under the simplification regime; (3) purchases in which final goods sold are exempt from VAT; (4) free samples; (5) inputs stolen, lost, or damaged before use or sale; (6) goods where a proper tax invoice showing VAT separately is not available; and (7) ineligible purchases such as automobiles, fuel, certain capital goods, etc. Because each state has its own VAT system, VAT incurred on purchases can only offset VAT charged on sales in the same state. In addition, no credit is available for CST payable on interstate purchases. However, the state VAT credit may be used to pay the CST.

Future of the Indirect Tax Structure in India

On Dec. 17, 2014, the Indian Cabinet approved a constitutional amendment bill that would pave the way for the constitutional changes necessary to allow the adoption of an integrated federal goods and services tax (the GST). The bill will be discussed in Parliament during the annual budget session. The framework of a proposed GST in India is a central GST (CGST) at the federal level, a state GST (SGST) at the state level, and interstate GST (IGST) on interstate transactions. Several important issues are still being discussed between representatives of the federal government and states before the GST can be introduced.

The proposed GST would replace most of the existing federal and state taxes, including central excise duty, service tax, VAT, and CST. Several states, however, have indicated an intention to maintain their entry tax instead of subsuming it into the new GST.

The GST would apply to all sales of goods and services in India, but representatives of the federal government and the states are discussing the exclusion of petroleum products from GST, most likely by subjecting them to a 0% tax rate.

The GST would have a registration threshold. The federal government is proposing a GST registration threshold of INR 2.5 million ($40,000), while the states would prefer a lower one of INR 1 million ($16,000).

According to discussion papers, the contemplated GST rate would vary between 12% and 27%. A finance commission task force originally proposed 7% for the SGST and 5% for the CGST, but the federal finance minister later proposed a 10% SGST rate and a 10% CGST rate, while the national institute of public finance and policy recently submitted a study based on a total GST rate of 27%.

Under the contemplated GST, the input tax credit rules would be simplified. Using credits interchangeably between goods and services would generally be allowed, but using federal GST credits against SGST liability (or vice versa) would generally not be allowed, except for certain interstate supplies of goods and services.

The most critical point of contention between the federal government and the states is around sourcing rules because services would be subject to SGST and would thus need to be attributed to a specific state. Issues arise when services are not provided from an identified fixed place, for example, telecommunication and electronically supplied services. Moreover, there are also ongoing discussions regarding whether business-to-business and business-to-consumer services should be subject to different sourcing rules and potentially different compliance requirements.

On Feb. 28, 2015, the Modi government released its first budget. It confirmed the government’s intention to implement the GST effective April 1, 2016, but did not disclose details of the new indirect tax. Rather, the budget includes several amendments to the existing indirect taxes, including elimination of the two education surcharges, increasing the service tax rate from 12% to 14%, and increasing the excise duty rates for specific products. In addition, the budget proposes to broaden the scope of the service tax by reducing services included in the negative list and exempt services.

Conclusion

The Indian federal government and states understand that the complexities of their indirect tax system constitute an obstacle to economic growth. If passed, the constitutional amendment bill would be an important step toward implementing the GST. Proposed changes in the recently announced budget point toward implementation of the new GST, and an April 1, 2016, implementation date is considered likely if certain issues are resolved soon.

EditorNotes

Mary Van Leuven is director, Washington National Tax, at KPMG LLP in Washington.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

This column represents the views of the authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. ©2015 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.