CA Dr Arpit Haldia
In the previous article, it was discussed in detail that what is meant by Principle of Destination and Origin Based Taxation and how they work. In this article I would dwell upon another key aspect of taxation i.e. Principle of Neutrality in Taxation. This principle is one of the key foundation principles alongwith the concept of destination based taxation upon which Goods and Services Tax has been implemented around the world.
The Report by Dr Amaresh Bagchi commonly referred to as Bagchi Report on “Reform of Domestic Trade Taxes in India: Issues and Options”, published by National Institute of Public Finance and Policy in 1994 stated that
“If the ills of the present system are to be remedied, the problems have to be attacked at their roots and not by symptoms. The guiding principles should be neutrality, simplicity and equity.”
If we observe the above comment, fact highlighted is that the evils of the system of taxation prevailing at that time could have been remedied by application of three principles, one out of which was principle of neutrality.
The report further went on to provide the negatives of not having principle of neutrality of taxation embedded in the taxation structure as follows:
“This lack of neutrality in the application of tax creates distortions in production and distribution channels, and creates inequities in the application of tax to competing firms. Such distortions and inequities force even otherwise honest dealers to resort to activities that are unethical or in contravention of the law.”
A very interesting example was quoted in the report to showcase how unethical activities are resorted for the claim of exemption which results in inequalities:
“In the case of exemptions granted to new manufacturing units, the exempt units set up in one State move to another on the expiry of the tax holiday. As used machinery bought from outside the State is regarded as new investment for purposes of the exemption, they are able to extend the exemption period through relocation to another State.”
The fact highlighted above was that the lack of neutrality in taxation provides distortions in production and distribution channels and creates inequalities amongst the competing firms which force them to adopt unethical practices.
Below are few of the hypothetical examples of inequalities being created amongst competing firms through taxation structure and tax having a primary influence on the decision of the both businessman and the consumer as well:
a) Supposedly, Tax on laptop is 5% and desktop computer is 14.5%. As both are very close substitutes of each other, it would be resulting in people preferring to purchase laptop than desktop computer and therefore as a result people would be more inclined towards investing in businesses engaged in producing laptops than desktop computers.
b) Supposedly, services obtained from a service provider in India is charged with tax at the rate of 14% and same services procured from a service provider outside India, is not chargeable to tax in India. It would then create a proposition wherein people would avail services from outside India rather than from a service provider in India.
c) Excise duty is leviable on Manufacture and is calculated as percentage of cost of manufacturing. It however does not include distribution margins of the distributors like Wholesaler, Retailer etc. Therefore products which have a high distribution margin have relatively low incidence of Excise Duty as percentage of selling price of the product as compared to the products wherein cost of production is high and distribution margin is low, thereby having higher incidence of Excise Duty as percentage of selling price of the product.
It has been further highlighted in the Bagchi Report on “Reform of Domestic Trade Taxes in India: Issues and Options”, published by National Institute of Public Finance and Policy in 1994 as follows:
“As noted earlier, a tax that steps at intermediate stages of trade will not be uniform in its impact on different goods and services because of differences in their pattern of production and distribution.”
This forms significant part of the cost and leads to distortion and inequality as excise duty paid by the distributor at the time of purchase of goods from the manufacturers is not allowed as credit against the tax liability arising at the time of selling of goods to the consumers and therefore higher the incidence of excise duty as percentage of the selling price more would be the inequality and distortion.
d) A transaction of sale of goods against C form, on principal to principal basis in the course of Inter- state trade or commerce would result in a levy of 2% Central Sales Tax each time the goods are sold in the course of Inter-State Trade or Commerce without any credit being available of the taxes paid earlier.
“Reform of Domestic Trade Taxes in India: Issues and Options”, published by National Institute of Public Finance and Policy in 1994 provided that
“Since the CST is leviable on each inter-State sale of goods, regardless of the application of the tax at prior stages, when the goods go through a chain of purchase and resale in several States, the tax cascades in a manner similar to a multistage turnover tax. For example, if a Karnataka dealer imports paper from Maharashtra and then resells it to a dealer in Tamil Nadu, the CST would apply twice, for a total burden of 8 per cent. Obviously, this becomes a handicap for the Karnataka dealer, compared with one who can arrange a sale directly from Maharashtra to Tamil Nadu.”
It has to be noted that the tax rate against C form in CST at that time was 4% as against present rate of 2%.
However, if the transaction is on principal to agent basis against F Form, then in such case there is no levy of Central Sales Tax. The dealers are therefore inclined towards integration of forward vertical chain and to shorten the distribution channel and open a direct outlet or branch of its own or appoint an agent to reduce the burden of taxes. Going one step ahead, such indifferent treatment results in dealers engaging themselves in dishonest practices and appointing agents on documents just to avoid the 2% Central Sales Tax.
“Reform of Domestic Trade Taxes in India: Issues and Options”, published by National Institute of Public Finance and Policy in 1994 provides that
“A simple and widely practised way is to camouflage inter-State sale of goods as transfer on consignment, or a depot or branch transfer. While there is no firm estimate of how much of the products of one State goes out in the form of consignment, it is widely believed that the volume is sizeable and in some cases (like pharmaceutical products of Maharashtra) the proportion is said to be as high as 80 per cent. According to knowledgeable persons, on an average, not less than 50 per cent of the inter-State movements of goods go as “consignment” transfers some of which, of course, could be genuine intra-firm transfer.”
Therefore such instances though not exhaustive and only illustrative lead to inconsistency in the taxation regime and thereby leading to a scenario where tax considerations affect the decision of the Investors in the business and also the consumers.
♠ What is principle of Neutrality?
Principle of Neutrality in taxation is a scenario wherein decision of Investor and the consumer are both neutral and devoid of tax considerations creating inequalities and secondly price of the product does not include tax as part of cost thereby avoiding cascading effect until the product reaches the final consumer.
a) The Report by Dr Amaresh Bagchi commonly referred to as Bagchi Report on “Reform of Domestic Trade Taxes in India: Issues and Options”, National Institute of Public Finance and Policy, New Delhi issued in the year 1994 stated
“The greatest virtue of VAT lies in its neutrality, that is, non-interference with the choices of decisions of economic agents and equal treatment of products, producers and consumers. Because of its anti-cascading effect, the number of times a product is traded before reaching the final consumer or how much of the value is added at what stage in the production-distribution process are of no consequence under a VAT. It is also neutral regarding choice of production technique as well as business organisation. Other things remaining the same, the tax liability does not vary as between corporate and non-corporate entities, or between integrated or specialised units.”
b) “Working Paper GST Reforms and Intergovernmental Considerations in India” for the Department of Economic Affairs Ministry of Finance, Government of India released in the month of March 2009 provided that
“The neutrality principle would suggest that:
- the tax be a uniform percentage of the final retail price of a product, regardless of the supply-chain arrangements for its manufacturing and distribution;
- the tax on inputs be fully creditable to avoid tax cascading; and
- the tax be levied on the basis of the destination principle, with all of the tax on a given product/service accruing in the jurisdiction of its final consumption.”
c) In the International VAT/GST Guidelines on neutrality issued by OECD (Organisation For Economic Co-Operation And Development) on 28 June 2011,
“The full right to deduct input tax through the supply chain, except by the final consumer, ensures the neutrality of the tax, whatever the nature of the product, the structure of the distribution chain and the technical means used for its delivery (retail stores, physical delivery, Internet).”
♠ How does the Principle of Neutrality Works:
⊗ Uniform percentage of Tax Rate on final retail price of the product and close substitutes should not be taxed at very different rates: There should be uniform percentage of Tax on final retail price of the product so that the complexities can be reduced for the taxpayers and it would also be easy to monitor for the government. This would also result in uniform incidence of tax on products and consumer choices not being influenced by the tax.
“Working Paper GST Reforms and Intergovernmental Considerations in India” for the Department of Economic Affairs Ministry of Finance, Government of India released in the month of March 2009 provided that
“In particular, it is important from an administrative perspective that close substitutes should not be taxed at very different rates—to avoid leakages and distortions.”
At the outset, it has to be observed that the above reference is about close substitutes and not perfect substitutes. The term close substitutes covers broader category than perfect substitutes.
There should be similar taxability of close substitutes. Tax consideration should not distort the mind of the consumers. The decision of the consumer in a price sensitive market is motivated by the most competitive price amongst similar products. The price under unequal tax regime is in turn affected by tax policy measures. The government unless intending otherwise, unknowingly through non-uniform taxes on close substitutes create market condition in favour or against a particular product.
Therefore, the decision between two close substitutes by the consumer should be neutral of tax effect and should be based upon quality and other considerations. For eg. if two close substitutes are charged at different tax rates, there would be an inclination in the mind of the consumer for the product having lower tax rate.
⊗ The definitions can also be understood with the help of the following three basic neutrality principles laid down in International VAT/GST Guidelines on neutrality issued by OECD (Organization For Economic Co-Operation And Development) on 28 June 2011:
a) “The burden of value added taxes themselves should not lie on taxable businesses except where explicitly provided for in legislation.”
The report provides that
“In domestic trade, tax neutrality is achieved in principle by the multi-stage payment system: each business pays VAT to its providers on its inputs and receives VAT from its customers on its outputs. To ensure that the “right” amount of tax is remitted to tax authorities, input VAT incurred by each business is offset against its output VAT, resulting in a liability to pay the net amount or balance of those two. This means that VAT normally “flows through the business” to tax the final consumers. It is therefore important that at each stage, the supplier be entitled to a full right of deduction of input tax, so that the tax burden eventually rests on the final consumer rather than on the intermediaries in the supply chain.
This principle can be understood on the basis of following factors:
- There should be full right available to the taxable businesses to deduct Input Tax throughout the supply chain to avoid cascading effect of taxes: To ensure neutrality of taxation, taxes should never form part of the cost and any taxes paid should be allowed as credit against the output liability during the course of entire supply chain until the product reaches the final consumer. Tax paid should be a complete pass through in the supply chain of taxable businesses unless specifically provided by law and except for the end customer.
In other words, taxable businesses should not burden their products with the cost of tax not allowed as credit. The right to claim credit of the input tax paid should be available to all taxable businesses unless specifically provided by the law and except to the end consumer.
- The right to deduct the input taxes should be available irrespective of the
i. Nature of product
ii. Structure of distribution chain
iii. Technical means used for delivery (retail stores, physical delivery, Internet)
There should be no barrier in the right to avail credit of the taxes paid by the taxable businesses irrespective of Nature of Product (not being a product exempted from levy of tax), structure of distribution chain i.e. retailer, wholesaler or direct selling office of the company and technical means used for delivery i.e. physical or purchased from a retail store or purchased online.
- Due to the anti-cascading effect, the number of times a product is traded before reaching the final consumer or how much of the value is added at what stage in the production-distribution process are of no consequence under a VAT:
The tax does not have a cascading effect, therefore each business whether producer or distributor pays tax in proportion to the value added by them after deducting the input tax paid by them from the tax collected by them and tax sticks as a cost to the product to the end consumer only.
In other words, tax is never added to the cost of the product even if the products are traded multiple times before reaching to the final consumer as all taxes paid in supply chain are allowed as credit and no taxes form part of the cost until it reaches to the final consumer thereby avoiding cascading effect i.e. tax on tax.
Therefore, inconsistency arising from lower incidence of Excise duty as percentage of selling price on products having high distribution margin as compared to products having lower distribution margin or levy of CST on multiple sale of same goods during the course of Inter-State Trade or Commerce without credit being available would not be a factor as all taxes paid would be allowed as credit to business other than final consumer.
- Other things remaining the same, the tax liability does not vary as between corporate and non-corporate entities, or between integrated or specialized units.
The tax incidence in both scenarios i.e. wherein particular manufacturing process is outsourced to specialized unit or wherein there is backward vertical integration of the entire manufacturing process, would be tax neutral. Further, neutral would be the result of tax incidence in a scenario wherein the company may decide to open its own retail outlet resulting in forward vertical integration or may decide to sale the product to another person on principal to principal basis.
There would be no saving in terms of taxes other things remaining the same as there would be no cascading effect of taxes and all taxes levied at procurement stage are allowed as credit to the purchaser and tax only sticks to the cost to the end consumer only.
b) Businesses in similar situations carrying out similar transactions should be subject to similar levels of taxation.
International VAT/GST Guidelines on neutrality issued by OECD (Organisation For Economic Co-Operation And Development) on 28 June 2011 provide that:
“Taxation should seek to be neutral and equitable between forms of commerce. Business decisions should be motivated by economic rather than tax considerations. Businesses in similar situations carrying out similar transactions should be subject to similar levels of taxation;”
This provides that the tax administration should not discriminate between two similar businesses. Similar Businesses carrying out similar transactions in similar situations should be taxed similarly.
- Meaning of Similar Level of Taxation: Businesses with similar levels of taxation means the final burden of tax taking into account all available refunds and credits.
- Meaning of Similar Business: The two business would be similar business on the basis of use of inputs for supporting the taxable activity and related right to deduct the input tax credit. The right to deduct input tax from output liability should be determined with reference to the right; two businesses have with regard to the availment of credit of the taxes paid by them on inputs used by them to support its taxable activities.
Similar Businesses would not be restricted only to similar Industries. The two businesses would not be similar businesses if one is carrying out taxable business activity and other one is carrying out exempted activity.
- Meaning of Similar Transaction: Similar Transactions would be based upon characterization of supply under the law. Once the characterization of the supply has been determined, then the source or terms of supply etc. should not be relevant.
- Example of the given Scenario: A simple example can be supposedly two Manufacturers are purchasing new machinery for manufacturing of taxable goods. One Business is a newly established entity and other business is an old business. The credit of the tax paid on machinery is allowed to the new entity and no credit is allowed to the old entity.
This would lead to similar business i.e. manufacturer of a taxable commodity carrying out similar transaction i.e. purchasing of capital goods not being taxed similarly i.e. newly established entity being allowed credit of the tax paid and old entity not being allowed credit of the tax paid on purchase of machinery.
Thereby, the entity established earlier would be facing higher incidence of tax and cascading effect on the taxes paid by them on the purchase of capital goods as compared to the entity newly established.
The Taxation structure should not discriminate between similar businesses carrying out similar transaction else it would lead to inclination of the investor to the business towards the business with lower tax incidence.
c) VAT rules should be framed in such a way that they are not the primary influence on business decisions.
The decision of the business should be primarily based upon economics rather than tax considerations. The decision whether to set up a permanent establishment, to open a branch, backward or forward vertical integration of the business etc. should be primarily based upon dynamics and economics of the business rather than the VAT Rules of the business.
A simple example has been provided in the report as follows:
“For example, in situations where foreign businesses are advantaged compared to domestic businesses in respect of the level of taxation (which is inconsistent with Guideline 2.4), a foreign business may change the decision it would otherwise make primarily in order to take advantage of this treatment. Thus, a business may decide to operate from offshore rather than in the domestic jurisdiction.”
This would not be covering cases where decision of business are governed by taxation of two different products having different tax status or where the business decision opts to take advantage of simpler taxation provisions for small business firms etc.
♠ Conclusion: How GST in India could follow the principal of Neutrality in Taxation:
With the Implementation of GST, Principle of Neutrality in Taxation should come into the framework and without the basic principles of Neutrality being incorporated in the statute; benefits of implementation of GST may not be reaped in fully by the stakeholders i.e. businesses, consumers and government.
If we have to summarize that how principal of neutrality should be incorporated in Implementation of GST in India as detailed provisions for Input Tax Credit and Levy of Taxes are yet to be brought in public domain, we can highlight following considerations:
a) Tax should be sought to be levied on the entire supply chain i.e. right from the starting to the end point of reaching to the consumer. It should not be a tax which is levied for the first time at an intermediary stage.
b) Tax Structure should contain minimum exemptions and should be broad based so that there is no cascading effect of tax being levied on tax again.
c) Tax levied should be a complete pass through during the entire supply chain and should not form part of the cost at any point until it reaches the final consumer.
d) Tax should be levied on a uniform basis without discriminating in any way i.e. between two close substitutes, businesses etc unless intended specifically.
e) Tax should be levied on the principle of destination based taxation wherein the tax revenue accrues to the jurisdiction wherein the goods or services are finally consumed. Any tax being levied or collected at origin or intermediary stage should be allowed as credit to the taxable business so that tax does not form part of the cost of the product until it reaches to the final consumer of the consumption state.
⊗ Levy of Additional Tax @ 1%:-How Far Neutral: The Levy of the proposed Additional Tax in GST at the rate of 1% on Inter State Supply of goods is against the very basis of principle of neutrality of taxation and should be avoided as it would lead to inheriting all the weaknesses of the present system as mentioned earlier in the article being caused due to the levy of Central Sales Tax.
Note from the Author: In the Next Article, I would dwell upon the principle of Reverse Charge Mechanism and how the same becomes the very core for Implementation of Goods and Services Tax.
This series of articles on Goods and Services Tax would be an effort to put forward a detailed view of the subject. The series would make an effort to analyze the intricacies and details about Goods and Services Tax. It would be an effort to narrate the issue to have an understanding on the subject.