India: GST Impact: Energy Sector

Last Updated: 28 September 2016
Article by Trilegal .

Though implementation of a unified GST regime is a huge step towards a much awaited tax reform, the implementation of GST could hike renewable energy costs and significantly increase the cost of energy projects in India.

The energy sector is a key driver for economic growth but remains plagued by policy and regulatory bottlenecks. Lack of pass through of indirect taxes contributes to the inefficiencies that have crept into this sector. Unfortunately, this legacy issue is set to continue under the Goods and Service Tax (GST) regime, with generation and sale of electricity being kept outside the purview of GST but capital goods and services used in the energy sector being brought within the GST net.

Currently, tax concessions and exemptions, both at the Central and State level are available on specified goods and services which are used in the energy sector. However, with the GST regime generally set to trim such exemptions and concessions, the effect on the energy sector may be significant.

In this update we analyse the key impact of the Model GST Law on the energy sector. To read our previous GST updates, please visit the Publications section of our website.

KEY IMPACT AREAS

(a) Increased cost of energy projects

Status of exemptions and concessions: While goods and services required for setting up energy projects will be subject to GST, they will not be creditable for the generating entity leading to a cascading of indirect taxes. Under the current indirect tax regime, various concessions and exemptions are available for setting up energy projects, especially in the renewable energy space to counter such cascading effect. However, there is no clarity on whether these concessions/ exemptions will continue under the GST regime.

Removal of concessional rate for inter-State procurement for EPC contracts: To take advantage of the concessional 2% rate provided for procurements by entities engaged in the generation or distribution of electricity, project owners are currently able to structure their procurements as inter-State sales to reduce tax costs. This 'in-transit sales' exemption on inter-State sales is also available on second (and subsequent) sales undertaken during the direct movement from a manufacturer to the principal (with title passing through contractors and sub-contractors). However, the Model GST law provides no such concessions or tax planning opportunities.

In the absence of such tax exemptions and concessions, there is a possibility of a significant increase in project costs.

(b) Impact on renewable energy

Owing to the higher set up costs of renewable energy projects, tariff rates for clean energy are generally not competitive vis-à-vis conventional energy. With a view to encourage clean energy, multiple tax concessions and exemptions have been extended to the renewable energy sector. As a result, green energy is generally available at reduced tariff rates. However, there is no clarity on whether such benefits would be extended under the GST regime. It is necessary that the government continues to offer tax breaks to the renewable energy sector, for it to remain a competitive option to conventional fuel based energy. One possible option could be to zero rate supplies to renewable projects. This would remove GST incidence at the terminal stage, and also enable suppliers to obtain tax refunds of their own input costs.

(c) Issues under existing power purchase agreements

Power Purchase Agreements (PPAs) generally provide for pass through of existing indirect taxes by way of incorporating the costs thereof into the contract price. However, PPAs generally provide for contract prices to be adjusted on account of any increase in taxes or introduction or change in taxes (these are covered as 'Change in Law' or 'Force Majeure' clauses under the PPAs).

Generally, introduction of GST would be seen as 'Change in Law' or 'Force Majeure' event under most PPAs. However, for those PPAs that do not provide an adjustment to cover increase or introduction of taxes, the introduction of GST would result in an escalation of contract prices.

Further, ambiguity remains in cases where GST is brought into force after the pre-bidding stage of a project but before the signing of the PPA. In such a situation, an issue may arise on whether such change in tax legislation would be considered as a 'Change in Law'.

(d) Reduction of legacy issues

Power projects, especially at the EPC stage, are plagued with issues centred around the indirect tax treatment of works contracts, which is complicated due to different aspects of such contracts being subject to service tax and VAT. Even splitting of supplies and services into separate contracts does not necessarily help address the issue as it often leads to litigation with indirect tax authorities. This is because they still seek to treat such contracts as composite works contract (involving supply of both goods and services), especially if there is a 'wrap agreement' or 'cross-fault breach clause' (a clause providing common indemnity across the contracts). EPC companies also face challenges on valuation of such contracts as authorities often claim that value of one type of supply has been artificially deflated in favour of the other, to take advantage of any rate arbitrage.

The Model GST Law specifically treats a 'works contract' as a 'service' and the whole value is likely to be subject to a uniform tax rate. This is likely to address the ambiguity and reduce disputes.

Further, central sales tax, on inter-State purchases, is currently a non-creditable tax. Therefore, where procurements are made by contractors from vendors outside the State, contractors currently seek to structure these as 'in-transit sales', where the second sale between the contractor and the project owner is exempt from tax. The pre-requisite of an 'in-transit sale' exemption is that the delivery of the goods should take place directly from the vendor to the principal (project owner) without possession being taken by the contractor or sub-contractor. However, the authorities have continually challenged in-transit sale exemptions in case of EPC contracts on the basis that the transfer of property during execution of works is predicated on the principle of accretion, that is, ownership over the goods passes from contractor to principal only upon incorporation of the goods during the execution of the works.

Under GST, both inter-State sales and intra-State sales, would be subject to a creditable GST system. The GST borne by the contractor while procuring the material from an out of State vendor can be set-off against the GST payable for undertaking the EPC contract. Hence this legacy issue is also likely to fall away.

CONCLUSION

Energy is a core sector in any economy since power is a key requirement for every commercial activity. Any tax distortion faced by this sector on account of electricity being outside the ambit of GST, will have a cascading effect on the rest of the economy, negating some of the very benefits sought to be brought about by the introduction of GST. Accordingly, it is felt that the Government has missed an opportunity by not integrating generation and distribution of electricity with other supplies which interact with it, under the umbrella of GST. Therefore, the viability of the energy sector, under the current GST regime, would depend upon the exemptions and concessionary tax which may be put in place to counter the impact of different tax regimes on the input and output side. Exemptions in renewables will need to be grandfathered for this sub-sector to remain viable.

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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