Introduction
Before the Goods and Services Tax (GST) revolutionized India’s indirect tax framework, businesses had to operate under a fragmented and often cumbersome system involving excise duty, VAT, service tax, and other levies. Central to this earlier regime was the concept of CENVAT credit, a mechanism introduced to reduce the burden of cascading taxes, or what is often described as “tax on tax”.
This article aims to simplify how excise duty worked, what CENVAT credit really meant, why reversal of credit existed, how exemptions differed from zero-rated supplies, and how the burden of taxation eventually fell on the consumer. Most importantly, we explore why, in many cases, businesses chose to pay excise duty despite being eligible for exemptions, and how these choices contributed to a more efficient tax credit chain that ultimately laid the groundwork for GST.
What is excise duty?
Excise duty was a tax imposed by the Central Government on the manufacture of goods[1]. It became payable at the point when goods were removed from the place of manufacture, typically the factory gate. This means excise duty was strictly a manufacturing tax, and only the manufacturer, not the trader or consumer, was responsible for paying it directly to the government.
However, the economic burden of excise duty didn’t stay with the manufacturer. Like all indirect taxes, excise was built into the price of the goods and passed along the supply chain. Each manufacturer included the duty in the cost, as per the value added, and it travelled downstream until it was embedded in the final price paid by the consumer. Thus, even though consumers never saw excise duty explicitly on their bills, they always bore the final cost.
Though excise duty was subsumed by GST in most sectors[2], it has not disappeared entirely. Certain sectors such as petroleum products, tobacco, and alcohol for human consumption, continue to be governed by the earlier excise provisions. In these cases, excise remains relevant, and so does the CENVAT credit mechanism for those industries.
Why is excise paid on input goods?
This leads us to a common and logical question: if excise is a tax only on manufacturing, why does it appear as a cost on input goods? The answer lies in understanding how goods move through a supply chain. Suppose a company manufactures compressors and sells them to an air-conditioner manufacturer. The compressor company pays excise duty on the compressors it produces. That duty becomes part of the price charged to the AC manufacturer. The AC company, in turn, uses the compressors as inputs.
So, while excise is technically levied only once on the manufacture, it travels with the product. Every subsequent buyer ends up indirectly bearing that cost unless they can offset it using input credit. This is how excise embeds itself in input goods and appears across the chain, even when each individual manufacturer only pays it once on their own output.
Understanding CENVAT credit
To prevent the cascading of taxes at multiple stages of production and distribution, the government introduced the CENVAT Credit Rules[3]. This system allowed a manufacturer or service provider to take credit for the excise duty (or service tax) paid on inputs and input services. In simple terms, if a business paid excise duty on goods it purchased as raw materials, it could claim that amount back as a credit and use it to reduce the excise duty it owed on the finished goods it manufactured. The purpose was to ensure that excise duty was paid only on the value added at each stage.
For example, if a business buys raw materials worth ₹1,000 and pays ₹125 as excise, and later sells the final product for ₹1,500, the excise duty on the final product might be ₹187.50. The business can subtract the ₹125 already paid as input tax and only pay ₹62.50 as the net duty on the value addition. This mechanism promoted transparency, encouraged proper documentation, and significantly lowered the effective tax burden on businesses.
The concept of reversal
While CENVAT credit was a powerful tool, it came with conditions. Businesses could only claim credit on inputs that were actually used in the production of taxable goods or services. If inputs were used to make exempted goods, were damaged, or written off, the credit could not be retained. In such cases, the credit had to be reversed. This means either paying back the claimed credit or reducing it from the available credit pool in the returns. Reversal ensures that businesses do not take undue advantage of credit for tax they are not liable to offset[4].
A useful analogy would be an employee receiving a travel allowance for 30 days, but only traveling for 20. In such a case, the employer would reasonably ask for the unused portion to be returned. Reversal of tax credit functions on the same principle.
Exemption vs. Zero-Rated Supply
One of the more confusing areas in indirect taxation is the distinction between exempted and zero-rated supplies. Although they both appear to offer relief from tax, the financial consequences for businesses are vastly different.
When a supply is exempt, it means no excise duty is charged on the output. However, this also means that the manufacturer cannot claim any input tax credit on the raw materials used to make that product[5]. The excise duty paid on inputs becomes a non-recoverable cost, increasing the cost of production and reducing profitability.
On the other hand, zero-rated supplies, such as exports, are treated differently. Even though the output is taxed at 0%, the business is allowed to claim full credit on inputs and even get a refund of unutilised input credit[6]. This maintains competitiveness by ensuring that the product is free from embedded taxes.
As a result, many businesses choose to opt out of available exemptions and voluntarily pay excise duty just to retain their eligibility for input tax credit, particularly in B2B environments, where competitiveness hinges on cost efficiency.
Transition to GST: A unified reform
While excise duty and CENVAT credit formed the backbone of the earlier indirect tax system, the fragmented nature of levies at the central and state levels created multiple issues. Businesses had to comply separately with excise, VAT, CST, and service tax, none of which allowed seamless credit across different domains.
GST fundamentally changed this structure by creating a single tax regime that subsumed almost all indirect taxes. It introduced a destination-based, value-added tax levied at every point of supply, allowing businesses to claim input tax credit seamlessly across goods and services and across state and central jurisdictions.
The credit chain that existed under CENVAT was limited to central levies like excise and service tax. There was no way to set off central taxes against state taxes (like VAT), leading to blocked credit and increased costs. GST eliminated this limitation by allowing complete cross-utilization of credits across CGST, SGST, and IGST.
Moreover, under GST, zero-rated supplies, which already existed under excise and service tax for exports, were codified and broadened. Supplies to Special Economic Zones (SEZs) were brought within the ambit, and uniform refund mechanisms were introduced to ensure liquidity for exporters. The principle remained the same, but the execution became far more efficient and consistent.
In essence, GST built upon the conceptual framework of CENVAT but expanded its scope, simplified compliance, and resolved long-standing systemic inefficiencies. It did not discard the value-addition principle of excise but generalized it across the entire economy with fewer exceptions and more uniformity.
Why do businesses sometimes prefer paying tax over availing exemption?
Government policies occasionally offer optional exemptions to businesses, for example, for setting up units in backward areas or operating below a certain turnover threshold. At first glance, these seem attractive. Why not avoid paying tax if you’re not required to? The reality, however, is more nuanced. Even if the output is exempt, the business continues to pay excise duty on its input goods. But since the final product is exempt, the business cannot claim credit. That input tax becomes a dead cost, reducing margins.
By choosing to forgo the exemption and pay output duty, the business becomes eligible to claim input credit, thereby reducing net tax liability and improving overall financial efficiency. This strategy reflects a sophisticated understanding of how the credit system works and demonstrates that sometimes, paying tax can actually make a business more competitive.
The Origin Manufacturer: Starting the credit chain
Every supply chain has a starting point, a manufacturer who produces goods without using any excise-duty-paid inputs. This person or entity cannot claim any input credit, because none exists. Yet, they are required to pay full excise duty on their output.
At first glance, it may seem like they are at a disadvantage. But in reality, they recover the duty by adding it to their sale price, just like everyone else. They become the origin of the credit chain. Their invoice allows the next party in the chain to claim credit and so on, until the product reaches the final consumer. This role is essential. Without someone to pay the first layer of duty, the credit chain cannot begin.
Traders and their role in the credit chain
Traders, who are not manufacturers, do not pay excise duty themselves. However, the system allows them to act as intermediaries who pass on the duty paid by the original manufacturer. They do this through documentation and registration under the excise system.
There are two types of such dealers:
- First-stage dealers, who buy goods directly from manufacturers.
- Second-stage dealers, who buy from other dealers.
If these traders are registered and issue invoices containing proper excise details, the buyers who purchase from them can claim CENVAT credit as if they had purchased directly from a manufacturer. This mechanism ensures that the credit chain remains unbroken even when goods change hands through multiple non-manufacturing intermediaries.
Why does the consumer ultimately bear the tax?
A common question is why the final consumer should bear the full burden of excise duty. The answer lies in the nature of indirect taxation. Excise is not intended to be a tax on business profit. It is a tax on consumption. Businesses merely collect it and pass it along the chain while claiming credit on what they paid.
The consumer, who doesn’t add value to the product, resells the product or uses it for manufacturing, cannot claim any credit. As a result, they bear the final burden. This isn’t unfair, it’s how consumption-based tax systems are structured all over the world. It prevents repetitive taxation at every business stage and ensures that the tax is applied only once, i.e. at the end.
Excise as a Value-Added Tax in spirit
Even though excise duty was charged on the full value of goods at each stage, the CENVAT credit mechanism ensured that the real burden was only on the value added. This is conceptually similar to how GST works today.
However, the credit system under excise had limitations:
- Credit was available only for central levies, not state taxes.
- There was no cross-credit between excise and VAT.
- Credit from service tax could not be used to offset state VAT, and vice versa.
These were significant inefficiencies in the system and were among the biggest reasons GST was introduced.
Conclusion
The excise and CENVAT credit system was a pioneering model in India’s journey toward a more efficient tax structure. It introduced the concept of taxing only the value added and allowed businesses to claim credit on tax paid at earlier stages. Yet, it had clear shortcomings, which included fragmented credit pools, lack of integration between state and central taxes, and complicated compliance requirements. It prepared the ground for the Goods and Services Tax, which unified the tax structure and removed nearly all cascading effects.
Even today, excise duty continues to remain relevant for specific sectors such as petroleum products and tobacco, where GST does not apply. In such cases, understanding excise and CENVAT remains critical. Understanding excise and CENVAT is essential not just for appreciating our tax history, but for understanding the logic behind GST — a system that took the best parts of CENVAT and VAT and made them universal.
Archi Aditya is a law graduate from Nirma University with a keen interest in indirect taxation and supply chain policy.
[1] Central Excise Act, No. 1 of 1944, § 3 (India).
[2] Constitution of India, art. 366(12A) expl., art. 279A(5), & sched. VII, list I, entry 84; Central Excise Act, No. 1 of 1944 (India)
[3] CENVAT Credit Rules, 2004, G.S.R. 600(E) (India).
[4] CENVAT Credit Rules, 2004, rr. 3(5B), 6(1), & 14, G.S.R. 600(E) (India).
[5] CENVAT Credit Rules, 2004, r. 6(1), G.S.R. 600(E) (India).
[6] Integrated Goods and Services Tax Act, No. 13 of 2017, §§ 16(1)–(3) (India).
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