The input tax credit (ITC) system, considered the soul of the Goods and Services Tax regime, needs an urgent overhaul. An ITC system based on invoice matching will reduce working capital blockage for 14 million GST registered firms, end fraud, and increase tax collection.

The GST used the concept of ITC to end the tax-on-tax problem faced by firms in the pre-GST era. For example, a shopkeeper selling a shirt had to pay VAT on the price of the shirt and also on the central excise duty already paid on it.

The GST solved the tax-on-tax problem by allowing credit for the taxes paid in the previous transaction stages. Firms could use such credit, called ITC, to pay the tax for the next step. An example of three firms in the apparel business will help.

An illustration

Firm A sells fabric to Firm B, which makes and sells shirts to firm C, the retailer. Assume GST on both fabric and shirt is 10 per cent. Firm A charges ₹110 from Firm B — ₹100 for fabric and ₹10 for GST. Firm A pays ₹10 as GST to government. Firm B will claim an ITC of an equal amount. Next, Firm B sells the shirts to a retailer at ₹275 — ₹250 as the price of a shirt and ₹25 as GST.

Firm B has to pay ₹25 GST to government. He pays ₹15 in cash (or ITC earned from other transactions) and uses the ITC of ₹10 available from the previous transaction. Finally, Firm C sells the shirts to the final consumer. Firms A, B, and C get ITC for all taxes, and the end-consumer pays all taxes.

A firm can claim correct ITC only when the buyer and seller invoice records for a particular transaction match. The GST law prescribes invoice matching by requiring firms to file three GST Returns (GSTR) monthly. But this system has not been implemented.

The modified system requires taxpayers to file details of outward supplies (GSTR-1) and a summary of transactions and taxes paid (a new form GSTR-3B). The lack of complete reconciliation led many firms to misuse the system. Here is how a fraud firm operates.

Fraudulent firms

The firm generates invoices through the GST system and mentions an enormous ITC value in its account. This is ITC created out of thin air. There is no corresponding tax paid or goods/services transferred. The firm then transfers the ITC via a series of shell firms located in different States. At the end of the chain, the firm uses the fake ITC to pay tax on its genuine transactions. A fraud firm may also transfer the ITC to an exporter who may use the ITC to pay IGST on his exports and claim cash refunds. If a firm inflates the export value, the government loses money by way of more refunds. The money involved is enormous.

Till October last year, the government had blocked ITC of ₹14,000 crore, affecting 66,000 taxpayers. Just one man had issued fake invoices of value exceeding ₹4,500 crore to over 600 firms. The genuine business person finds it difficult to ensure if the ITC claimed by him is true.

To check misuse, the government has introduced new rules and more safeguards since January. Now, a buyer can claim ITC only after the supplier files GSTR-1 (details of sales) and GSTR-3B (consolidated details of inward and outward supplies, ITC, and tax payment).

Buyers can view details of these documents through the auto-generated mirror documents. GSTR-2A mirrors GSTR-1, and GSTR-2B reflects GSTR-3B information. But even this approach is not foolproof.

Through the GSTR-2A, the buyer can merely know if the supplier has filed the GSTR-3B. It does not give the details of transaction-level tax payments. Buyers will never know if suppliers’ GSTR-3B does not include details of buyers’ transactions. Also, the reconciliation is not systems but taxpayer driven.

The buyer bears the burnt if the supplier is fake. Detecting fake bills is complex when many suppliers link through a long chain. Officers usually scrutinise only 5 per cent of cases. Their access to other cities’ data is restricted even if all data resides on GSTN.

The current system works through many checks and balances. But a buyer is at the mercy of the supplier.

Automating the system

ITC should be seamless, system-driven, and must not rely on human intervention. The government may invite proposals for modifying the GSTN design. The new system may contain a new GSTN utility called the Invoice Generation System (IGS). Firms would use IGS for uploading business invoices and GST payment/ITC details.

Invoices would contain the HS Code of the product and the GST number of the buyer. The IGS will fetch the GST rate from the system and details of the buyer from GST registration records to populate the invoice.

The GSTN will match the details of sales and purchase invoices. The buyer can check from the government record if the seller has paid tax to government on his transaction. GSTN will allow ITC after verifying payment of that corresponding tax. This will take seconds. Each taxpayer will have a national ITC account.

Total tax paid must equal full ITC. Individual firms’ ITC amounts will change as they transact business. GSTN will be responsible for the integrity of the system.

GST-paid goods and services generated 60 per cent of India’s GDP last year. A seamless, fraud-free ITC system, as mandated in the GST law, will be the best gift to the tax-paying firms.

The writer, a former Indian Trade Services officer, is the author of the book, ‘The GST Nation’