This New Year has ushered in an exciting set of events on the public policy front in India, with the nation signing or agreeing to free trade agreements (FTAs) with the European Union and the United States, alongside the annual Budget unveiling a host of new policies and promises. These developments have coincided with heightened geopolitical volatility, disrupted global supply chains, and persistent geoeconomic headwinds. In a tough negotiating climate marked by strong geopolitical developments, the FTAs have brought a sense of relief to exporters by promising greater market access and lower tariffs. At the same time, ongoing global uncertainties continue to impact trade flows, logistics costs, and investment decisions. The Indian market is now set for more aggressive competition as tariff barriers are lowered and the competitiveness of Indian goods is tested.
Impact of GST Credit Accumulation on Manufacturing
Accumulated GST credits represent locked capital at a time when manufacturers require liquidity and agility. As India opens its markets through FTAs, domestic cost structures—especially those linked to GST credit accumulation—become even more critical to ensure a level playing field. GST has been one of the biggest economic reforms of this century and continues to evolve into an efficient indirect tax structure for the country. The recent rate rationalization, dubbed GST 2.0, has brought major changes by reducing the four-rate structure of GST to effectively a two-rate structure of 5% and 18%, doing away with the rates of 12% and 28%. It is expected that this will boost demand in the country, leading to growth and competitiveness.
Inverted Duty Structure and Its Consequences
Globally, in most mature VAT jurisdictions, a single standard rate is the applicable rate on most goods and services, with little deviation and minimal exemptions. The Indian GST structure now consists of most services and capital goods at 18%, while most finished goods of an essential nature used by common households are at 5%. Given the substantial difference in rates, inversion of duties is inevitable, and accumulation of credit is an expected by-product. The accumulation of credit leads to a reduction in the ability to recover credit input in the supply chain, along with an interest cost due to cash flow disruption, which increases the effective rate of GST. Depending on the business model, this increase in effective GST rate can vary from 2-5% of the overall cost or even more, bringing domestically manufactured essential goods nearer to an 8% rate.
The impact of this inversion also means that any new capital investment for goods manufactured in India and taxed at 5% GST will lead to the capital cost being higher by 18%, the GST rate on the capital asset being purchased. This occurs because there is no leeway to utilize the credit of the capital goods purchased due to existing accumulated input credits from the already inverted duty structure. Consequently, the capital cost of any manufacturing investment goes up, and hence the cost of the product being manufactured will be higher in India. A similar product when imported does not have such an inbuilt cost of credit accumulation over and above the IGST levied at the time of import. This puts Indian manufactured products at a disadvantage compared to those manufactured in other countries. Therefore, this issue requires resolution for continued investment inflow and the success of Make in India.
Short-Term Measures and Refund Solutions
As the appetite for any big reforms will return once the results of GST 2.0 are evident, short-term measures to solve the inverted duty structure will revolve around providing a refund of the accumulated credit. The current law also provides for a refund of accumulated credit in cases of inverted duty structure; however, eligibility is limited to inversion occurring due to rates of input goods being higher than rates on finished goods and services. Even if eligible, the refund itself is limited to the accumulation of credit on account of GST paid on input goods only. This leaves out a major part of the accumulated credits for most eligible companies.
The solution lies in including GST paid on input services and capital goods for inverted duty refunds. The total refund on capital goods may be linked to depreciation in a year. The eligibility for such refunds should also not differentiate between goods and services while evaluating whether the rate of inputs is higher than the rate of output supply.
Freeing Blocked Capital
The accumulated credit in a company is blocked capital, and freeing it will reduce costs and also increase competitiveness and investment. If these accumulated credits are refunded, they should not be seen as a revenue outflow for the government, since the government is spending an equivalent amount to boost the manufacturing of these goods in India. Since refunds of these accumulated credits improve the competitiveness of products in Indian and global markets, the GST Council needs to build in a solution for refunding all accumulated credits at the end of the year if accumulation is sustained over at least two years.
The rationalization of the credit mechanism and providing for refund of accumulated credit is a must for goods to genuinely compete in global markets. Measuring these changes based on short-term revenue losses will only harm companies. While imports will generate as much revenue, allowing refund of accumulated Input Tax Credit (ITC) to the industry will accelerate the 'Make in India' story.
(The author, Bipin Sapra, is Tax Partner at EY India. Views are personal.)
