Inverted Duty Structure the way forward?

Accumulation of Input Tax Credit happens when the tax paid on inputs is more than the output tax liability. Such accumulation will have to be carried over to the next financial year till such time as it can be utilised by the registered person for payment of output tax liability. However, the GST Law permits refund of unutilised ITC in two scenarios, namely if such credit accumulation is on account of zero-rated supplies or on account of inverted duty structure, subject to certain exceptions.

As per Section 54(3) of the CGST Act, 2017, a registered person may claim refund of unutilised input tax credit at the end of any tax period. A tax period is the period for which return is required to be furnished.

1. What is the difference in Inverted Duty Structure in PRE-GST Regime and GST Regime?

In Pre-GST Regime Inverted Duty Structure is applicable under cases where import duty on raw materials used in the production of finished goods is higher than the import duty of finished goods.

But Under GST Regime the Inverted Duty Structure refers to the cases where the rate of tax on inputs received are higher than the rate of tax on paid on outward Supplies.

However, the Inverted Duty Structure have wider scope as compared to Pre-GST regime because now it includes input services also.

2. Inverted duty structure IN GST Regime?

Where the credit has accumulated on account of rate of tax on inputs being higher than the rate of tax on output supplies (other than nil rated or fully exempt supplies), except supplies of goods or services or both as may be notified by the Government on the recommendations of the Council.

3. Refund of ITC on account of inverted duty structure

As per Section 54(3) of CGST Act, 2017, refund of accumulated ITC will be granted where the credit accumulation has taken place on account of inverted duty structure. However, the Government also has the power to notify supplies where refund of ITC will not be admissible even if such credit accumulation is on account of an inverted duty structure. In exercise of the powers conferred by this section, the government has issued Notification no. 15/2017-Central Tax (Rate) dated 28.06.2017 wherein it has been notified that refund of unutilised input tax credit shall not be allowed under sub- section (3) of section 54 of the said CGST Act, 2017, in case of supply of services specified in sub-item (b) of item 5 of Schedule II of the CGST Act, 2017. The supplies specified under item 5(b) of Schedule II are construction services.

In respect of goods, the central government has issued Notification no. 5/2017- Central Tax (Rate) dated 28.06.2017 as amended by Notification no. 44/2017-Central Tax (Rate) dated 14.11.2017. The government has notified the following goods in respect of which unutilized ITC will not be admissible as refund: –

It has been clarified by the Government vide Circular no. 18/18/2017- GST dated 16.11.2017, that the aforesaid notification having been issued under clause (ii) of the proviso to sub-section (3) of Section 54 of the CGST Act, 2017, restriction on refund of unutilised input tax credit of GST paid on inputs will not be applicable to zero rated supplies, that is (a) export of goods or services or both; or (b) supply of goods or services or both to a Special Economic Zone Developer of special Economic Zone Unit. Accordingly, as regards export of fabrics, it has been clarified that subject to provisions of Section 54(10) of the CGST Act, 2017, a manufacturer of such fabrics will be eligible for refund of unutilised input tax credit of GST paid on inputs (other than input tax credit of GST paid on capital goods) in respect of fabrics manufactured and exported by him.

Further, Rule 89(2) (h) of CGST Rules, 2017 stipulate that refund claim on account of accumulated ITC (where such accumulation is on account of inverted duty structure) has to be accompanied by a statement containing the number and date of invoices received and issued during a tax period. Rule 89(3) of CGST Rules, 2017 also provide that where the application relates to refund of input tax credit, the electronic credit ledger shall be debited by the applicant in an amount equal to the refund so claimed.

4. Net ITC on Inverted Duty Strucutre

Parliament while enacting the Central Goods and Services Tax Act 2017, has incorporated a provision for refund of tax in Section 54. Sub-Section (3) embodies a provision for refund of unutilised input tax credit2 in cases involving:

(i) zero rated supplies made without payment of tax; and

(ii) credit accumulation “on account of rate of tax on inputs being higher than rate of tax on output supplies”.

While envisaging a refund in the latter of the above two situations, Parliament was cognizant of the fact that ITC may accumulate due to a variety of reasons.

However, Parliament envisaged a specific situation where the credit has accumulated due to an inverted duty structure, that is where the accumulation of ITC is because the rate of tax on inputs is higher than the rate of tax on output supplies.

Taking legislative note of this situation, a provision for refund has been provided for in Section 54(3). The Central Goods and Service Tax Rules 20173 have been formulated in pursuance of the rule making power conferred by Section 164 of the CGST Act. Rule 89(5) provides a formula for the refund of ITC, in “a case of refund on account of inverted duty structure”. The said formula uses the term “Net ITC”. In defining the expression “Net ITC”, Rule 89(5) speaks of “input tax credit availed on inputs”.

High Court of Gujarat & Madras

Writ petitions under Article 226 of the Constitution were instituted before the High Court of Gujarat and the High Court of Judicature at Madras. The petitioners before the High Court submitted inter alia that

(i) Section 54(3) allows for a refund of ITC where the accumulation is due to an inverted duty structure;

(ii) ITC includes the credit of input tax charged on the supply of goods as well as services;

(iii) Section 54(3) does not restrict the entitlement of refund only to unutilised ITC which is accumulated due to the rate of tax on inputs being higher than the rate of tax on output supplies. It also allows for refund of unutilised ITC when the rate of tax on input services is higher than the rate of tax on output supplies;

(iv) While Section 54(3) allows for a refund of ITC originating in inputs as well as input services, Rule 89(5) is ultra vires in so far as it excludes tax on input services from the purview of the formula; and

(v) In the event that Section 54(3) is interpreted as a restriction against a claim for refund of accumulated ITC by confining it only to tax on inputs, it would be unconstitutional as it would lead to discrimination between inputs and input services.

By its judgment dated 24 July 2020 in VKC Footsteps India Pvt. Ltd. v. Union of India (R/ Special Civil Application No 2792 of 2019) , the Division Bench of the Gujarat High Court, held that:

“Explanation (a) to Rule 89(5) which denies the refund of “unutilised input tax” paid on “input services” as part of “input tax credit” accumulated on account of inverted duty structure is ultra vires the provision of Section 54(3) of the CGST Act, 2017.”

The High Court therefore directed the Union Government to allow the claim for refund made by the petitioners before it, considering unutilised ITC on input services as part of “Net ITC” for the purpose of calculating refund in terms of Rule 89(5), in furtherance of Section 54(3).

By its judgment dated 21 September 2020, in Tvl. Transtonnelstroy Afcons Joint Venture v. Union of India (Writ Petition Nos 8596, 8597, 8602, 8603, 8605 and 8608 of 2019)  and connected cases the Division Bench of the Madras High Court came to a contrary conclusion, after having noticed the view of the Gujarat High Court, which it has declined to follow. The Madras High Court has concluded that

“63…

(1) Section 54(3)(ii) does not infringe Article 14.

(2) Refund is a statutory right and the extension of the benefit of refund only to the unutilised credit that accumulates on account of the rate of tax on input goods being higher than the rate of tax on output supplies by excluding unutilised input tax credit that accumulated on account of input services is a valid classification and a valid exercise of legislative power.”

The writ petitions challenging the validity of Rule 89(5) on the ground that it is ultra vires Section 54(3)(ii) were dismissed.

The divergence between the views of the Gujarat High Court on the one hand, and the Madras High Court on the other, forms the subject matter of this batch of appeals.

5. Statutory Provisions

Rule 89 was originally inserted in the CGST Rules through the Central Goods and Services Tax (Second Amendment) Rules 2017 , which came into force on 1 July 2017. Rule 89(4) and Rule 89(5) were in the following terms:

“(4) […]

(B) “Net ITC” means input tax credit availed on inputs and input services during the relevant period;

[…]

(E) “Adjusted Total turnover” means the turnover in a State or a Union territory, as defined under sub-section (112) of section 2, excluding the value of exempt supplies other than zero-rated supplies, during the relevant period;

(5) In the case of refund on account of inverted duty structure, refund of input tax credit shall be granted as per the following formula: –

Maximum Refund Amount= {(Turnover of inverted rated supply of goods) x Net ITC ÷ Adjusted Total Turnover} – tax payable on such inverted rated supply of goods

Explanation:- For the purposes of this sub rule, the expressions “Net ITC” and “Adjusted Total turnover” shall have the same meanings as assigned to them in sub-rule (4).”

On 18 April 2018, the Central Goods and Services Tax (Fourth Amendment) Rules 20187 were notified. Rule 89(5) was amended in the following terms

“(5). In the case of refund on account of inverted duty structure, refund of input tax credit shall be granted as per the following formula:-

Maximum Refund Amount= {(Turnover of inverted rated supply of goods and services) x Net ITC ÷ Adjusted Total Turnover} − tax payable on such inverted rated supply of goods and services.

Explanation:- For the purposes of this sub-rule, the expressions-

(a) “Net ITC” shall mean input tax credit availed on inputs during the relevant period other than the input tax credit availed for which refund is claimed under sub-rules 4(A) or (4B) or both; and

(b) “Adjusted Total turnover” shall have the same meaning as assigned to it in sub-rule (4).”

The amendment was with prospective effect. Rule 89(5), as it stands at present, was substituted on 13 June 2018 by the Central Goods and Services Tax (Fifth Amendment) Rules 2018. By the amendment, Rule 89(5) was substituted with the retrospective effect from 1 July 2017 in the following terms:

“(iii) with effect from 01st July 2017, in rule 89, for sub-rule

(5), the following shall be substituted namely:-

“(5) In the case of refund on account of inverted duty structure, refund of input tax credit shall be granted as per the following formula:-

Maximum Refund Amount= {(Turnover of inverted rated supply of goods and services) x Net ITC ÷ Adjusted Total Turnover} − tax payable on such inverted rated supply of goods and services.

Explanation:- For the purposes of this sub-rule, the expressions-

(a) Net ITC shall mean input tax credit availed on inputs during the relevant period other than the input tax credit availed for which refund is claimed under subrules 4(A) or (4B) or both; and

(b) Adjusted Total turnover shall have the same meaning as assigned to it in sub-rule (4).””

The above sequence indicates that the definition of the expression ‘Net ITC’ in Rule 89(5) originally meant “input tax credit availed on input and inputs services”. By the amendment of 18 April 2018, the definition of ‘Net ITC’ was substituted so as to mean ITC availed on inputs, with prospective effect. On 13 June 2018, this definition was made applicable with retrospective effect from 1 July 2017.

6. Held by Supreme Court

As there were contrary judgements by High Court of Gujarat & Madras matter went to Supreme Court. Various discussions and Court Verdict is as follows:

The Object & Purpose of Refund in Inverted Duty structure is:

(a) The purpose of the provision is to give effect to the doctrine of equivalence or neutrality which is the basic objective of the GST and this is sought to be achieved by granting seamless credit through Section 16;

(b) The legislative background and preparatory material duly support the purpose of the legislation;

(c) The State does not want the taxpayers to suffer the ill effect of tax cascading solely because of its decision to offer a reduced rate of tax on outputs, relative to the tax rate on inputs;

(d) Section 54(3) is not intended to cover a situation where the inverted duty structure is created by assessee due to its own actions such as discount/distress/non-supply as distinguished from the rate structure created by the State.

The international jurisprudence on GST and tax neutrality postulates that such taxes are not a permanent cost to the business and that businesses are pass through entities. The essential character is of an economically neutral tax through a seamless flow of credit.

Goods and services, though defined separately, are treated substantially in a similar manner in several aspects both in the Constitution and in the CGST Act.

The decision of a Constitution Bench of this Court in RK Garg v. Union of India [(1981) 4 SCC 675], where it was observed that the economic legislation ought not to be measured by abstract symmetry, since it is essentially empirical in nature and is based on experimentation.

Honourable Supreme Court held that the judgment of the Madras High Court needs to be affirmed in the case of Tvl. Transtonnelstroy Afcons Joint Venture whereas the decision of Gujarat High Court in case of VKC Footsteps India Pvt. Ltd. needs to be set aside. Therefore, Refund in cases of Inverted Duty Structure would be based on latest amendment to Rule 89(5) and it would be on ITC on Inputs (Goods) only.

7. Inverted Duty Structure the way forward

Does today’s Judgement would bring end to controversy or litigations in this matter? The answer is Negative. The Observations in Para 104 to 111 are few anomalies noted by the Honourable Supreme Court and has observed that GST Council shall consider them in accordance with the law. Few anomalies that has been noted are:

(a) The formula creates a distinction between suppliers having a higher component of input goods than those having a higher component of input services, and must be read down accordingly, must be rejected. The purpose of the formula in Rule 89(5) is to give effect to Section 54(3)(ii) which makes a distinction between input goods and input services for grant of refund. Once the principle behind Section 54(3)(ii) of the CGST Act is upheld, the formula cannot be struck down merely for giving effect to the same.

(b) the formula is not perfect. The formula makes a presumption that the output tax payable on supplies has been entirely discharged from the ITC accumulated on account of input goods and there has been no utilisation of the ITC on input services

(c) Another rule of equal importance is that laws relating to economic activities should be viewed with greater latitude than laws touching civil rights such as freedom of speech, religion etc. It has been said by no less a person than Holmes, J., that the legislature should be allowed some play in the joints, because it has to deal with complex problems which do not admit of solution through any doctrinaire or strait-jacket formula and this is particularly true in case of legislation dealing with economic matters, where, having regard to the nature of the problems required to be dealt with, greater play in the joints has to be allowed to the legislature. The court should feel more inclined to give judicial deference to legislative judgment in the field of economic regulation than in other areas where fundamental human rights are involved.

(d) Legislation is directed to practical problems, that the economic mechanism is highly sensitive and complex, that many problems are singular and contingent, that laws are not abstract propositions and do not relate to abstract units and are not to be measured by abstract symmetry.

(e) It is well settled that if the provision of law is explicitly clear, language unambiguous and interpretation leaves no room for more than one construction, it has to be read as it is.

This Court (Supreme Court) has only intervened to read down or interpret a formula if the formula leads to absurd results or is unworkable. In the present case however, the formula is not ambiguous in nature or unworkable, nor is it opposed to the intent of the legislature in granting limited refund on accumulation of unutilised ITC. It is merely the case that the practical effect of the formula might result in certain inequities.

Court cannot move down the path of recrafting the formula and walk into the shoes of the executive or the legislature, which is impermissible. Accordingly, we shall refrain from replacing the wisdom of the legislature or its delegate with our own in such a case. However, given the anomalies pointed out by the assessees, we strongly urge the GST Council to reconsider the formula and take a policy decision regarding the same.

Thus, in my opinion, after this judgement, matter would be considered by the GST Council and anomalies as pointed out by the Supreme Court would be removed. This Judgement is not settling the controversy forever but issue is now with GST Council.