India: GST Impact: Manufacturing Sector

Last Updated: 27 July 2016
Article by Trilegal .

The implementation of GST will significantly improve the competitiveness and performance of India's manufacturing sector.  However, prior to its roll out, it will be incumbent upon the Indian government to address certain stakeholder concerns, if it wants to foster long term growth in this sector.

INTRODUCTION

The manufacturing sector in India is not only plagued with concerns ranging from decline in exports and infrastructure spending but also with the burden of complying with a complex indirect taxation system.  Multiple indirect tax legislations have led to significant compliance and administrative costs, classification and valuation disputes and generally impaired the ease of doing business in this sector.  The implementation of goods and services tax (GST) is therefore critical and necessary to give a boost to an already flagging sector.

In this update, we analyse the key impact of the model goods and services tax law (Model GST Law) and the likely issues relevant to the manufacturing sector.  This is our second update in the series of updates regarding the impact of GST on key sectors of the Indian economy.  Our first update on the impact of GST in the e-commerce sector can be accessed from here.  

IMPACT OF GST ON THE MANUFACTURING SECTOR

State incentives

Companies have set up units with significant investment outlays based on incentives offered by States under their respective investment promotion policies.  These incentives are usually in the form of tariff incentives (lower tax rates, refund /deferment of taxes etc.) and non-tariff incentives (economical land lease terms, lower electricity duty etc.).  At present, States have the flexibility to offer such incentives.  However, under the GST regime, such flexibility given to the States is likely to be curtailed to achieve the intended effect of uniformity.  Further, the Model GST Law does not clarify the fate of current incentives.  Companies which have based their financial projections around these fiscal incentives may have to reassess their projections.

The implementation of GST will also signal a move away from the producer State tax system to a consumption State tax system.  Producer States will have a lower financial incentive to offer such concessions, as GST will only be credited to the State where the supplies are consumed, as opposed to the present situation where the producer State is credited with central sales tax on inter-state sales.  This would lead to a loss of revenue for the producer States and therefore such States may not be in a financial position to continue offering such incentives, even though there may be other compelling reasons such as generation of labour, improvement of infrastructure, market creation etc.  However, it seems likely that future incentives may only be non-tariff based.

Area based incentives

Manufacturing units enjoy exemption of taxes based on their location in specified backward areas, capital investment etc.  There is no clarity under the Model GST Law on the treatment of such area based exemptions.  Given this uncertainty, companies should make a representation to the Government for appropriate compensation for the unutilized portion of such incentives.

Increased working capital

Impact on working capital may be significant for the manufacturing sector.  Under the current regime, stock transfers are not subject to tax.  However, under the GST regime, stock transfers are deemed to be supplies and are subject to GST.  Though GST paid at this stage would be available as credit, realization of this GST would only occur when the final supply is concluded.  This would likely result in cash flow blockages and therefore companies would have to rethink their supply chain management strategies to minimize this impact on their cash flows.

Free supplies

Under the present indirect tax regime free supply of goods are not subject to VAT.  The Model GST Law stipulates that specific transactions without consideration would also be treated as supplies.  Accordingly, free samples may be subject to GST, leading to increase in overall costs.

Discounts

The Model GST Law stipulates that post supply discounts are to be excluded from the transaction value, provided such discounts are known at or before the time of supply of goods and are linked to the invoices for such supply.  Companies may need to analyse existing post supply discounts/incentive schemes where the quantum of discount is not known at the supply stage.  Example, secondary market incentive schemes, volume based discounts etc.

Valuation of self-supplies

Supply under the GST Model Law includes self-supplies such as stock transfers and branch transfers.  However, the GST Model Law does not prescribe valuation rules for such supplies and therefore further clarity is required.

MRP valuation

Currently, various pre-packaged products for retail consumption are subject to excise duty not on the ex-factory transaction value but on a specified percentage of the maximum retail price (MRP) printed on the package.  The MRP based value (which is usually between 30%-35% of the MRP) is in most cases, much higher than the ex-factory transaction value leading to a higher excise duty liability than would otherwise be the case.  This increased excise duty itself, results in a higher MRP, ultimately leading to a higher cost burden for the consumers.  Under the GST regime, GST is payable by the manufacturer at the transaction value, and is creditable for all subsequent resellers up to the final consumer.  Accordingly, the unnecessary tax burden of the MRP regime will no longer be relevant

Reduction of cascading taxes

Under the present indirect tax regime, the manufacturing sector is able to set-off most input taxes levied in the production value chain.  However, Central taxes cannot be set-off against State taxes and vice versa.  This often leads to a situation where manufacturers are unable to set off excess credit of central or state levies.  Further, central sales tax paid on inter-state procurements is also not creditable and are costs for the company. 

Another issue faced currently is the cascading of taxes at the post manufacturing stage.  Dealers, retailers etc. are subject to taxes on their input side which are not creditable (service tax on input services, excise duty on capital goods).  This leads to an increase in the cost of goods, ultimately affecting the competitiveness of Indian manufactured goods vis-à-vis imports.

All of the above issues are addressed under the Model GST Law, which permits tax set offs across the production value-chain, both for goods and services.  This will result in a reduction of the cascading effect of taxes and bring down the overall cost of production of goods.

Reduction of classification disputes

Currently, due to varying rates of excise duty and VAT on different products, as well as several exemptions provided under excise and VAT legislations, classification disputes are a regular cause for litigation under both central excise and VAT, especially for the manufacturing sector.  It is expected that the inception of GST which is based on the principles of a simplified rate structure and minimization of exemptions will significantly reduce disputes regarding classification of products.

Supply chain restructuring based on economic factors

Current supply and distribution models are structured to optimize indirect tax impact arising at various levels of value addition.  Transition to GST should hopefully result in such decisions being taken to optimize business efficiency (as opposed to indirect tax efficiency).  Example, currently warehousing choices are often based on arbitrage between VAT rates in different States/ between applicable VAT and CST rates.  With the advent of GST, it is hoped that such warehousing and logistics decision would be based on economic efficiency such as costs and locational advantages vis-a-vis key customers.  However, a key hindrance could be the proposal to levy a 1% origin tax on inter-state supplies.

Exclusion of petroleum from GST

The Central government will continue to impose excise duty on five petroleum products (petroleum crude, high speed diesel, motor spirit, natural gas and aviation turbine fuel), while the State governments will continue to impose VAT on these petroleum products.

Currently, credit of excise duty paid on specified petroleum products is available.  However, exclusion of petroleum products from GST will add to the cost of manufacture as excise duty on such products would not be creditable under the GST regime.  Petroleum products such as high speed diesel, are common fuels used in various manufacturing processes, as also for transportation of inputs and final products.

Therefore, industries that consume petroleum products as their main inputs (such as the fertilizer industry which use natural gas as an important input) will get significantly impacted by this exclusion.

CONCLUSION

The manufacturing sector stands to benefit significantly with the introduction of GST.  The overall reduction of cascading effect of taxes, especially on the post-manufacture stage of the supply chain should have a positive effect on the cost of manufactured products in the hands of consumers.  However, concerns remain on specific issues such as the additional 1% origin tax, increased cash flow issues on account of GST payable on stock transfers, and increased costs owing to exclusion of petroleum fuels from the ambit of GST.  The Government should look into these issues in more detail if its keen to promote its 'Make in India' initiative.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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