JULY 23, 2022

By Shailesh Sheth,Advocate, M/s. SPS Legal

c. A plethora of exemptions- A distorting and disruptive element!

We, Indian taxpayers have a perennial love for tax exemptions! This love for tax breaks stems more out of an inborn allergy to payment of tax rather than any pragmatic and practical considerations justifying the need for tax breaks.  Unfortunately, the canvasof the country's tax regime - be it Direct Tax or Indirect Tax - has always remained daubed with a plethora of exemptions, a large number of which were either unjustified in the first instance or have outlived their utility. In a developing country like India, where the 'tax base' is already too narrow, the grant of tax exemptions should, at least reflect pragmatism, serious application of mind and comprehensive consideration of all relevant aspects and not adhoc -ism and arbitrariness.

However, ironical as it may seem, the 'exemption ills' that had plagued the erstwhile Central Excise and Service Tax regime, have continued to afflict the GST regime as well! If one hoped that GST will witness a bare minimum of exemptions considering the fact that the avoidance of 'cascading effect of tax' is its principal objective, such hopes were truly belied! A cursory glance at notification nos. 11/2017-CT(Rate) and 12/2017-CT(Rate) both dated June 28, 2017 granting exemption, full or partial, and conditionally or unconditionally to the supply of specified services will show how this main objective of the GST has taken a backseat!

Basically, in practice, there are three ways in which exemptions and zero rating can be justified. First, there are exemptions that may be designed to improve, rightly or wrongly, the progressivity of VAT. Second, there are those goods and services that are in Musgrave's terminology so "meritorious" that they may deserve to be tax free. Third, some goods and services are just too difficult to tax and administratively it is common sense not to try to tax them. Some goods could be justified under all three headings; for instance, farmers are difficult to tax, the food they produce can be considered meritorious, and exemption of food may improve the progressivity of a sales tax. [Allan Tait, 1988 ].

While exemption notifications under tax legislations including the GST legislation are always issued or deemed to have been issued in the 'public interest' with an aim to sub-serve the economic policy of the Government, such exemptions lead to many adverse and harmful consequences, particularly in the case of an indirect tax like GST.

Some of these harmful effects are briefly explained below:

- When exemptions are granted without ITC benefit, they create distortions in the tax system by breaking the 'credit chain'. An exemption occurs when output is untaxed but input tax is not recoverable. It is thus an aberration in terms of the basic logic of VAT. This idiosyncrasy is aptly captured in the following words:

"The VAT is a paradox: (using the credit method) the VAT is a tax in which those who believe themselves exempt are taxed, and those who believe themselves taxed, are generally exempt. This is not valid at the retail level; a retailer who believes he is exempt is nevertheless taxed, and indeed taxed, when subject to taxation. Whoever grasps the meaning of this, will not have any trouble understanding VAT." [Reugebrink&Hilten, 1997]

- Exemption breaks the VAT chain. Whether this increases or decreases the net revenue raised by the VAT depends where in the chain of supply the break occurs; [Ebrill, Keen,Bodin& Summers (2001)]

- Exemption also distorts the production choices that a firm may make. Not only this, the effect of the exemption may not remain confined to the sector exempted but may go much beyond that, affecting the users who use the exempted supply as 'input' and thus making the entire system quite opaque;

- Exemption incentivizes 'insourcing' or 'self-supply', something which GST, as a tax policy aims to discourage;

- Where a taxpayer is engaged in both, taxable and exempted supply, he will face complications of reversal of proportionate ITC on common inputs/input services and consequential litigation;

- Moreover, exemptions often result in interpretational disputes as the taxpayers and the tax officers forever remain at loggerheads with each other, with the former strenuously claiming the exemption as their 'birth right' and the latter zealously guarding the 'Revenue' by denying that right on any and every pretext!

There are many other harmful effects of these exemptions but only a few are highlighted here. A fact that is often lost sight of by all is that the exemption, in the long run, does not benefit anyone, neither the recipient of the exemption nor the consumer nor the Government. Moreover, when the decision on the grant of exemption is driven, not by economic logic, but more by public perception and political patronage (as is often the case), the consequences can only be disastrous in the long run! Only one example is enough. Healthcare services have always been considered sacrosanct and essential for the welfare of the people at large. So it has always been considered rational and reasonable to exempt such services (barring a couple of exceptions) from the levy of indirect tax so as to ensure that the patients' cost of healthcare is not increased. Thus, these services were always exempted under the erstwhile service tax regime and continue to remain exempt under GST as well. However, has this exemption really served its purpose? Hospitals and other clinical establishments pay crores of rupees by way of GST on their taxable inward supplies like medicines, instruments, manpower, housekeeping, maintenance, costly machines, etc. However,they are simply not able to take the ITC of such tax paid by them since their outward supply of healthcare service is exempted. Thus, a huge amount of tax, which otherwise should have been available as ITC to the sector, goes down the drain merely because we have not yet come out of that age old notion that 'one can't tax the healthcare services as it will be a burden on the patient!' Let us also remember that the tax (GST) that is being paid by the sector and of which it is unable to take the ITC represents its working capital and becomes a drag on its finances! Needless to say, the tax paid by the sector on various inward supplies then becomes a cost which, one way or other,finds its way into the medical bill thrust on the patient!

There are many other sectors (for instance, education) which also suffer! Instead, can't a nominal rate of tax with ITC benefit be prescribed for such sectors with close monitoring over the prices? But who will bell the cat?

Be that as it may, it is now imperative that the Council takes a serious relook at the plethora of exemptions ruling the GST regime at present. The large list of exemptions has already eroded the base of GST and it is important (to) revisit the list to broaden the tax base.[Rao, 2019]. The Council, after considering all aspects, must withdraw, boldly and ruthlessly, as many exemptions as possible and restore the ITC chain. No doubt, there will be a predictable hue and cry, mass protest and intense lobbying in some cases against such a move, but that is to be expected. The point is how pragmatically, rationally, reasonably, deftly and convincingly the Council makes its moves to withdraw unjustified exemptions!

It is heartening to note that an exercise to prune the exemptions appears to have seriously begun with significant recommendations made by the Council at its 47th Meeting and since then implemented by a slew of notifications issued.

Though there is a long way to go, at least, a beginning appears to have been made!

d. Exemption threshold - 'Still searching for the right mix!'

"One of the most important decisions to be taken in designing a value-added tax (VAT) is the threshold level of turnover above which firms are required to charge VAT on their outputs (and entitled to reclaim tax on their inputs). Too high a threshold compromises the basic objective of raising revenue; too low a threshold may leave the authorities overwhelmed by the difficulties of implementation and impose excessive compliance costs on taxpayers. The design problem is further complicated, moreover, by the distortion of competition associated with the differential tax treatment of firms above and below the threshold." [Keen and Mintz (2004)].

Prior to April, 2019, the threshold exemption limit recommended by the Council was very low at Rs. 20 lakhs which was same for both, goods and services. However, a lower threshold limit of Rs. 10 lakhs had been prescribed for the special category States of Manipur, Mizoram, Nagaland and Tripura. It is now clear that such a low threshold was at the insistence of the States and this was yet another costly compromise the Centre had made to bring the States on board with GST. It is interesting to note that in its 'Report on the Revenue Neutral Rate and Structure of Rates for the Goods and Services Tax(GST)' released in December, 2015, the Committee led by Dr. Arvind Subramanian, the then Chief Economic Advisor to Government of India had favoured a high threshold of Rs.40 lakhs.

Fortunately, however, it was soon realised that the above exemption thresholds were too low and impractical.  The Council, at its 32 nd Meeting held on 10.01.2019, then recommended a raise in the threshold exemption limit interestingly to the level as originally suggested by the Subramanian Committee albeit, restricting it to 'goods',and also made some other significant recommendations in this regard.  The recommendations have since then been implemented w.e.f. April 01, 2019 and it is not necessary to go into the details thereof here. What we are witnessing on the 'threshold front' since then is, however, something weird! We now have different thresholds for goods and services, multiple thresholds for different States, optional thresholds for specified states and so on and so forth!

This complex structure of 'threshold exemption' raises many issues which are briefly discussed below:

Are the existing threshold limits adequate?

The Council's decision to raise the exemption threshold was certainly a step in the right direction as the global empirical evidence emphatically shows that a lower threshold means higher compliance costs for the small businesses and no revenue gain for the exchequer. The low threshold limit also forces the Revenue to grapple with administrative nightmares and galloping collection costs. As Keen and Mintz (2004) show, the threshold should be chosen to balance the collection cost with marginal revenue gains. While arguing in favour of a higher VAT threshold, the authors observe that even if some revenue is lost by dropping small taxpayers, the administration can be freed to make greater effort on those who can contribute more.

In fact, the experience suggests that many countries have tended to set the threshold too low, putting themselves in considerable difficulty when their tax administration is found to be insufficiently developed to administer a large VAT population. Indeed, in both Ghana and Malta an initially low threshold was one of the primary reasons for the failure of their first VAT. [International Tax Dialogue, 2005 ]. The international experience also shows that high thresholds are also important for equity because the consumption of the poor largely comprises purchases from small traders. [Rao, 2011]. A common rule of thumb is that 80 per cent of the tax is collected from 20 per cent of the taxable firms. In other words, it is not worth the cost in dealing with hundreds of thousands of small businesses that contribute very little to revenue. In any case, over time, inflation would erode the size of the threshold. [Cnossen,2012]

So as [Rao, 2019] suggests, the GST Council should revisit the issue to have a proper threshold after analyzing the turnover range wise: number of taxpayers, their turnovers and tax paid at each stage. It is possible to devise a policing system to minimize the misuse of the threshold by mining data from the returns. Furthermore, in GST, it does not make sense to have separate thresholds for goods and services. A common threshold limit of Rs. 50 lakhs for goods and services as suggested by [Rao, 2011] seems ideal and reasonable in the Indian context. Insofar as the North-eastern States and other Special Category States are concerned, the Council must look for some imaginative, innovative and practical solution which not only secures their financial autonomy but also passes the legal test.

Are different thresholds for goods and services and multiple thresholds for the States Constitutionally valid?

Aside from the thorny issue of deciding an ideal 'threshold exemption limit', the Council may have to seriously consider the issue of the Constitutional validity of the different threshold limits prescribed for goods and services and also of the multiple threshold limits prescribed for different States. Whatever may be the compulsion and practical considerations that might have prompted these decisions, their Constitutional validity remains susceptible to challenge. The Council cannot ignore this serious and complex issue.

Article 279A of the Constitution of India [as amended by the Constitution (101st Amendment) Act, 2016] contains comprehensive provisions providing for the constitution of the GST Council, its composition, the matters on which the Council may make its recommendations, the Council's functioning, the weightage of the vote of its constituents and such other matters. Clause (4) of Article 279A empowers the Council to make its recommendations on the various matters enumerated therein. Sub-clause (d) of clause (4), as is relevant for the present discussion reads as under:

"(4) The Goods and Services Tax Council shall make recommendations to the Union and the States on -

……. ….
……. ….
(d) the threshold limit of turnover below which goods and services may be exempted from goods and services tax".

[Emphasis provided] 

A careful reading of sub-clause (d) and the highlighted words "goods and services" will make it evident that there cannot be different threshold exemption limits for goods and services and the council is not empowered to set such limits. The word 'and' used as a conjunction joining the two words 'goods' and 'services' makes this amply clear. Applying the golden principle of Interpretation, there is no reason to read 'and' as 'or' here as the lawmakers certainly never intended to have different threshold limits for goods and services.

Moreover, the use of the expression 'the threshold limit' in the sub-clause (d) also signifies that the Council cannot prescribe varying threshold limits for different States depending upon their economic status. Sub-clause (d) of clause (4) simply does not empower the Council to prescribe such multiple threshold exemption limits whatever may be the compulsion and justification.

The above are serious Constitutional issues and the Council will do well to seriously deliberate upon it and initiate corrective action as deemed necessary before the issue turns into an ugly Constitutional fight one day! The Council must also appreciate that the varying threshold exemption limits for goods and services and multiple threshold exemption limits are detrimental to uniformity, neutrality, clarity and consistency, and breed complexities, tax evasion and litigation.
 
In the end, while a common higher threshold exemption limit for goods and services is legally inevitable and extremely desirable, it is equally essential that GST laws and their implementation should be such as would entice and encourage even small businesses, otherwise entitled to an exemption, to forgo the exemption and embrace the tax net willingly so as to be a part of an uninterrupted, seamless credit chain, instead of wasting its time, money and energy in forever devising new 'ways and means' to escape the tax net ! After all, as a country, what should we be looking for - 'willing taxpayers' or 'unwilling tax-avoiders'?

As Keen and Mintz [2004] caution:

"The issues at stake in setting the threshold for a value added tax are important - experience shows indeed, that they can be critical to the success or failure of the tax - and their neglect has been unfortunate."

"There are times, too, when the law doesn't give a damn who gets caught beneath its wheels".
[Susanne Alleyn]

[To be continued…]

Read Part I & Part II

References:

1. Cnossen, Sijbren, 'Will true GST ever come to India?' [February,2012]

2. Ebrill,Liam, Keen Michael, Bodin Jean-Paul and Summers Victoria - 'The Modern VAT' - IMF, 2001 (p-85)

3. Keen, Michael and Jack Mintz (2004)- 'The Optimal Threshold for a Value-added Tax', Journal of Public Economics, 88 (3/4)

4. Rao, M. Govinda (2011), 'Goods and Services Tax: Is it a Gorilla, Chimpanzee or a Genus Like Primate?' - Economic and Political Weekly, Vol XIVI no.7

5. Rao, M. Govinda - 'Goods and Services Tax in India: Progress, Performance & Prospects' - (Working Paper No. 2019-02); Columbia/SIPA

6. Reugebrink J./M.E.VanHilten, Omzetbelasting -Deventer 1997, p.40

7. Tait, Allan - 'Value Added Tax, International practice and problem'. IMF 1988

8. 'The Value Added Tax- Experiences and Issues' - A Background Paper prepared for the International Tax Dialogue Conference on VAT [ March,2005].

[The views expressed are strictly personal.]