A fundamental flaw in GST

The trust deficit between the citizens of India and the Government appears to have plummeted new depths. Upon reading the model GST law, it seems as though in one fell swoop, businesses are staring at their death knell — instead of being the promising vehicle for growth, GST has the potential to destabilise all that is good.

On the bright side, this is still a draft law and corrections can be applied, so that GST indeed becomes the Greatest Simplified Tax regime, and the biggest economic event of independent India. It has all the ingredients for this. Why, then, am I sounding the danger bells?

Where the faults lie The most critical cause of the failure of GST will be in the transference of responsibility and liability of tax remittance to the customers of a supplier (Section 16(11)( c)). Basically, the law postulates that if a particular supplier has failed to comply with the law correctly — by furnishing the correct returns (Section 27(3)) and/or making the correct payment(Section 27(2)) — then its customers cannot avail themselves of the input credit; if given, it will be reversed.

The origin of this provision lies in the history of tax avoidance through false representations by a small section of businesses, and the fact that it is not feasible for the Government to systematically contain this problem. With the framing of this law, the Government hopes that the market will itself weed out the bad eggs — which is not wrong in theory. What is wrong is not understanding the cascading consequences of doing this in practice and the mayhem it will create. While the effort for driving compliance will reduce, the consequential effect of businesses shutting down, and therefore collections going down, have not been treated seriously enough.

What’s the problem? Let us understand this through visualising a scenario. Assume Business A operates on a retained margin in the range of 8-9 per cent. Because it is (say) an SME, it buys without access to credit terms. So, it has purchased goods worth ₹50,000, and with GST of 20 per cent, has paid ₹60,000 for the invoice. It now sells this at ₹55,000 with an applicable GST of ₹11,000 — and so it raises an invoice of ₹66,000 on Business B.

Business B is a distributor, operating on a margin of (say) 2 per cent. Now, Business B is concerned that the input credit of ₹11,000 may or may not be available to it, in case Business A is negligent in its compliance. Therefore, it refuses to pay the GST amount until it can be certain to get the input credit (which is an entire ‘return’ cycle away). So, it pays only ₹55,000 on an invoice valued ₹66,000.

Now, Business A, in order to ‘get’ the balance due of ₹11,000, has to first finish all compliance requirements, including payment of tax, when it has not yet ‘collected’ the tax amount!

In contrast, if Business B ‘trusts’ Business A and does pay the ₹11,000, and if, for whatsoever reason (negligence, cash difficulties, mal-intent), Business A fails to complete the compliance, Business B will lose not just ₹11,000, but in effect, the ‘margin’ it makes on 10 other such invoices (since it operates on a thin margin of 2 per cent).

Apart from this, there are going to be collateral problems. For example, when the input credit is denied, will this be formally treated as a ‘business expense’ and not be taxed by income tax? Obviously yes. But at what point do I treat this as ‘contingent expense’? Will my advance tax payments made on the assumption of ‘possible write back’ be accepted? If not, will I be reimbursed for the cash-flow cost I incurred? How do I report my end-of-quarter and end-of-year? Will banks fund me? Will insurance cover this risk? How much more working capital will I require? Will I be eligible for it?

When the input credit is uncertain, and outside one’s span of control, the corresponding questions which will arise — and corresponding litigations can only be imagined. The last two-three questions will kill a large number of businesses that work on wafer-thin margins and/or with inadequate cash).

The reasoning of the Government is that people are today colluding (albeit in small percentages) to fraudulently take input credit when it is not due. Therefore, it is only fair to put this risk back on the citizen. It also reasons that because this is a small percentage, which will keep declining due to self-correction by citizens, it is not a ‘great burden’ — that is, the ‘business risk’ is small enough to manage.

The problem is not the ‘management of a manifest risk’ – the problem is the side-effects of cash flow, improper accounting, and reduced ability for people to trade with new suppliers and new customers – since there is uncertainty about the business outcome.

Is there a solution? Of course. One of the greatest benefits of GST is that it is built ground-up as a technology-enabled tax system. In the past, it was not feasible for the Government to systematically mitigate the risk of fraud, since there was no practical human ability to keep track and trace the culprits — who could/would repeatedly create phantom organisations, and/or phantom invoices. Against this history, it is no wonder that the Government wants to control this menace.

However, GST gives extraordinary traceability. For one, it fully eliminates the ability to have phantom invoices. That alone will massively reduce the problem. Second, with the near ubiquity of Aadhaar, and the passage of the Aadhaar Bill, the Government must mandate that all GST registrations are traceable to individuals based on their Aadhaar identity.

Now, the ability to repeatedly create phantom organisations that allow credit to be taken without corresponding payment will rapidly evaporate. And, of course, the sheer traceability of the individuals, and strong public actions showcased for deterrence, will now become effective.

Clearly, GST has all the ingredients to be great. Making it practical and convenient, by removing this one major lacuna, will go a long way in its ‘welcome embracement’ rather than ‘resisted embracement’.

Being technology-led, it also has all the ingredients to spiral upwards the trust deficit, rather than spiral downwards.

The writer is managing director of Tally Solutions Pvt Ltd

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