Restrictions on input tax credit under GST

It's been said that, under the Goods and Services Tax (GST), credit would flow seamlessly throughout the supply chain – meaning all taxes paid on inputs (i.e., goods and services including capital goods) would be available as credit – and that would reduce tax costs. But that may not be entirely true. The Model GST Law (MGL) prescribes several restrictions on input tax credit, and there's a lot less being said about them. Let's examine the restrictions one by one.

Section 16 of the MGL disallows input tax credit on goods and services not intended to be used “in the course of business” or “for furtherance of business”. In fact, the credit chain ends when goods or services are sold to the final consumer for personal use. For example, a credit chain that started with the manufacture and sale of steel would end when a washing machine, made out of that steel, is sold for personal consumption.

This distinction between personal consumption and business consumption could very well become a litigious issue. The law provides that if any input is used partly for business and partly for non-business purposes, then credit would be available only to the extent it is attributable to business use. So strictly speaking partial credit could be disallowed on an office laptop if it's also used to send personal email or make personal purchases from an eCommerce site – though that would be practically impossible to implement.

Although service tax law prohibited credits on outdoor catering services consumed by individuals or employees, there was no specific prohibition in regards to entertaining a customer or prospect. That changes with GST; expenditures on food and beverages for whatever purpose will not qualify for credit. That extends to outdoor catering services, including restaurants, banquets, etc. Thus a sizeable portion of business expenses for many companies (e.g., taking a client or a prospect out to dinner) is falling out of the credit net.

Beauty treatments, dentistry, and cosmetic surgery also are outside the credit net. The reason seems to be that these services are very rarely associated with core business activities, except in the case of a few professions like cinema artistes, models, etc.

There are, of course, exceptions carved out for all these cases. For example, if a beautician uses the services of another beautician or a caterer uses another caterer's services, the restriction would not apply if the services are used in connection with the business and not for consumption by employees.

When final supply is exempt, credit of GST paid on inputs would not be available. Therefore, if health services provided by a hospital are exempt, the GST the hospital pays to its vendors (i.e., manpower suppliers or pharmaceutical suppliers) would not be credited to the hospital. This follows the simple principle that credit is allowed on inputs only if tax is charged on the output.

However, there are cases when final supply may be exempt but credit is still allowed – exports, for example. Such supplies are often called “zero rated supplies. Many sectors are using this rationale to ask for a reduced rate of tax rather than an exemption from GST.

Section 16(4) provides that in respect to any invoice, credit must be taken before the filing date for the September return the following year (ordinarily 20 October) or the filing date for the annual return the next year (ordinarily 31 December), if filed earlier. This means that a taxpayer would roughly get a minimum of 6.5 months for an invoice issued by a supplier on the last day of any financial year (i.e., 31 March) and a maximum of 18.5 months for an invoice issued on the first day of any financial year (i.e., 1 April) to claim credit.

These timelines will prevent the act of claiming credit from going on endlessly, as it did under the CENVAT regime prior to September 2014, when there was no time limit for taking credit.

Could there be instances when credit cannot be taken even within the allowed time limits? The answer is “yes” – for example, when goods are not received by the purchaser until after the expiry of such a time limit. In such cases the taxpayer may lose the credit. But in the larger interest of any tax system, it is always beneficial to have such a limitation – even legal recourse has a limitation period in most cases.

MGL disallows credit on means of transport: cars, buses, trucks, boats, yachts, aircraft, etc. However, if the taxpayer is involved in the buying and selling of such goods or uses these goods for training, such as for a driving or flying school, credit would be available. Credit is also available for passenger transport agencies.

Frankly there is a case for providing credit of GST paid on vehicles used for business purpose. Countries like Australia and Canada allow it, but the EU does not. The proponents of this restriction say there is a thin line differentiating personal use and business use of motor vehicles, as they are not fixed in place like an office air conditioner, on which credit would be available.

However, the office itself is now a concept with fewer physical boundaries: employees are allowed to work from home, from a café, or even from their cars (assuming they have a chauffeur, at least until we see the days of driverless cars). So what holds true for an office laptop or mobile device (on which credit is allowed) could also one day hold true for a car; however, the law will take some years to catch up to this proposition. For now, it may be better to accept the reality that credit on motor vehicles and other conveyances is not available.

Rent-a-cab services, a key facility for most businesses and even more so for IT service companies with 24/7 operations, would continue to be left out of the credit net, just as they were under CENVAT. Perhaps the logic behind this is that services consumed outside the office premises should not be included in the credit net. However, GST does allow credit for the use of cab services as mandated by law, such as for women's safety or for physically challenged persons.

Also allowed, or at least not specifically restricted: credit of GST charged on air travel and other means of travel for business purposes. That means GST paid on a taxi bill for office travel from Pune to Mumbai would not be allowed, but GST paid on air travel between the same two cities would be admissible.

The rent-a-cab exclusion differs from Section 37 of the Income Tax Act, under which such expenses were eligible for deduction provided they were expended wholly or exclusively for the purposes of business and not for personal use.

Much like cab services, life insurance and health insurance fall within the credit net only when mandated by law, such as insurance for those who work in hazardous professions. Insurance purchased voluntarily is not covered by the credit provisions.

Construction services/works contract have always faced the wrath of lawmakers as far as credit is concerned under CENVAT rules. The same plight continues under GST – probably because works contract services result in the creation of immovable property, which is outside the purview of GST.

However, the logic is not so sound, as the transactions before and after the creation of immovable property would generally be liable for GST and such restrictions would artificially block the flow of credit. Construction of a commercial complex would attract GST, for example, and renting space in that complex would also attract GST. However for a business that engages a contractor to construct the building, credit of the GST paid on such construction activity to the contractor would not be available. Even a person engaged in the business of renting immovable property would not be allowed credit for GST paid to the developer/builder of the property.

Many are of the opinion that this holdover from the CENVAT days should have been removed under GST. But that was not to be. However, if a works contractor receives works contract services from his subcontractor, he would be eligible to claim credit for such services.

Even though the input tax credit provisions do not provide a seamless flow of credits under the coming GST regime, as was expected, transitional provisions are quite liberating for some. For example, a small-scale manufacturer who was not liable to register under excise (turnover less than INR 1.5 crore) but will be liable to register under GST would be allowed to avail credit of excise duty paid on goods in stock at the time of transition. An invoice evidencing the excise duty amount will be needed. If no such invoice is available, the manufacturer could carry forward the notional credit at a rate that would be prescribed. Similar provisions exist for other categories of taxpayers, which would make their transition to GST easier.

On the whole, credit provisions will be simpler under GST. Previously taxpayers had to check provisions under both CENVAT rules and the state's VAT law to claim the correct credit, and the two provisions had very little in common.

With just a little more effort, companies can update their IT systems to conduct primary scrutiny of the credits to further simplify the process. That will bring real savings to the companies.

That being said, the real game changer in the GST days ahead would be automated matching of a buyer's input credits with the supplier's output details. Such electronic matching would put substantial pressure on efforts by companies. The answer to this will be automated reconciliation solutions offered by application service providers such as one by Avalara India i.e. Avalara India GST.

Thanks to Dr. Waman Parkhi, Partner, Indirect Tax, KPMG (in India) for this whitepaper contribution.

To ready your company and vendors for GST, contact us about Avalara India GST here: http://avalara.com/in/products/gst-returns-filing/