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Inverted duty structure - Refund of Input services allowed
By Dhwani Mainkar, BLS/LL.B, LL.M (Queen Mary University of London)
Aug 11, 2020

IN the landmark judgement by the Hon'ble Gujarat High Court, in the case of VKC Footsteps India Pvt. Ltd. v/s. Union of India Special Civil Application 2792 of 2019 - TOG-572-HC-GUJ-GST-2020, the Court has categorically laid down that the denial of unutilized input tax credit accumulated owing to the inverted duty structure with respect to 'input services' within the meaning of Explanation (a) to Rule 89(5) of the CGST Rules, 2017 [hereinafter referred to as 'the Rules'] is ultra vires of the provisions of S. 54(3) of the CGST Act, 2017 [hereinafter referred to as 'the Act']. The detailed judgement has explicitly studied the implications and intricacies of Input Tax Credit as envisaged under the provisions of the CGST Act & Rules, the discussion paper released by the Empowered Committee of State Finance Ministers in November 2019, the intent of the legislature as established from the Statement of Objects & Reasons appended to the Bill introducing CGST Act, the list of FAQs issued by the CBEC on GST in June 2016, the International VAT/GST Guidelines issued by the OECD and a plethora cases prior to arriving at this pathbreaking decision. The judgement delivered by the Division Bench of Justice J.B. Pardiwala and Justice Bhargav D. Karia clubbed ten group matters on para materia issues and pronounced the order reading down the explanation (a) to Rule 89(5) of the CGST Rules, 2017 which unilaterally singled out the value of 'input services' while defining 'Net Input Tax Credit' [hereinafter referred as ITC] in the formula envisaged therein.

Facts of the Case: The Petitioner in the instant case is predominantly engaged in the business of manufacture and supply of footwear subject to GST @ 5%. In the course of his business, the Petitioner avails input services such as job work, goods transport agency service, as well as inputs such as synthetic leather, PU Polyol etc., on payment of the applicable GST thereon and avails ITC. The majority of the inputs and input services availed by the Petitioner attract GST at either 12% or 18%. Thus, GST rate paid by the petitioner on the procurement of these inputs and input services is significantly higher than the GST of 5% leviable on their outward supply of footwear. Hence, despite utilizing the ITC for the payment of GST on outward supply, there results in the accumulation of unutilized credit in the electronic credit ledger of the Petitioner. This scenario wherein the rate of tax on inputs is higher than the rate of tax on output supplies is termed as 'inverted duty structure'. An integral feature of the GST regime is to effective tax the value addition and all taxes paid at the anterior stage should be entirely absorbed in the tax on outward supply. Where it is not so, refund of accumulated unutilized credit is provided, in order to effective tax only the final consumer. This is elucidated vide S. 54(3) read with second proviso of the Act as it provides for the refund of unutilized ITC in cases of inverted duty structure. Rule 89(5) of the Rules stipulates a formula for determining the refund owing to inverted duty structure, which has been given retrospective effect vide Notification No. 26/2018-CT dated 13/6/2018. This formula inter alia excludes input services from the ambit of 'Net Input Tax Credit' for the computation of refund amount under this Rule. Thus, in the instant case, the Revenue authorities have allowed the refund of accumulated ITC of tax paid on inputs such as synthetic leather, PU Polyol, while the refund of accumulated ITC paid on availing input services such as job work, goods transport agency service, etc. is denied. The Petitioners have challenged the validity of the Rule 89(5).

Issues Involved: Whether the Rule 89(5) of the CGST Rules, 2017 is valid to the extent it denies refund of input tax credit relatable to input services?

Contentions of the Petitioners: The prime contentions of the Petitioners have been summarized in the following points:

i) GST is essentially a destination-based tax on consumption of goods & services which is levied at all stages of value addition wherein the final consumer alone ultimately bears the tax burden.

ii) GST predominantly aims to achieve a continuous chain of set-off from the original manufacturer to the last retailer, thereby eliminating burden of all cascading effects.

iii) Due to seamless transfer of input tax credit from one stage to another in the chain of value addition there is an in-built mechanism in the design of GST that would incentivize tax compliance by tax payers.

iv) Uninterrupted and seamless flow of ITC is a key aspect of GST.

v) While illustrating the scenario where output tax payable is higher than the input tax credit at all stages, it was established that an Assessee pays certain amount of tax in cash to the government at each stage due to value addition even after utilizing ITC.

vi) In cases of inverted duty structure, the direct consequence would be cascading effect of taxes in the form of unabsorbed excess tax on inputs which is in stark contrast to the basic principles of the GST law. In order to mitigate this anomaly, the law prescribes a provision for refund of accumulated unutilized ITC. Hence the intent of the legislature in enacting S. 54(3) was to avert such distortions and in fact ensure that GST truly remains a consumption-based tax.

vii) S. 54(3) provides for refunds of 'any unutilized ITC' and second proviso to this section enacts a condition precedent, i.e. inverted duty structure.

viii) S. 2(63) defines input tax credit means 'credit of input tax'. While the expression 'input tax' within the meaning of S. 2(62) means the 'tax charged on any supply of goods or services or both made to a registered person'.

ix) Rule 89(5) in the garb of fixing a formula for determining pro-rata amount of credit relatable to inverted duty structure turnover vis-à-vis total turnover, has restricted the refund of ITC on inputs and by denying ITC on input services by defining 'Net ITC' to mean ITC availed on "INPUTS ONLY" which consequently overlooks input tax credit relatable to input services. This is contrary to the main Section 54(3) and proviso (ii) thereto and therefore to this extent Rule 89(5) is ultra vires.

The relevant extract of amended Rule 89(5) reads thus:

"(5) In the case of refund on account of inverted duty structure, refund of input tax credit shall be granted as per the following formula:

Maximum Refund Amount = {(Turnover of inverted rated supply of goods and services) x Net ITC ÷ Adjusted Total Turnover}- tax payable on such inverted rated supply of goods and services. Explanation : For the purposes of this sub-rule, the expressions- (a) Net ITC shall mean input tax credit availed on inputs during the relevant period other than the input tax credit availed for which refund is claimed under sub-rules (4A) or (4B) or both;

x) Explanation (a) to Rule 89(5) has whittled down the effect of the word 'any' in the phrase 'any unutilized input tax credit' employed in S. 54(3) which would obviously mean 'all' input tax credit including input services.

xi) This Rule is not 'for the purposes of this Act' and is rather restricting the provision of S. 54(3) and thus this rule cannot even be sustained even under the general rule making power of the Government as conferred by S. 164(1).

xii) The offending words 'on inputs' are easily severable and liable to be struck down to bring Explanation (a) in consonance with the primary refund rule under S. 54(3) read with proviso (ii) thereto.

xiii) It was submitted that the Rule 89(5) results in perpetual retention/appropriation of unutilized ITC on services by the Government contrary to the intent of the Legislature.

xiv) The Rule 89(5) violates Article 14 of the Constitution as it denies a crystallized and vetted right of refund created by the Statute and lacks rationale in arbitrarily disallowing refund of only input services on account of inverted duty structure. There is no intelligible differentia which has a rationale nexus to the object sought to be achieved by the Act.

xv) Thus, it was submitted that Rule 89(5) prescribing the formula to calculate the refund on account of inverted duty structure in therefore contrary to the provision of Section 54(3).

Contentions of the Revenue: The main submissions on behalf of the Revenue are captured below:

i) The Respondent submitted that the petitions are not maintainable as Rule 89(5) merely provides the mode of calculation of refund available to the taxpayers due to the inverted duty structure and the same is not contrary to the provisions of S. 54(3).

ii) S. 164 empowers the Central Government to make rules on the recommendations of the Council and this power is conferred in the widest possible manner to make rules for carrying out the provisions of the Act. Further, S. 164(2) enables the Government without prejudice to the generality of S. 164(1) to make rules for all or any of the matters of the Act. S. 164(3) empowers the Government to give retrospective effect to such Rules.

iii) The Government has framed the Rules in exercise of this conferred power under S. 164 and the Rule 89(5) cannot be held to be ultra vires as it simply provides a calculation formula for the refund on account of inverted duty structure.

Held by the Division Bench:

i) On a conjoint reading and detailed perusal of the provisions of the Act, rules, Notifications and supporting documents in the form of the discussion paper released by the Empowered Committee of State Finance Ministers in November 2019, Statement of Objects & Reasons appended to the Bill introducing CGST Act, the list of FAQs issued by the CBEC on GST in June 2016, the International VAT/GST Guidelines issued by the OECD and the relied upon cases; it appears that the explanation (a) to Rule 89(5) which denies the refund of 'unutilized input tax credit' paid on 'input services' accumulated on account of inverted duty structure is ultra vires the provision of S. 54(3) of the CGST Act, 2017.

ii) The Explanation (a) to the Rule 89(5) is read down to the extent that it defines 'Net Input Tax Credit' means 'input tax credit' only. The said explanation is contrary to S. 54(3). In fact Net ITC should mean 'input tax credit' availed on "inputs" and "input services" as defined under the Act.

iii) The Respondents were thus directed to allow the claim of refund made by the petitioners considering the unutilized input tax credit of 'input services' as part of the 'net ITC' for the purpose of calculation of the refund claim as per Rule 89(5) of the CGST Rules, 2017 for claiming refund under S. 54(3), CGST Act, 2017.

iv) Petitions Allowed.

Comments: The ratio laid down in this case is considered as a welcome move on the maintainability of the inclusion of input tax paid on services for the purposes of refund arising on account of inverted tax structure. It would essentially benefit taxpayers operating in the pharmaceutical industry, solar modules, railways locomotives and parts as well as textiles. It will be pertinent to see whether the Revenue authorities approach the Hon'ble Supreme Court in Appeal against this decision in order to curtail the incessant refund claims that may arise. The judgement though will not have a binding effect in States other than Gujarat under the principle of stare decisis, it will significantly play a role in persuasive capacity to motivate the other industries to file Refund claims even for 'input services' in cases of accumulated input tax credit arising due to the inverted tax structure. The Court by upholding the inclusion input services has given true effect to the intent and object of the Legislature while enacting GST, which categorically described a predominant feature of GST to be having a 'systematic and seamless flow of input tax credit'. The Hon'ble Supreme Court has held time and again that the law should be interpreted in its spirit and not in letter. There are many a cross-roads in the interpretation of statutes. However, it has to be seen pragmatically whether the wordings of a statute (or an unintended error) could override the logical conclusion that one could arrive by looking at the law in its entirety. If the answer is NO, then the wordings of the statute have to be benevolently interpreted so as to not distort the intent of the statute as a whole, by following the selective or isolated wordings.

[The views expressed are strictly personal.]