Inverted duty structure. The challenges of stabilising the reverse pyramid

Inverted duty structure connotes a structure or situation where the rate of tax levied on the outward supply of goods (output) is lesser than the tax rate levied on the inward supply of goods (inputs). The taxation system under the GST regime in respect of most of the products involves lesser payment of tax on the inputs and a relatively higher payment of tax on the final product.

However, there is a deviation from the above general concept in respect of certain final products such as footwear, textile products, fertilisers, steel utensils, solar modules, tractors, tyres, electrical transformers and pharmaceutical products where the levy of tax is inverse resulting in inverted duty structure.

For example, the rate of GST in respect of readymade garments is 5 per cent, when the transaction value of the product per piece is less than ₹1,000, and 12 per cent, when the transaction value exceeds ₹1,000 per piece. However, some of the inputs, which are forming the essential and integral part of the product, either during the course of the manufacture of the final product or during the process of job work attract a much higher rate of GST. While inputs such as chemicals, dyes an buttons attract a GST rate of 18 per cent, the final product attracts GST only to the tune of 5 per cent or 12 per cent, depending on the sale value.

Peculiar situation

This anomalous situation leads to accumulation of input tax credit (ITC) even after reasonable value addition in respect of the final product. This accumulation will have to be carried over infinitely until the accumulated credit is utilised for payment of output tax liability, which will never happen. The peculiar situation of inability to make optimum utilisation of the ITC is certainly not in consonance with the intent and spirit of its mechanism, which has been introduced with the goal of eliminating the cascading effect of pricing on account of the tax on taxes.

The GST Act, however, provides a little solace by allowing the refund of the unutilised ITC instead of having the necessity to carry it over to result in accumulation without any useful purpose. The mechanism facilitating the taxpayer to claim refund of the ITC accumulated on account of the inverted duty structure is formulated under Section 49 (6) read with Section 54 of the CGST Act, 2017 and Rule 89 of the CGST Rules, 2017.

The grant of refund of the accumulated ITC on account of the inverted duty structure is subject to certain conditions and safeguards and as per the formula prescribed under Rule 89 (5) of the CGST Rules, 2017.

Though the complexity arising on account of the inverted duty structure is largely addressed by the defining feature of refund mechanism, it still leads to practical issues of the blockage of working capital involving undue outflow of interest on the loans for the trade and industry in those select sectors, especially the footwear and textile industries, which by and large operate with thin profit margin. Further, this refund mechanism causes increased scrutiny work for the department, which ultimately results in undue delay and related hassles for the taxpayers pertaining to those sectors. Further, the complicated refund mechanism involves additional compliance requirements and finally leads to more cost of compliance. In addition to the requirement of making the application in Form-GST-RFD 01, there are many other forms to be filled for other issues relating to claim of refund. Further, the application for refund will be considered only if the Forms GSTR-1 and GSTR-3B have already been filed for the relevant tax period for which the refund is claimed, thereby creating a long chain of compliance procedures for getting the refund.

The agony and confusion that had arisen on account of the inverted duty structure is further compounded by the stringent provisions of Rule 89 (5) of the CGST Rules, which has limited the refund of unutilised credit only in respect of the input goods and not to the input services used in the manufacture or process of the final products.

The input services, as that of the input goods, are also getting consumed in the manufacture or processing and forming an essential and integral constituent of the final products. Therefore, exclusion of the input services in the formula for the purpose of grant of refund defies the logical reasoning. Such a denial is yet another dampener for the industry, which is already suffering on account of the onslaught of the inverted duty structure. In a recent judgment, the Supreme Court in the case of Union of India Vs VKC Footsteps Pvt Ltd had upheld the constitutional validity of the aforesaid legal provisions. The Court was categorical to the effect that the law and the formula prescribed being unambiguous, and said that a registered person can only claim refund due to accumulation of unutilised input credit on the input goods and not on the input services.

Though the formula governing the grant of refund suffers from inequities, the Supreme Court had refused to strike down the formula with due recognition for the intent of the legislature. The Court had, however, made the observations as follows: “We strongly urge the GST Council to reconsider the formula and take a policy decision regarding the same”.

Corrective measures

Besides the observations of the Supreme Court on the reconstruction of the formula for refund, there is a dire necessity to deploy various other scientific tools, so as to move forward towards a refined taxation system and there is a long way to go in that direction. As a step towards that destination, the GST Council, in the 45th meeting held on September 17, 2021, had taken the vital decision to correct the anomalies contained in the inverted duty structure effective from January 1, 2022. Theories are going round in the industry circles propagating various probabilities and possibilities relating to the subject matter.

The anomalies and practical problems arising as a result of inverted duty structure can be corrected either by reducing GST on the inputs or by raising levies on the finished products. The general perception is that the rate of the final product might be increased to a uniform rate of 12 per cent. Superfluously, this proposition may sound as the perfect logical solution.

Advocating the concept of increase in duty, however, is easier said than done, especially in respect of textiles sector, which is the second largest employment provider in India and major contributor of the export earnings across the wide spectrum of the organised and unorganised sector with clusters in the small, medium and large scale industries.

Undoubtedly, the measure of increasing the rate of GST is a sensitive matter, which would have wide ramifications in unimaginable proportions. Same is the case with the footwear industry and other sectors facing such anomalies.

The suggestion for reduction of tax on the inputs is also not practical and viable, as the inputs such as chemicals and dyes are used in various other industries also. Another measure advocated for correction of the aforesaid anomalies is grant of complete or partial exemption for certain inputs. Going by the past experience, end use based exemptions would result in diversions, complications, impractical monitoring mechanism for compliance and inter-state revenue considerations.

While the Group of Ministers constituted by the GST Council are engaged in the unenviable challenge of stabilising the reverse pyramid, the industry is on the anxious wait with its fingers crossed as to how the modalities are going to be formulated for correction of the anomalies of the inverted duty structure, so as to have a refined taxation system without any complications and hassle-free compliances to provide a win-win situation for the industry as well as the nation.

(The author is a Senior Advisor at AKM LLP)

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