By Bipin Sapra and Swati Saraf
The current ITC refund mechanism does not take into account the GST paid on input services and capital goods. Aligning rates, enabling refunds, and gradually moving toward a unified rate will give businesses certainty and foster long-term investment, explain Bipin Sapra & Swati Saraf
From a four-tier to a two-tier rate structure
The rollout of Goods and Services Tax (GST) rate rationalisation on nearly 400 items marks a decisive step in India’s tax reform journey. The GST Council has demonstrated responsiveness to stakeholder concerns, balancing revenue mobilisation with the objective of easing inflationary pressures on households. The newly rationalised GST structure reflects this balance. With the current reforms, India has moved from a four-tier to a two-tier system, reducing complexity and making taxation more predictable. Most essential goods and certain services now fall under the 5% slab, ensuring affordability, while the majority of services remain under the 18% slab, sustaining fiscal revenues from a fast-growing sector.
Rationalisation enhances affordability, global competitiveness, and predictability representing one of the most significant overhauls since GST’s inception. The dual-rate system is already visible in sectors like food, FMCG, and consumer goods, where the benefits of lower rates are being passed on to consumers.
Why do inverted duties matter?
The GST rate reduction also brings a challenge: the inverted duty structure (IDS), where rates on input supplies exceed the rates on output supplies. This creates significant accumulation of Input Tax Credit (ITC). While refunds exist, they are currently limited to ITC on inputs, excluding accumulation from input services and capital goods, leaving businesses with stranded credits and liquidity stress.
The challenge is particularly acute for companies with a narrow product portfolio, where rates across most products have been reduced to 5%. In contrast, companies with diverse product lines spanning 5% and 18% GST slabs can offset accumulated ITC against liabilities without restriction. This distinction is especially relevant for FMCG companies with limited versus extensive portfolios.
Sectors affected by IDS
One of the objectives of the current reforms was to eliminate IDS by aligning input and output rates. Yet, mismatches persist in sectors like pharmaceuticals and textile yarns. In pharma, inputs such as active pharmaceutical ingredients and key starting materials attract higher rates than finished formulations. In textiles, nylon chips, PTA, MEG, and polyester chips are taxed higher than yarn or fabric.
On the services side, particularly in insurance, the government’s decision to exempt individual life and health policies is beneficial for consumers. However, insurers may face higher input costs due to the loss of ITC recovery. So, while they may initially absorb some of the impact , over the medium to long term the higher input costs are likely to be passed on to policyholders.
The concept of inverted tax structures has undergone a change post this reform. Earlier the differential input output rates caused the inversion, some of which have got settled now. However, new inversions on account of input services and capital goods are becoming more visible. These inversions are dependent on business models depending on the use of services and the status on investment in capital expenditure of the company. These are difficult to solve as they cannot be generalised till goods and services are brought at par in treatment of IDS.
How can IDS be resolved?
THE ENSUING IDS will bring with it ITC accumulation, pricing recalibration, and working capital strain, highlighting the need for policy action to ensure uniformity. Globally, most developed economies operate with a single VAT/GST rate or a narrow band, reducing arbitrage and simplifying compliance. India should aim for such convergence over time. A single GST rate would eliminate IDS and other anomalies, strengthen neutrality, and make India’s system globally comparable. While a single rate remains a long-term goal, short-term targeted measures are critical. Sector-specific anomalies, particularly in pharma and textile yarns, should be addressed. The current refund mechanism aims to refund the accumulation of credits on account of IDS, yet it does not take into account the GST paid on input services and capital goods.
Comprehensive refund process
The solution lies in designing a more comprehensive refund process including all ITC with refund of capital goods in a phased manner linking it to depreciation. However, given the intricacies of justifying the inverted duty structures as a reason for credit accumulation, the progressive solution is to look at refund of accumulated ITC at the end of the year either in full or as a percentage of the accumulated credit. The revenue concerns, however, need to be aligned as GST continues to be a major source of revenue for the Centre and the states. To unlock its potential, IDS must be decisively addressed. Aligning rates, enabling refunds, and gradually moving toward a unified rate will ensure GST remains business-friendly and fiscally sustainable.
Sapra is tax partner while Saraf is tax director at EY India