Inverted Duty Structure under GST – An Overview

Widened scope for refund of accumulated ITC in Electronic Credit Ledger – A Detailed Study of Refund under Inverted Duty Structure

Ever since the formula has been amended in July 22 for refund of accumulated ITC under Inverted Duty Structure, the scope for obtaining refund has widened and businesses can be benefited by converting the idle credit into cash, thereby contributing towards the working capital requirements. This document intends to provide a detailed understanding of the refund under Inverted Duty Structure from the inception, challenges faced in the old formula, numerical illustration of the benefit out of revised formula and the extended time period for obtaining the refund.

Table of Contents

1. Background of Refund under Inverted Duty Structure in GST

Value Added Tax on goods and services across the globe envisage the full credit of tax paid on underlying inputs, such as goods and services, for the payment of outward tax applicable to the principal transaction. This is to ensure that there is no cascading effect of tax, that is, ‘tax-on-a-tax’, after every stage in the supply chain.

Before the inception of the GST law, the recognition of the principle of providing a refund in the case of IDS was limited to a few states by way of their independent VAT legislation. The constitutional power of states to impose VAT was limited to goods and not on services. However, provisions pertaining to inverted duty were largely absent under the erstwhile indirect tax regime.

One of the major objectives of introducing ‘One Nation One Tax’ structure called GST is to avoid the cascading effect of taxes. This anomaly was cured by the advent of a unified GST regime with effect from 1 July 2017. However, with the different tax rates made applicable for various goods & services, there arises a scenario where ITC gets accumulated without being fully utilised towards output taxes. Such accumulation is a result of defined pattern wherever it is due to rate of tax on input goods or services being higher than the rate of tax on output goods and services. The newly instituted regime recognised such defined pattern of accumulation due to differential rate structure and thus provided for the refund of accumulated input tax credit in such cases. However, such refunds can be claimed only when the rate of tax on the inputs (of goods and not that of services) being higher than the rate of tax applicable on the outward supply of goods or services. Such a refund could be claimed within a two-year period.

Because credit accumulation on account of unutilised ITC can result in higher tax costs to businesses and/or a rise in the hidden tax cost for consumers, Governments have sought to address this issue in different ways. One of such ways is to claim refund of ITC under Inverted Duty Structure under Section 54 of the Act.

Inverted Duty Structure (‘IDS’): Where the credit has accumulatfed on account of rate of tax on inputs being higher than the rate of tax on outward 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.

In simple words, IDS arises when rate of tax on Inward supply of goods is higher than the rate of tax on the outward supplies. This indicates that the inverted duty structure should be on the RATE OF TAXES and not on the mere absolute quantum of taxes.

2. Relevant provision in the GST Act – Section 54

Section 54(1) states that any person claiming refund of any tax and interest, if any, paid on such tax or any other amount paid by him, may make an application before the expiry of two years from the relevant date in such form and manner as may be prescribed.

Section 54(3) states that a registered person may claim refund of any unutilised input tax credit at the end of any tax period:

Provided that no refund of unutilised input tax credit shall be allowed in cases other than

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

(ii) 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.

Explanation:

Originally, “Relevant date” means-

(e) in the case of refund of unutilised input tax credit under sub-section (3), the end of the financial year in which such claim for refund arises.

With effect from 01^st February 2019, this has been amended to

(e) in the case of refund of unutilised input tax credit under clause (ii) of the first proviso to sub-section (3), the due date for furnishing of return under section 39 for the period in which such claim for refund arises;

3. Restriction of refund under IDS for certain goods & services

Following notifications restrict the eligibility of goods & services for refund under IDS, based on the HSN of the outward supply of goods or services:

a) Notification No.5/2017-Central Tax dt. 19.06.2017.

b) Notification No. 15/2017-Central Tax dt. 01.07.2017.

c) Notification No. 29/2017-Central Tax dt. 22.09.2017.

d) Notification No. 20/2018-Central Tax dt. 26.07.2018.

e) Notification No. 9/2022- Central Tax dt. 13.07.2022.

Taxpayer ought to verify these notifications and any further notifications in this regard, in order to check if the goods or services supplied in the given scenario is specifically restricted from claiming refund under IDS, before making the refund application.

4. Applicability of circulars

Circulars play a vital role with specific regards to the refund under GST law and most of the practical procedures have been clarified only through circulars. Circulars are explanatory or clarificatory in nature and could be issued for the purpose as specified in the Act. GST circulars are issued by the CBIC to provide any clarifications at large, as may be needed. While the Act, Rules & Notifications are equally binding on the revenue and the taxpayer, Circulars are binding only upon the revenue officers. Whereas, the Assessee/ taxpayer is at his discretion to follow the directions/ clarifications provided in the circular. In so far as the circular is in line with the provisions laid down in the law, taxpayers do comply with the circulars, as long as it is beneficial in the given instance.

5. Tests for applying for refund under IDS

As the proviso to Section 54(3) states that no refund of unutilised input tax credit shall be allowed in cases other than the two scenarios cited, it can be understood that a mere balance in the Electronic Credit Ledger would not entitle refund for the taxpayer, unless the conditions specified persists. Accordingly, accumulated ITC in the case of inverted duty structure has to pass through the following 3 major tests for it to be qualified for refund under IDS:

Test #1 – Inverted duty structure u/s 54: Refund can be claimed as per (ii) proviso to Section 54(3), 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). Accordingly, taxpayer should have atleast one of the inward supplies of goods which attracts higher rate of tax than the outward supply made in order to be eligible for refund under IDS.

Test #2 – Not restricted specifically: Taxpayer should not be engaged in the outward supply of goods and services which are restricted from refund under IDS vide the above-mentioned notifications.

Test #3 – Maximum eligible refund as per Formula: When Tests 1 & 2 are satisfied, refund needs to be computed as per the formula prescribed in Rule 89(5). Taxpayer would be eligible for refund only to the extent of maximum amount of refund by applying formula provided under Rule 89(5) of the CGST Rules, 2017. Such maximum amount of refund would be restricted to minimum of the following three figures:

a) Refund calculated using the formula prescribed under Rule 89(5)

b) Balance in Electronic Credit ledger at the end of tax period for which the refund claim is being filed after the return for the said period has been filed.

c) Balance in Electronic Credit ledger at the time of filing of refund application.

Meaning, if the result of maximum refund derived based on the formula provided and subject to the minimum of the above three figures is not positive, taxpayer would not be eligible for any refund even of the above 2 tests are duly passed through.

6. Old Formula for refund upto 4^th July 2022 – Rule 89(5)

The formula for claiming refund under IDS is provided under Rule 89(5) of CGST Rules,2017 as follows:

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 (4A) or (4B) or both.

Note: Sub-rule (4A): In the case of supplies received on which the supplier has availed the benefit of the Government of India, Ministry of Finance, Notification No. 48/2017-Central Tax dated the 18th October, 2017 published in the Gazette of India, Extraordinary, Part II, Section 3, Sub-section (i), vide number G.S.R 1305 (E) dated the 18th October, 2017, refund of input tax credit, availed in respect of other inputs or input services used in making zero-rated supply of goods or services or both, shall be granted.

Sub-rule (4B): Where the person claiming refund of unutilised input tax credit on account of zero-rated supplies without payment of tax.

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

As per sub-rule (4), “Adjusted Total Turnover” means the sum total of the value of-

(i) the turnover in a State or a Union territory, as defined under section 2(112), excluding the turnover of services; and

 (ii) the turnover of zero-rated supply of services and non-zero-rated supply of services, excluding-

(a) the value of exempt supplies other than zero-rated supplies; and

(b) the turnover of supplies in respect of which refund is claimed under sub-rule (4A) or sub-rule (4B) or both, if any, during the relevant period.

Note: As per section 2(112), “turnover in State or Union territory” means the aggregate value of all taxable supplies (excluding the value of inward supplies on which tax is payable by a person on reverse charge basis) and exempt supplies made within a State or Union territory by a taxable person, exports of goods or services or both and inter-State supplies of goods or services or both made from the State or Union territory by the said taxable person but excludes central tax, State tax, Union territory tax, integrated tax and cess;

7.  Challenges in Refund under IDS using old formula

With the objective of ‘One Nation One Tax’, GST intends to maintain similarity in treatment between goods and services. However, goods and services have been separately defined in the Act to maintain their identity. Moreover, Schedule II to the CGST Act provides a clear distinction between activities to be treated either as Supply of goods or services involved in certain specified transactions. Such distinction when made in the refund under IDS, has sown its seeds to the anomaly in claiming legitimate refunds.

As per the above formula, Net ITC means the ITC availed on inputs only and thus the refund of ITC on input services is not eligible for the refund, even though the accumulation could be contributed due to goods or services. This has led to fund flow issues is several industries where accumulation of ITC is primarily due to rate of input services being higher than the rate of output goods or services or both. Naturally, when such accumulated credits beyond utilisation is not being refunded, it leads to cascading effect of taxes.

When such challenges faced by the industry is being presented in the petition to Honourable Gujarat High Court, the court gave a relief in the case of VKC Footsteps India Pvt. Ltd. Vs UOI.

8. VKC – Hon’ble Gujarat High Court decision

Companies pay GST on procurements, consisting of capital goods, inputs i.e., raw materials, consumables etc and input services. The formula that is prescribed in the legislation enables refund of GST paid on inputs only. The dispute centres around whether the formula should have also enabled refund of GST paid on input services.

The key question to be addressed was whether the above section provides a condition to be fulfilled for claiming refund of unutilised input tax credit (including input services), or whether it should be viewed as a restriction, meaning thereby that the refund has to be restricted to inputs only.

The Judgement passed by Gujarat High Court in the case of VKC Footsteps India Pvt Ltd vs. Union of India & Others dated 24.07.2020 (R/Special Civil Application No. 2792 of 2019) is a welcoming decision in favour of suppliers having inverted duty structure.

The following important observations have been made by the Judges:

a) Conjoint reading of the provisions of Act and Rules, it appears that by prescribing the formula in Rule 89(5) of the CGST Rules, 2017 to exclude refund of tax paid on “input service” as part of the refund of unutilised input tax credit is contrary to the provisions of Section 54(3) of the CGST Act, 2017 which provides for claim of refund of “any unutilised input tax credit”.

b) The word “Input tax credit” is defined in Section 2(63) means the credit of input tax. The word “input tax” is defined in Section 2(62), whereas the word “input” is defined in Section 2(59) means any goods other than capital goods and “input service” as per Section 2(60) means any service used or intended to be used by a supplier. Whereas “input tax” as defined in section 2(62) means the tax charged on any supply of goods or services or both made to any registered person. Thus “input” and “input service” are both part of the “input tax” and “input tax credit”.

c) Therefore, as per provision Section 54(3) of the CGST Act, 2017, the legislature has provided that registered person may claim refund of “any unutilised input tax”, therefore, by way of Rule 89(5) of the CGST Rules, 2017, such claim of the refund cannot be restricted only to “input” excluding the “input services” from the purview of “Input tax credit”. Moreover, section 54(3)(ii) also refers to both supply of goods or services and not only supply of goods as per amended Rule 89(5) of the CGST Rules, 2017.

d) In view of the above analysis of the provisions of the Act and Rules keeping in mind objects of the CGST Act, the intent of the Government by framing the Rule restricting the statutory provision cannot be the intent of law to deny the registered person refund of tax paid on ‘input services’ as part of refund of unutilised input tax credit.

9. Contrary  judgement from Madras High Court

Hon’ble Madras High Court, in the case of Tvl. Transtonnelstroy Afcons Joint Venture vs Union of India dated 21.09.2020 (W.P No. 8596 of 2019), contrary to the aforecited judgment of Gujarat High Court, upheld the constitutional validity of Section 54(3). The court also held that Rule 89(5) of the CGST Rules, 2017 is in conformity with the parent statute. Consequently, the Court disallowed refund on input services.

Contentions of the appellant in this case is briefed as below:

a) Section 54(3) allows refund of ITC where ITC is accumulated on account of inverted tax structure.

b) Section 2(63) of the Act defines ITC as credit of Input tax. Similarly, section 2(62) defines ‘Input tax’ to mean tax charged on supply of goods or services or both.

c) Hence, section 54 of the Act does not bar refund on input services.

d )Rule 89(5) of the CGST Rules excludes input services from computation of refund.

e) Taxpayers challenged that Rule 89(5) is ultra vires of Section 54(3) for prescribing restriction on claiming refund on input services.

Whereas, Hon’ble Madras High Court rejected taxpayers’ contentions and held that:

a) Resort should be given to statutory definition of the term ‘input’ as used in Section 54(3), which clearly excludes input services and capital goods.

b) Right of refund is statutory in nature and can only be availed strictly in accordance with the conditions prescribed in law.

c) Rule 89(5) is amended in conformity with Section 54(3) and is intra vires the section.

10. Final Verdict by The Apex Court

When the Hon’ble Supreme Court heard on the contrary views of this matter, it was held that the section does not impose a condition, but provides a restriction. Hence, the meaning of unutilized input tax credit would only include GST paid on inputs. Several other grounds of challenge were argued before the Apex court that the law should be interpreted to ensure equivalence between inputs and input services, and hence such interpretation would be discriminatory between two class of companies etc. But the Court recognised the supreme power of the legislative authority in framing the legislation and did not find merit in circumventing it through judicial process.

However, the Supreme Court agreed that the prescribed formula, which assumes that all output taxes are paid using GST paid on inputs only may not be the appropriate mechanism. It has left it to the wisdom of the GST Council to propose amendments to address this imbalance.

11. Supreme court observation on the formula

The Supreme Court affirmed the Madras HC judgement restricting the refund of unutilized input tax credit only to input goods in cases of inverted duty structure. Accepting the argument put forth by the government, the Supreme Court observed that:

a) The Constitution only guarantees that the levy should be legal and that the collection should be in accordance with law. There is no constitutional right to refund. Refund is always a matter of a statutory prescription and can be regulated by the statute subject to conditions and limitations;

b) The proviso to Section 54(3) is not a condition of eligibility but a restriction which must govern the grant of refund under Section 54(3);

c) The precedents of this Court provide abundant justification for the fundamental principle that a discriminatory provision under tax legislation is not per se invalid. A cause of invalidity arises where equals are treated unequally and unequal are treated as equals. Both under the Constitution and the CGST Act, goods and services and input goods and input services are not treated as one and the same and they are distinct species. 76 Parliament engrafted a provision for refund Section 54(3). In enacting such a provision, Parliament is entitled to make policy choices and adopt appropriate classifications, given the latitude which our constitutional jurisprudence allows it in matters involving tax legislation and to provide for exemptions, concessions and benefits on terms, as it considers appropriate. The consistent line of precedent of this Court emphasises certain basic precepts which govern both judicial review and judicial interpretation of tax legislation. 

d) Clause (ii) of the first proviso is not merely a condition of eligibility for availing of a refund but a substantive restriction under which a refund of unutilized ITC can be availed of only when the accumulation is relatable to an inverted duty structure, namely the tax on input goods being higher than the rate of tax on output supplies. There is therefore no disharmony between Rule 89(5) on the one hand and Section 54(3) particularly Clause (ii) of its first proviso on the other hand.

However, the Court acknowledged the inequities in the formula making a faulty presumption that the output tax payable on supplies of both goods & services have been entirely discharged from the ITC accumulated on account of input goods and there has been no utilisation of the ITC on input services; and observed that:

e) This 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.

f) 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.

Resultantly, the Supreme Court has urged the GST Council to make the necessary policy corrections without them having to overstep into legislative independence.

12. Amended formula & related notification

Pursuant to the aforecited Supreme court direction to correct anomaly in the refund formula for IDS, GST Council in its 47th meeting held on 29^th June 2022 recommended as follows:

Change in formula for calculation of refund under rule 89(5) to take into account utilization of ITC on account of inputs and input services for payment of output tax on inverted rated supplies in the same ratio in which ITC has been availed on inputs and input services during the said tax period. This would help those taxpayers who are availing ITC on input services also.

As per the above recommendation, CBIC vide Notification No. 14/2022-Central Tax dated 05-07-2022 has made an amendment in the formula under Rule 89(5).

Notifications 14/2022 dt 5-July-22 – Formula change:

Old formula:

Amended formula:

13.  Illustration of the impact due to formula change

 –

Net ITC under Rule 89(5) = ITC on inputs = Rs. 1,95,000.

Computation of refund under old formula:

Refund claim amount = (3,750)

Computation of refund under amended formula:

Refund claim amount = Rs. 54,844/-

It can be inferred from the above illustration that the inequity in the formula making a faulty presumption that the output tax payable on supplies of both goods & services have been entirely discharged from the ITC accumulated on account of input goods has been made good and hence when the utilisation is considered pro rata to the input on goods, refund formula under IDS is in line with the intent of law.

It is also pertinent to note that the formula change would be most beneficial for those taxpayers who has credit accumulations due to inward input services and were obtaining lesser or nil refund as per the old formula.

14. Circular on applicability of the formula

With such major change in the formula, naturally the next concern would be on the period of applicability.

Circular No. 181/13/2022-GST dated 10.11.2022 clarifies that the said amendment vide Notification No. 14/2022-Central Tax dated 05-07-2022  is applicable prospectively with effect from 05.07.2022 and would be applicable in respect of refund applications filed on or after 05.07.2022. The refund applications filed before 05.07.2022 will be dealt as per the formula as it existed before the amendment made vide Notification No. 14/2022-Central Tax dated 05-07-2022.

It is pertinent to note that since the circular clarifies applicability of revised refund formula based on date of filing the refund application and hence it can be straight forwardly inferred that irrespective of the ‘relevant period’ for which refund application is being made, the refund can be computed as per the revised formula, as long as the application is being made on or after 5^th July 2022.

Author’s note: In the independent view of the author, the formula change is not due to a decision taken by the GST council to additionally extend the benefit to a larger sector only from a decided date/period; rather a resultant action of the GST council to correct the formula when an anomaly is specifically pointed out by the Supreme Court, since the practical effect of the old formula resulting in certain inequities. Hence, the amended formula is applicable & extendable to any relevant period with retrospective effect from 1^st July 2017, since it is a correction of the anomaly in the erstwhile existing refund formula. Even taxpayers who have already claimed & obtained refund under inverted duty structure as per the old formula can also apply for refund of ITC to the extent of differential claim due to formula change. However, such views or refund claims may not be acceptable by the proper officer sanctioning the refund, who is bound by the circular clarifications and hence such refund claims could be subject to litigations.

15. Time limitation for refund

Refund can be claimed within two years from the relevant date. “Relevant date” means the due date for furnishing of return under section 39 for the period in which such claim for refund arises.

However, Notification No. 13/2022-Central Tax dt. 05.07.2022 excludes the period from 01.03.2020 to 28.02.2022 for computation of period of limitation for filing refund application under section 54 of the said Act. In simple words, the time limit for claiming is extend by another 2 years and is in addition to the two years from relevant date as prescribed in the Act. As an effect of this extension, as of May 2023, taxpayers can claim refund for the relevant period on or after May 2019.

Conclusion:

With the widened scope for obtaining refund under Inverted Duty Structure, businesses can encash the accumulated ITC lying idle in the electronic credit ledger. One has to carefully scrutinize the compliance with all the conditions & restrictions imposed to obtain refund, so as to ensure that legitimate refunds are obtained without any error, since erroneous refund would also result in repayment with interest in the future. Nevertheless, if there is a credit balance lying idle in the ECL, it is high time to explore the possibility of encashing it within all the legitimate ways & means.