Exemption versus Zero rating: Demystifying non-taxable supplies under Goods and Services Tax

 

  1. Immediate Context

A tax issue is currently being the subject-matter of strenuous discussion in the mainstream discourse. It relates to levy of goods and services tax (GST) on Covid-related medicines and equipment. Given the havoc created by the pandemic and the impelling need to make life-saving equipment accessible, the levy of GST upon them is being extensively debated. One suggestion is to exempt these supplies, thereby reducing the tax burden. However, the Government does not appear keen on this suggestion. Then there is another suggestion to make these supplies as zero rated, which has its own dimensions. Given the life-saving value of these equipment, the arguments against levy of tax on them are overwhelmingly emotive, and understandably so. However, to put the debate in proper perspective, a conceptual appreciation of the relevant variables is necessary. In this context, this article attempts to enunciate the significance and consequences of exemption and zero rating in the paradigm of GST laws.

 

  1. Introduction: Appreciating the nuances of a VAT

Conceptually, GST is a value-added tax (VAT). In simplest of terms, when a tax is described a VAT, it implies that the tax is on the value addition. In other words, a person subject to VAT is taxed on the incremental value added by that person. In the context of a manufacturer, the incremental value would be determined by computing the difference between the value of the manufactured output vis-à-vis the value of the inputs used for manufacturing such output. For illustration, where the value of manufactured output is 150 whereas the value of inputs is 100, the value addition is 50 and therefore the VAT would be on 50. In order to ensure that the VAT system remains a tax on value addition, the VAT laws make allowance for taxes on inputs. One of the usual methods to achieve this principle is by allowing “credit” of taxes suffered on inputs. In other words, the VAT paid on the input of 100 would be allowed to the manufacturer as credit towards discharging the VAT on 150. Through this mechanism the manufacturer is kept insulated of the tax liability on inputs.

 

Another variant of the credit mechanism is the “right to deduct” input VAT. Conceptually, in the context of European VAT, it is illustrated by the “fiscal neutrality” principle. This implies that the manufacturer (or any supplier in the value chain) remains “neutral” to the VAT suffered by the inputs and the supplier is called upon to discharge VAT only on the value addition made by it. This principle, apparently simple, is required to be scrupulously observed in order to maintain the sanctity of VAT system. The reason is, inter alia, because (i) the supplier is neutral as regards the VAT suffered on inputs; and (ii) higher VAT on inputs implies higher credit to discharge the VAT on outputs, there is an encouragement to fully report the business dealings and lesser propensity to engage in off-market transactions. This pragmatic aspect assumes significance given that the VAT is generally implemented by way of self-assessment mechanism instead of an officer-led assessment i.e. the determination of the VAT liability is computed by the supplier itself and therefore the collection of appropriate VAT requires a diligent participation of the supplier in the assessment process.

 

  1. Issues with VAT exemption and need for zero rating

A logical corollary of the aforesaid discussion is that where the outputs of a supplier are exempt from VAT, the neutrality is affected in the event the inputs continue to be subject to VAT. This disturbs the equilibrium insofar as ensuring the fullest participation of the supplier in the VAT assessment process is concerned. This is because the supplier continues to pay VAT on the inputs but, because the output is exempt from VAT, the supplier is left stranded with the credit of such VAT paid on inputs. In economic terms, the input VAT becomes “dead cost” to the seller. This situation can brood unwarranted scenarios, such as off-market purchase of inputs (i.e. from the grey economy, which would not require GST) by the supplier. In fact, law reports are replete with instances wherein businesses have superimposed artificial corporate structures in order to minimise the loss of input VAT. The decision[1] of the Grand Chamber (i.e. the Full Court) of the European Court of Justice in Halifax is one of the most celebrated decision which addresses this aspect in great detail from a variety of perspectives, in particular the fact that exemption pushes businesses towards tax avoidance manoeuvres.

 

The essence of the aforesaid discussion is that, for the supplier, exempt supply is an anomaly which increases the cost of the supply. The increase in the cost is equivalent to the VAT suffered on the inputs for making such exempt supply. Let us understand this by way of an illustration. Keeping the numbers same as in earlier example, the value of manufactured output is 150 and the value of inputs is 100. Assuming a consistent 20% VAT rate, the manufacturer would have paid 20 as input VAT (on inputs of 100) and would ordinarily have collected 180 (i.e. 150+20% VAT) from the customer. In this transaction, were VAT payable on the output supply, the manufacturer would have taken credit of 20 and only paid incremental 10 (i.e. 30-20) as VAT to the Government. However, the situation is different as the manufactured output is exempt from VAT. This implies that there is no VAT on 150 to be collected by the manufacturer but simultaneously, the manufacturer is left with a credit of 20 input VAT, which will turn out to be a cost. In other words, the cost of manufacturing increases by 20 in this case. Given that this affects the profitability margin of the manufacturer, pragmatically the manufacturer is likely to increase the price to recover the cost of unutilised input VAT. This implies that the manufactured output may no longer be sold at a price of 150 and instead may be sold at a higher price. Thus, VAT exemption becomes a direct cost for the supplier and an indirect cost to the consumer.

 

The situation of exemption generally arises in case of such goods and services where the public interest element overwhelms the need for revenue collection. For illustration, products which are human necessities, are generally not subjected to VAT. In such situations, VAT exemption may turn counter-productive given that it may lead to increase in the prices. Thus, the very purpose of granting VAT exemption for such supplies may get defeated owing to the innate consequences of such exemption. Zero rating is one method to obviate such a situation.

 

Put simply, zero rating implies a situation wherein the output continues to remain VAT exempt without the supplier losing its right to deduct input VAT. In our example, it would mean that the manufacturer would sell the manufactured output at 150 without charging VAT and will also retain the right to claim deduction of 20 as input VAT. Given that there is no practical way of exercising this right of deduction, the 20 can be recouped to the manufacturer by way of refund, etc. By way of zero rating, therefore, there is no prejudice caused to the supplier or the consumer. However, the Government loses in this process because it is deprived of VAT revenues at two levels. Firstly, it does not collect VAT at the output level (which is exempt) and secondly it refunds back the VAT at the input level (owing to zero rating). Thus, which is natural, Government extends zero-rating benefit to limited situations and it is not as frequent as instances of VAT exemption.

 

  1. Legal framework of zero-rated supplies under GST

With these conceptual dimensions, let us traverse the legal provisions relating to zero rating in India. This is provided for in the Integrated Goods and Services Tax Act, 2017 (IGST Act). Section 16 of the IGST Act provides for “zero-rated supply”.

 

Declaration of zero rating: Sub-section (2) of Section 16 declares the conceptual foundation of zero rating. It provides that “credit of input tax may be availed for making zero-rated supplies, notwithstanding that such supply may be an exempt supply”. Thus, the declaration of zero rating under the GST laws is in line with the commonly understood concept i.e. allowance for credit of input VAT even though the output is exempt.

 

Scope of zero-rated supplies: Sub-section (1) of Section 16 lays down that zero rating under GST laws covers only two classes of supplies, namely, “(a) export of goods or services or both; or (b) supply of goods or services or both to a special economic zone developer or a special economic zone unit”. From this provision it is evident that the zero-rating benefit under the GST laws is not vis-à-vis the nature of the goods or services supplied. Instead, it is tied down to the status of the recipient because the zero-rating benefit is available only for those exempt supplies where the supplier is exporting the supply or making the supply to a SEZ developer/unit. It is noteworthy that under the Special Economic Zones Act, 2005 [Section 2(m)], supply of goods or services within India to a SEZ developer/unit is considered as “export”. Thus, the GST laws grant zero-rating benefit to actual exports and deemed exports by way of supply to SEZ.

 

Effectuating benefit of zero rating: Sub-section (3) of Section 16 gives two options to the supplier to claim benefit of zero rating. In both options, the benefit is granted by way of refund. The difference is only vis-à-vis the stage at which the benefit is availed. In the first option, the supplier can make output supply “without payment of [GST] and claim refund of unutilised input tax credit”. In the second option, the supplier can make the output supply “on payment of [GST] and claim refund of such tax paid on” such output supply. The detailed working of both these options are subject to “conditions, safeguards and procedure as may be prescribed” by way of rules under the GST laws.

 

  1. Significance and Conclusion

 

Zero rating of exports appears to be in line with the avowed policy of the Government that at the time of exports from India taxes should not be exported. Thus, by way of zero rating, the suppliers are recouped with the GST paid by them on the inputs and thereby the cost of the exported supplies does not get affected despite the fact that the exports are not subject to GST and the supplier cannot claim credit of input VAT.

 

At the same time, however, the limited scope of zero rating under GST laws must be realised. Unless the GST laws are amended, no supply made within India (obviously other than one made to SEZ developer/unit) can claim the zero-rating benefit. Thus, lowering GST rates or exemption from GST appear to be the limited option with the policymakers. However, GST exemption presents a vivid possibility that the consumer may face increased prices on account of increase in cost of supplier due to unutilised GST. This becomes a real possibility in most cases except where their inputs are also exempt from GST. In other words, even though the possible permutations and combinations are endless, exemption from GST is invariably not necessarily a good situation for a consumer and instead, in certain cases, a taxable supply may turn out to be a better bargain for a consumer than an exempt supply.

 

To conclude, it is undeniable that zero rating (or the lack of it) has a significant influence on pricing decisions of suppliers and has a direct bearing on the prices consumers pay. Furthermore, it is notable that the consumer cannot know the situation of the supplier because in neither case (i.e. exemption or zero rating) GST is not charged upon the supply received by the consumer. Nonetheless, even though the consumer cannot directly perceive the effects of zero rating upon the supplier, the indirect impact of zero rating is significant on the consumer as it is very likely that in case of an exemption (unlike zero rating) the impact of unutilised input VAT may be built in the price by the supplier.

 

Coming back to the immediate context, under the current GST framework, zero rating of domestically sold medicines and equipment is not legally permitted. Thus, exemption versus taxability appear to be the only binary choices. Given that the effect of exemption and the building up of input VAT in the price is each supplier’s decision, conceptually there are relative merits in both policy choices (i.e. exemption or taxability) but the net impact to the consumer would depend upon the decision of the supplier whether (or not) to absorb the cost of unutilised input.

 


†Tarun Jain, Advocate, Supreme Court of India; LLM (Taxation), London School of Economics.

[1] Halifax plc v. Customs and Excise Commrs. (C-255/02) ECLI:EU:C:2006:121, 2006 Ch 387 : (2006) 2 WLR 905, available at <HERE>.

Join the discussion

Your email address will not be published.

This site uses Akismet to reduce spam. Learn how your comment data is processed.