FEBRUARY 19, 2025

By M G Kodandaram, IRS. Assistant Director (Retd) ADVOCATE and CONSULTANT

Need for Classification in Taxation

IN the field of taxation, particularly under the Goods and Services Tax (GST) system, the classification of goods and services is of paramount importance. Given the vast and diverse range and arrangement of goods and services in the market, it is neither practical nor feasible to list every item with a corresponding GST rate or to implement a single, uniform tax rate for all categories of supply. Therefore, an effective classification system is essential to maintain the much required consistency, transparency and efficiency in taxation. One widely accepted method for classifying goods is the Harmonized System of Nomenclature (HSN), which is used globally. In India, HSN is used, among others, by the Customs for prescribing tariff rate and by the Directorate General of Foreign Trade (DGFT) in formulating Foreign Trade Policy (FTP) regulations. A legal and logical arrangement of traded goods like HSN offers several benefits as it ensures uniformity across the regulatory bodies, preventing inconsistencies and misinterpretations. Such standardization is particularly crucial in tax structures like Customs and GST, where seamless coordination between different tax authorities - Union, State, and Union Territories - is necessary. Additionally, the use of common codes facilitates smooth international flow of trade and commerce from Domestic Trade Area.

While a well-structured classification system enhances efficiency and fairness in taxation, benefiting both the government and taxpayers, the improper adaptation of customs classification to GST realm has led to significant confusion and legal disputes. The flaws in the current classification approach have resulted in ambiguity, causing an increase in litigation. Similarly, the faulty approach adopted to classify the services under GST has diluted the intended benefits of GST. I have previously discussed this issue in my article, Classification of Services – A GST Nightmare? , published on September 5, 2019. However, no efforts have been made to rectify the system.

This article aims to highlight some of the critical lapses that require immediate attention, with a hope that the Group of Ministers on Rate rationalisation formed by GST council will examine these aspects in a fair and open manner before the intended introduction of rationalised rates.

Classification of Goods under GST

With the expansion of international trade, the need for a standardized classification system became evident to facilitate faster legitimate trade, ensure transparency, and enable accurate trade data analysis. To address this, the HSN was developed by the World Customs Organization (WCO). Recognised and adopted by nearly 200 countries, HSN ensures uniform classification of goods in global trade. A simplified version of HSN is said to have been adopted under the GST system; however, the criteria and parameters used for this simplification have not been disclosed, nor has its impact on interpretational rules been thoroughly examined. Notably, the HSN classification system used in global trade and customs is based on a strong legal foundation. If GST intends to utilize it, it should either adopt it in its entirety or clearly disclose the rules of simplification as a legal reference for taxpayers and adopt it without causing disruptions in trade.

Before the implementation of GST, there was no proposal to incorporate a classification system. However, it was unexpectedly imposed on registered taxable persons (RTPs), leading to widespread confusion. As a result, the ‘GST return process system' outlined in the Report of the Committee for Business Processes had to be abandoned, and a new return format, namely, GSTR 3B, resembling the VAT return, was introduced. One of the key reasons for the failure of the proposed return system was the faulty classification framework, which created significant compliance challenges and prevented GST from achieving its intended goal of easing business operations.

The lack of administrative control over the flawed classification system also created opportunities for dishonest traders to exploit the system, as tax authorities had limited data to verify returns. Additionally, the backend implementation of Module 1 by certain authorities contributed to poor GST administration. However, the introduction of mechanisms such as e-way bills, e-invoicing, and the invoice management system has gradually enhanced transparency in the GST framework. It is now understood that all administrative bodies are transitioning to Module 2 for backend management, marking a long-overdue but necessary step toward a unified GST system. (refer TIOL Non-uniform Implementation of Unified GST MARCH 23, 2022 , GST Administration - Need of Comprehensive Approach AUGUST 17, 2022, – By the author)

Issues on classification of Goods

To tide over the problems relating to compliance burden with respect to classification-related issues under GST, the CBIC issued Notification No. 12/2017 – Central Tax on June 28, 2017, prescribing the number of HSN/SAC digits required on tax invoices for the supply of goods and services. Under this notification, registered taxpayers with an aggregate turnover of up to Rs.1.5 crore were not required to declare HSN or SAC codes. Those with a turnover between Rs.1.5 crore and Rs.5 crore were required to use a 2-digit HSN/SAC, while businesses with a turnover above Rs.5 crore had to use a 4-digit code.

However, the use of the term SAC (Service Accounting Code) in the GST framework is a misnomer. Originally, SAC was meant to denote accounting codes under the service tax regime, but it has now been inaccurately used for service classification under GST. This has contributed to further confusion in the classification process.

As the GST system evolved, the classification requirements were revised through Notification No. 78/2020 – CT on October 15, 2020, which made it mandatory, from April 1, 2021, for businesses with a turnover up to Rs.5 crore to use 4-digit HSN/SAC codes, while those with a turnover exceeding Rs.5 crore had to use 6-digit codes. Later, Notification No. 90/2020 – CT on December 1, 2020, mandated that 49 specified chemicals must be classified using an 8-digit HSN code on tax invoices. Despite these changes, for most goods, the requirement to indicate classification beyond 6 digits remains non-mandatory, except for the notified chemicals.

Customs HSN System in GST Realm

The integration of the Customs HSN system into GST has not been without issues. One of the significant concerns is the arbitrary reduction of tariff entries in GST without any clear legal or logical reasoning. Unlike the Customs tariff, which provides a detailed classification, GST has simplified the classification structure, leading to instances where a product classified under GST does not align with its Customs classification, and vice versa. This misalignment has resulted in numerous litigations, as reflected in various advance rulings and orders-in-original. Due to the absence of appropriate classification, businesses are often forced to use residuary entries, which automatically subjects such goods to higher tax rates of 18% or 28%. This is unfair as it arises purely from the flaws in arbitrary policy decisions rather than the nature of the goods themselves.

Another major challenge is the fundamental difference in classification principles between Customs and GST. The HSN system, which is globally recognized, primarily classifies goods based on their physical characteristics, making it suitable for international trade and customs purposes. In contrast, GST classification often considers the purpose or end-use of goods. This difference in approach has created conflicts in interpretation, making it difficult for businesses and tax authorities to reach a consensus on the correct classification of certain products.

Adding to the confusion, GST rates are determined not solely by HSN classification but also by notification issued, leading to situations where different GST rates apply to goods under the same HSN code. This has resulted in identical goods attracting different GST rates, adding another layer of complexity to the system. For example, processed and unprocessed versions of the same commodity may be taxed differently, despite falling under the same HSN classification.

Compliance Challenges

While the Customs HSN system is periodically updated to align with global trade requirements, these updates have not been incorporated into GST. The latest Customs tariff revision, effective January 1, 2022, has not been reviewed or incorporated into GST classifications. To date, there has been no official communication regarding whether GST should continue using the old HSN codes or transition to the updated codes now in force for Customs and international trade. This lack of clarity has resulted in businesses struggling with compliance and dealing with inconsistent classifications.

Importers and exporters, in particular, face difficulties in reconciling Bills of entry, shipping bills, invoices and related accounting records, as the same product may have different classifications under GST and Customs. These inconsistencies not only increase compliance burdens but also lead to disputes, penalties, and operational inefficiencies.

Some industries, such as pharmaceuticals, food processing, and electronics, have been significantly impacted by HSN classification issues under GST. In several instances, raw materials and intermediates, which are essential for manufacturing, have been classified differently under GST compared to Customs. This has resulted in tax inefficiencies and cascading tax effects, ultimately affecting product pricing and competitiveness. Immediate corrective measures are essential to bring GST classification in alignment with Customs, ensuring a seamless and efficient tax system that benefits both businesses and regulatory authorities. Without such reforms, businesses will continue to face unnecessary tax burdens, legal battles, and compliance complexities, undermining the very objective of a simplified and business-friendly GST system.

Lawmakers should adopt a more cautious approach when implementing changes through notifications. An example of the casual approach by the policy makers is the changes effected in respect of levy of GST on actionable claims . After long debates, the GST council arrived at a consensus on the issue relating to taxation of actionable claims, since inception. Based on the Council's recommendation of the Council, the 'specified actionable claims' have been modified with GST imposable at uniform rate at 28%. By issue of Notification No. 14/2023-Integrated Tax (Rate) Dated 29th September 2023 and other related notifications under CGST Act and SGST act and UTGST act, to be effective from1st day of October 2023, mandated the rates of GST as follows:

"(a) after S. No. 227 and the entries related thereto, the following S. No. and entries shall be inserted, namely:-

The Customs Notification No. 72/2023-Customs (N.T.), issued on September 30, 2023, following deliberations in the council, mandates the classification of specified actionable claims, effective from October 1, 2023, as follows:

"(iii) after tariff item 9806 00 00 and the entries relating thereto, the following shall be inserted, namely :

These classification codes have not been incorporated into the GST law. The said goods continue to be classified under ‘any chapter' in the GST schedules to this day. This highlights the approach of lawmakers and policymakers in drafting legislation on issues that are frequently litigated. Similar anomalies can be found in numerous notifications issued by the authorities, which are regularly addressed in the Council's meetings.

Classification of Services under GST

The classification of services is a fundamental aspect of the GST framework, ensuring uniformity and consistency in taxation. To standardize this process, the Government introduced a Scheme of Classification of Services as an annexure to Notification No. 11/2017-CT (Rate) dated June 28, 2017. This classification system is based on the United Nations Central Product Classification (UNCPC), as confirmed by the CBIC press release on June 11, 2018. While the Customs Tariff covers goods under Chapters 1 to 98, Chapter 99 has been exclusively designated for the classification of services under GST. Each service is assigned a six-digit classification code, ensuring uniformity and facilitating easy reference.

To maintain a structured classification, services are divided into five broad sections namely Section 5 – for Construction Services, Section 6 – for Distributive Trade Services, Accommodation, and Food Services, Section 7 – for Financial and Related Services, Section 8 – for Business and Production Services and Section 9 – Community, Social, and Personal Services The third digit of the six-digit classification code represents the section under which a service falls. For instance, all construction services begin with the code ‘995'. The classification follows a hierarchical structure: (i) Sections – Identified by the third digit in the code. (ii) Headings – A four-digit code that provides a broader categorization.(iii) Groups – A five-digit code that refines classification further. And (iv) Tariff Items – A six-digit code that offers the most specific classification.

It is evident from the above that the classification system for services differs significantly from the HSN-based classification of goods. In the HSN system, sections represent broader groups, while chapters within these sections indicate sub-divisions. Under Customs and GST classification for goods, an eight-digit tariff code is structured as follows: two digits for the chapter, four digits for the heading, six digits for the subheading, and eight digits for the tariff entry. In contrast, service classification is limited to six digits. Moreover, the terminology used - such as sections, headings, groups, and tariff items - differs entirely from the HSN system for goods, adding an initial layer of complexity for businesses, tax professionals and the administrations.

Due to the diverse nature of services, certain activities may fall under multiple tariff items, resulting in overlaps. In such cases, a thorough analysis is necessary to determine the most suitable classification. To assist businesses and professionals, the CBIC has provided explanatory notes as a reference tool. It has been explicitly stated that when a service can be classified under a specific description, it will always take precedence over a general one. This principle ensures accurate categorization, and the General Interpretative Rules (GIR) of HSN do not apply to service classification under GST. Despite these guidelines, ambiguities remain, requiring businesses to exercise caution in selecting the appropriate classification to ensure compliance and minimize disputes with tax authorities.

Unscientific Classification of Services

The classification of services under GST is officially based on the UNCPC, a globally recognized framework designed to categorize both goods and services. While this system aims to establish a standardised classification for goods and services in a combined form, on an international level, its direct application to India's taxation structure for services alone raises serious concerns. One of the most glaring issues with the current faulty classification system is its inconsistency and arbitrary grouping of services. Many services listed under the classification framework are either irrelevant or inapplicable to the Indian context, while several crucial services that hold significance under Indian GST law do not find a proper place in the classification structure. This mis-alignment leads to confusion among taxpayers and complicates tax administration and compliance, as it lacks scientific accuracy and fails to address the unique characteristics of the Indian economy.

Additionally, the system suffers from overlapping classifications, where certain services fall under multiple categories, creating ambiguity and increasing the risk of misclassification. This overlap not only results in compliance challenges but also contributes to frequent disputes between taxpayers and tax authorities. The absence of clear distinctions between service categories further complicates the determination of GST rates, exemptions, and abatements.

Another significant flaw is the continued use of the term ‘SAC' (Service Accounting Code) in GST returns. Originally, under the service tax regime, SAC codes were used for accounting purposes to categorize different taxable services. However, in the GST framework, there is no concept of ‘accounting codes' for services. Despite this, the term remains embedded in GST registration and return-filing systems, reflecting a legacy issue from the past. This outdated terminology adds unnecessary complexity, making it difficult for businesses to navigate the classification system effectively.

Further, the lack of clarity regarding "ancillary" and "incidental" services adds another layer of confusion. Under GST law, taxability depends on whether a service is classified as the main supply or merely as an accessory to another service. However, this distinction is often subjective and open to interpretation, resulting in inconsistencies in tax treatment. Addressing these flaws through a more logical, well-structured, and contextually relevant classification framework is essential to ensure a simpler, fairer, and more predictable taxation system for businesses and taxpayers alike.

Impact of Adopting a Flawed Classification System

The shortcomings in the classification of goods and services under GST have far-reaching consequences, affecting both businesses and tax authorities. One of the most immediate and significant impacts is the rise in litigation and disputes between taxpayers and tax officials. Ambiguous and overlapping classifications lead to conflicting interpretations, forcing businesses into prolonged legal battles to resolve their tax liabilities. These disputes consume valuable resources, not just for businesses but also for the government. Instead of focusing on productive activities and economic growth, companies and tax authorities are forced to allocate time, effort, and money toward resolving classification issues. Another major consequence is the increase in compliance costs for businesses. The complexity of the classification system often necessitates the engagement of expensive tax consultants and legal experts to interpret the rules and ensure compliance. This additional financial burden increases operational costs, particularly for smaller businesses that may struggle to afford such advisory services.

The flawed classification system also creates an uneven playing field in the market. Businesses that adopt different interpretations of the same classification may end up with varying tax liabilities, leading to unfair competition. Some companies may benefit from lower tax rates due to a particular classification, while others may face higher taxation for the same service, distorting the competitive landscape.

Moreover, these inefficiencies undermine the overall effectiveness of the GST system. GST was introduced with the objective of simplifying taxation and ensuring ease of compliance, but the inherent complexities in service classification contradict this goal. Instead of streamlining tax administration, the flaws in the classification framework hinder the smooth functioning of the GST system, preventing it from realizing its full potential as a transparent and efficient tax regime. In essence, the flawed classification structure not only adds to the administrative and financial burden of businesses but also erodes the credibility of the GST framework, making urgent reforms necessary to enhance clarity, fairness, and compliance.

Need for a Rational Approach

Given the numerous challenges and inconsistencies in the classification of goods and services under GST, there is an urgent need for an India-centric revision of the system. The dynamic nature of manufacturing and services further compounds the issue. With rapid technological advancements leading to the emergence of new and innovative goods and services, the existing classification framework often proves inadequate and deficient. This ambiguity creates uncertainty, particularly for startups and businesses in emerging sectors, hampering their growth and innovation.

Addressing these shortcomings require a multi-pronged approach. The tax administration and the GST Council must undertake a comprehensive review and revision of the current classification system for both goods and services. This process should involve collaborations with industry stakeholders, legal experts, and tax professionals to identify areas of ambiguity and develop clearer, more precise definitions. Additionally, a user-friendly digital platform must be developed to provide businesses with clear guidance and search functionality for identifying the correct classification codes and applicable GST rates. The existing platforms that provide GST-related information fail to meet the required standards.

For example, the information available at https://cbic-gst.gov.in/gst-goods-services-rates.html does not include a tariff classification system and, therefore, does not serve any purpose in cases of ambiguity and comparison with customs classification. Furthermore, it is not updated regularly, with the last recorded update being on April 1, 2023. Given the frequent changes in tax laws, an outdated system creates compliance challenges for businesses and weakens tax administration. To enhance clarity and transparency, a chapter-wise tariff schedule must be introduced, ensuring alignment with the GST rate schedule. The classification and rates prescribed should be reviewed periodically, especially after every GST Council meeting, to reflect any updates or modifications.

Moreover, the inefficiencies of government-managed digital portals further worsen compliance requirements. The author has personally attempted to access the CBIC's GST Circulars platform at https://taxinformation.cbic.gov.in/content-page/explore-circulars since over two years. While using the utility designed for searching circulars, every attempt resulted in an error message: "Oops! Something went wrong. Some error occurred while processing your request. Please contact your system administrator. Exception ID: 1739763163975." Despite repeated occurrences, there has been no response or resolution from the concerned authorities. This highlights the urgent need for a more efficient and responsive tax administration system that not only provides accurate and updated information but also ensures seamless user access to crucial tax-related resources.

The Way Forward

In response to Lok Sabha Starred Question No. 93, the Ministry of Finance recently clarified key aspects of GST rate rationalization. It is reported that ‘following the GST Council's 45th meeting in September 2021, a Group of Ministers (GoM) on Rate Rationalization was constituted to review and recommend adjustments to the existing tax structure'. Recently, it was informed that the Rate Rationalization Committee's report is nearing finalization. However, if GST rates are revised without first addressing the flaws in the classification of goods and services, could lead to significant litigation. Businesses would be forced to determine their tax liabilities based on an outdated classification system, resulting in compliance challenges and legal disputes. Therefore, before implementing any revised GST rates, a thorough review of the classification framework is necessary.

Furthermore, publishing a draft classification for public feedback would allow registered taxpayers (RTPs) and other stakeholders to raise concerns, ensuring a smoother transition. It is also crucial that these updated classification codes are integrated into the GST Network (GSTN) before implementation, as failing to do so could cause major disruptions to trade and the economy.

A recent Madras High Court ruling in the case of Parle Agro Pvt. Ltd. Vs. Union of India (W.P. Nos. 16608 & 16613 of 2020, order dated 31/10/2023 [2023-TIOL-1592-HC-MAD-GST]) has further clarified the role of the GST Council in rate determination. The court held that while the GST Council has the authority to recommend tax rates, it does not have the power to determine the classification of goods and services. This ruling reinforces the need for a dedicated Committee to address classification issues and develop a streamlined, well-structured classification system that aligns with trade realities and economic requirements.

The existing classification of goods and services under GST is flawed, unscientific, and impractical. Rather than depending on an international classification model that fails to address India's unique requirements, a more India-centric rational approach should be adopted while creating classification codes for Domestic Tariff needs. Unless these systemic issues are resolved, businesses and tax authorities will continue to face unnecessary complexities, resulting in inefficiencies in tax administration and compliance. It is hoped that the GST Council will consider these concerns and addresses them appropriately during the rate rationalization process.

[The views expressed are strictly personal.]