The onset of the goods and services tax, notwithstanding its tax-unification benefits and reformative impact, has been mired in controversies. Especially, the wide-ranging disputes in relation to input tax credit or ITC that could have been avoided in the interests of simplicity and mitigating litigation.

A recent judgment of the Madras High Court has exacerbated matters by upholding the government’s objection to transition of various credits under the GST law. This warrants a revisit of the underlying tax policy lest the ITC problem threatens GST’s foundations.

An Insight Into The Value Added Tax Design: Setting the Context

A key benefit of GST is that it arrests the cascading effect of taxes. This is achieved by designing GST as a value-added tax which ensures that each supply is taxed only to the extent of the value-addition made by the supplier, who is granted allowance of taxes paid on inputs to discharge the output tax liability. This design is effectuated through the ITC mechanism.

 Under the European Union VAT system, this design is explained by the ‘fiscal neutrality’ principle, which is set out in the EU law that its VAT “entails the application to goods and services of a general tax on consumption exactly proportional to the price of the goods and services, however many transactions take place in the production and distribution process before the stage at which the tax is charged.” If this declaration was not enough, its pragmatic application is also stipulated to imply that “[o]n each transaction, VAT, calculated on the price of the goods or services at the rate applicable to such goods or services, shall be chargeable after deduction of the amount of VAT borne directly by the various cost components.”

As a consequence of such legal declaration, a supplier’s entitlement to input credit is an indefeasible right fiercely protected by law and courts, including the European Court of Justice.

 In the Indian context, while it is commonly acknowledged that GST is designed as a VAT, there is no such overarching declaration in the law. Much less, there is no legislative or executive guidance, either by the GST Council or the executive arm of the government, with regard to the policy underlying the ITC mechanism. Thus, one is relegated to deciphering this overarching principle through a maze of legal provisions and their fine-print, a quest that is susceptible to missing the forest for the trees.

 Unravelling The Controversy

The GST law became effective on July 1, 2017 and simultaneously the erstwhile indirect tax laws ceased to have existed, forcing businesses to migrate to the GST framework.

 Businesses carrying credits which had accrued to them under the erstwhile laws would have ended up with dead costs on such account. To obviate their difficulties, the GST law provided for ‘transition’ of such credit into the GST regime. The transition provision was, however, technically scoped. On its literal reading, only credit under certain enumerated erstwhile laws could be transitioned. As a consequence, large quantum of credit was locked out of GST transition; Education Cess and related cesses being prime-examples, leading to economic loss to business. When multiple representations to the executive arm failed, understandably, the controversy reached court.

• The Bombay High Court, first to adjudicate the dispute, concluded against the taxpayer highlighting lack of any legal entitlement to claim such credit.
• The Gujarat High Court, however, disagreed and declared that businesses had the right to avail of such ‘vested’ tax credits and that they could not be taken away.

Thus a clear denunciation of the law eluded and the battleground shifted to the Supreme Court. Before the Supreme Court could hear the case, much less express an opinion, the central government and states were aligned to proactively settle the controversy, albeit against the taxpayers.
 

• Accordingly, the GST Council proposed amendments to expressly provide that taxes ‘eligible’ for transition credits exclude cess. To ensure that past and pending cases were covered, the amendments were given retrospective effect – i.e. from the first day of GST law. Without further ado, the recommendations were accepted by the Parliament and the state legislatures and enacted in respective GST laws.

Thus, by legislative fiat, the credit entitlement of taxpayers qua cesses stood whittled down.

• Taking note of legislative amendments, recently the Madras High Court held that credit mechanism is only a facility for tax payment and cannot be allowed by implication in absence of legislative sanction

This decision has elucidated why taxpayers cannot claim credit as a matter of right, while the issue awaits determination of the Supreme Court.

 Effect Of Credit Denial On GST Structure

A review of the jurisprudence from recent decisions of the apex court reveals that tax-credits have been the Achilles’ heel for taxpayers as they have seldom succeeded in their claims for credit in absence of a conspicuous provision in the law. In the context of retrospective amendment, which takes away the basis for taxpayers’ claim, it is unlikely that the Supreme Court would opine differently. While this may arguably be the legal position, its continuation in the GST regime is not conducive for businesses.

 The policy rationale for input credits from a GST design standpoint needs to be calibrated differently from how courts interpret the law.

 By design, indirect taxes are considered to be regressive in nature as they apply equally irrespective of the taxpayers’ paying capacity and consequently, are averse to the progressive principle of taxation. A sense of equity is sought to be instilled in indirect tax laws by introduction of the VAT scheme to address the cascading effect of taxes, which was rampant under the pre-GST regime, making them inefficient and a burden on businesses and consumers. Thus, denial of input credit, albeit partially, is equivalent to a declaration that the VAT principle is not sacrosanct and instead, input credits are a matter of discretion. Legal declaration aside, this trend has ominous overtones as it dilutes the very foundation of GST at such an early stage of its implementation and hence, is a flawed approach.

The retrospective amendment to GST law for undoing basis for taxpayers’ entitlement, particularly when the issue is before the Supreme Court, is also against the unequivocal policy to not introduce such amendments, in the wake of past amendments to override judgments of the final court, which serve as a binding law under the Constitution.

Such retrospective amendments to disadvantage taxpayers are not just against solemn assurances of constitutional functionaries but also take away fairness and precarious equity embedded in the tax system. At a larger level, this militates against trust-building efforts with the taxpayers.

Unlike laws which can change retrospectively, the ability to revisit past transactions eludes taxpayers, who must suffer to bear the cost and consequences of such amendments.

Policy Prescription(s)

A compelling reason for a conceptual revisit to the existing design is the positioning of credit under the GST system. Owing to absence of a clear policy delineating the importance of credit system, the judicial treatment of credit is still governed by a three-decade old judicial characterisation of the principle.

In the current state of affairs, credit mechanism continues to be described as a mere tax-payment mechanism, a facility extended by law where the tax liability could be discharged by offsetting the credit instead of payment in cash. The extension of such understanding and its application to the GST regime fails to recognise a vital distinction. The previous limited play of credit scheme was contextual to the setting of the earlier laws where credit was indeed a facility arising out of government’s indulgence vis-à-vis the GST laws where input credit is a fundamental pivot on which the value added design of GST is cast.

Hence, the underlying approach of allowing input credit as a facility, is misplaced and must be replaced with such credit as a fundamental touchstone of GST and brought at par with the EU system, for reasons of both functional-efficiency and design-purity.

The cause for many woes in the complex tax design of our system lies in conspicuous absence of a policy-prescription, which entails laying down key features of a fiscal law.

Owing to the lack of an overarching policy, the executive often resorts to short-term solutions to address institutional deficiencies instead of coherent response guided by central vision of the reform – One Nation, One Tax.

 In such policy situations, even judicial intervention for interpreting laws do not reveal a substantial shift owing to unarticulated policy-vision and design deficiency. Unsurprisingly therefore, the courts continue to conform to interpretation of a deficient provision in the statute.

This, if permitted to continue, will erode the foundational tenets of GST and therefore needs an intervention. The GST Council, being an all-pervasive repositor of constitutional authority on GST, would do well to examine the issue and urgently and undertake course-correction measures.

While the transition credit may at best be a temporal issue, it is imperative that the lessons are learnt at this early stage to ensure against enforcement of laws which entail credit-denials.

 Mukesh Butani and Tarun Jain are Partners, at BMR Legal Advocates. The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.