Abolition of Incentive Schemes - Alternatives under VAT

Sales tax incentive schemes and rate disparities in various Indian states were the most favorite avenues exploited by the Indian corporate, for tax planning in the areas of Indirect Taxes. States were competing with each other to offer sales tax based incentive schemes to attract investments. One of the critical recommendations of the NIPFP reforms committee was that the incentive schemes were not yielding the desired result and hence, the sales tax based incentive schemes should not continue any more.

Accepting the recommendations of NIPFP, the Conference of Chief ministers held on 16.11.1999 has unanimously decided to do away with all future sales tax based incentive schemes with effect from 1st Jan.2000.It is declared that the states will honor the commitment with respect to ongoing incentives schemes as well as in cases where the companies have taken substantial step in establishing the incentive units on the date of abolition or within such prescribed period.

How ever, it is later clarified that as and when VAT is introduced, such incentive units opted for exemption schemes, shall be required to switch over to deferral schemes. The proposal to shift exemption units to deferral schemes was inevitable for various reasons. Even if the exemption continues under the VAT regime, such exemption will have no meaning, except for the units that sell its products directly to the consumers. This is because the exemption, if continued under the VAT regime, will be available only to the manufacturer and any subsequent resale would attract VAT on its full resale value in the hands of the reseller.

Moreover, under the proposed VAT regime where all goods of the same descriptions are taxable at the same rate, discriminatory exemptions creating different status to the same goods can not co-exist.. This would pose a serious threat to the effective VAT administration as unscrupulous elements in the trade can exploit the situation to evade tax and it would be difficult to correlate taxable and exempted goods of the same description, in the market place beyond the first stage of sale.

As on date three types of incentives schemes viz. Exemption, remission and Deferral are in vogue in a various states. These incentives are to be availed within a fixed period and are directly linked to the category of the back ward area and the quantum of capital investment made for establishing a new unit or expansion of the existing unit. This incentive lapses if the unit fails to exhaust its entitlement within the prescribed period. Under these schemes what is considered for deferral or exemption is the net tax liability.

Under exemption Scheme all local purchase of inputs and sale of finished goods, as the case may be, manufactured by the eligible unit are exempt from local and central sales tax provided the sale is effected from the same state. Under this option, the buyer stands to gain as the price charged is exclusive of tax and the manufacturer will have advantage of competitive price over the competition.

The deferral scheme on the other hand offers no exemption from the sales tax either on purchase of inputs or sale of finished goods. The eligible unit is required to charge sales tax as in the case of normal sale but is allowed to retain such taxes collected for the prescribed period. After the end of the deferment period, the eligible unit has to make the payment of taxes so deferred, to the government without any interest. The benefit under deferral schemes is that the manufacturer can enjoy the benefit of cash inflow as the eligible unit is allowed to retain the taxes collected during the period of deferral. The other benefit would be that the NPV of the money to be re-paid after the prescribed period would be significantly lower than the amount collected as tax.

The remission scheme, which is in vogue only in the State of West Bengal, allows the manufacturer to collect the tax on sale of goods but the liability to pay tax is set off against the incentive receivable by the unit. Though comparatively the quantum of benefit offered is less under this option, the manufacturer earns additional revenue by appropriating the tax collected from buyers against the tax payable on sale of finished goods.

As discussed above each scheme has it’s own merits and demerits, the decision by a unit to opt for a particular scheme is exclusively based on certain rationales such as sale and consumption pattern of the product, price competition, rate of sales tax etc., so as to optimize the return on the capital invested. If the manufacturers who have already opted for exemption schemes which best suits their requirement, are made to compulsorily shift to the deferral mode due to the impending introduction of VAT, they will suffer huge financial set back in terms of;

     1. Loss of price advantage since the sales tax is required to be charged above the existing price,

     2. Loss of margin if the tax is absorbed to sustain the existing prices and

     3. The net present value (NPV) of the return on the investment of the deferred taxes would be lower than the NPV of the total benefits, which would be otherwise available under exemption/remission schemes.

While appreciating the intention of the state governments to honor the commitments given to the eligible units, the proposal to shift exemption units to the present deferral scheme will have huge financial impact on exemption units, which can be seen from the illustration given below;

From above it is crystal clear that shifting over from exemption to deferral will result in reduction in absolute margin of the eligible unit. Under this circumstance it would be worth its while to examine the alternatives, which would neither impact the units and the governments negatively nor would be in conflict with the proposed VAT regime. While considering alternative options to replace the existing exemption scheme one has to keep in mind that such option should not deprive the incentive units of the benefits other wise available under the present exemption schemes. Such option shall not result in drain on the government revenue, it shall be legally and constitutionally valid and most importantly, it should not interfere with the effective implementation of VAT. Considering the above requirements, there can be three options that are available to the government;

     1. Replace the exemption with remission scheme based on the model prevailing in the State of West   Bengal.

     2. Replace the exemption with deferral scheme with an option to make upfront payment at a discounted rate equivalent to the NPV of deferred sales tax payable to the government. This discounting rate and tenure may be suitably adjusted so as to match the benefit otherwise available under exemption scheme.

     3. Replace the exemption with deferral scheme with an extended period of deferment, so that the NPV of the return on the investment of the deferred taxes will be equivalent to that of exemption scheme.

It seems that these could probably be the only options which could satisfy both the government and industry without creating any conflict with the proposed VAT regime. Any attempt to replace the present exemption scheme with the current deferral schemes would send a wrong signal to the industry and it may only act as a boon to the vested interests to create suspicion about the post VAT regime, generate protest and under mine the good intentions of the government.

Viable alternatives:

1) Remission scheme: Under this model the eligible unit charges the tax in the invoice, retains the tax collected and files the periodical return showing the tax payable along with a request to adjust the tax payable against the incentives receivable. The government subsequently sanctions the request for remission and allows to set off the receivables against the incentives payable. At present the above scheme is in operation in the State of West Bengal. Under this model the assumption is that the total price to the consumer including tax shall remain as the same and the amount of tax remitted to eligible unit is available to the buyer as tax credit. It is clear from the following illustration that both industry and the trade will be in a win-win situation under this option.

From the above it can be observed that the remission model would be compatible with VAT and it will not break the VAT chain since, the invoice will show the tax at all stages and credit is allowed against the invoice as in the case of any other sales. Though sales tax is recovered separately on the invoice of manufacturer, it will remain with him as it is available to him in the form of remission and hence the actual margin of the manufacturer will remain the same as in the case of exemption. If the manufacturer so desires, he may compensate the loss of margin of the dealer (due to VAT on dealers margin) by absorbing the loss. This would not only meet the government’s objective of protecting consumer from price rise after VAT implementation but also result in slight rise in the government revenue by Rs. 1.90 as illustrated when compared to the exemption scheme.

However, certain reservations are expressed against remission model from certain quarters with respect to its constitutional validity in view of the Supreme Courts judgment in the case of Amrit Banaspati Co. Ltd Vs. State of Punjab (85 STC 493). In this case the Government of Punjab had announced an incentive scheme ie. refund of sales tax for a period of five years, for manufacturer who set up large scale industries at a specific location. The government subsequently withdrew this scheme and the appellant challenged the said decision in the Supreme Court. The Supreme Court held that as per article 265 of the Constitution of India, tax that is collected without the authority of law only can be refunded and no law can be made to refund tax to a manufacturer, realized under the statute. In view of this, it is argued that the remission scheme will be ultra vires the Constitution.

It seems the decision of Supreme court is totally misconstrued by the critics of remission model and meaning of "remission" is literally construed as refund. The matter under consideration before the court was whether an incentive scheme based on refund of sales tax for prescribed period is ultra vires to the article 265 of the constitution. The entitlement for incentive under remission scheme is not based on refund of sales tax. Under this scheme, the unit entitled to receive an incentive equal to certain percentage of the capital investment, depends upon the gradation of the location. The maximum incentive the unit can claim during each year is limited to the amount of sales tax collected by the unit, subject to the maximum limit allowed to each unit. Under this scheme, the unit is not allowed to set off the sale tax collected against the incentive due to them unless permitted by the government on specific application. This mechanism has logical justification since it will not make sense to the government to collect the sales tax by one hand and give equivalent incentive by the other hand instead of allowing the units to set off the receivable against payable. . In one of the famous, English Cases, Harmony and Montage Tin & Copper Mining Co., Spargo’s Case (1873) 8 Ch App 407, it was held that "there is no reason why the cancellation of a genuine debt by mutual consent cannot be treated as payment in cash." Accordingly, for administrative convenience and expediency, if the act provides for collection and appropriation, the same shall be considered as "constructive payment" and no way be construed as refund of tax. The ratio of the Amrut Banaspati case is not applicable to the remission scheme as the facts of the case are entirely different from each other. In view of this, the argument that remission scheme is ultra-vires the Constitution will not be valid. The fact that the scheme was prevailing in West Bengal for last so many years without any dispute on its constitutional validity, further confirms its legality.

However, to check any potential misuse of the remission scheme, the states shall limit the input tax credit in case of branch transfer or inter-state sale of finished goods to 4% or interstate sales tax paid or payable whichever is higher. This may be necessary because it is possible that the units may set up one more dummy unit and sell goods under remission scheme to such dummy units before selling or stock transferring it inter-state, so that it can have double benefit .e. once as remission and second time as input tax credit before selling or stock transferring it, interstate.

2) Upfront payment of tax at the discounted rate: Under the prevailing deferral schemes, the manufacturer collects money but payment is deferred to a future date. By the time the government receives the deferred taxes, say, after a period of 10 years, the net present value of the money received would be much lower than the actual amount of tax collected. The government may explore the possibility of replacing exemption with a deferral scheme, which allows the unit to make upfront payment of the money payable after 10 years, upon collection on a monthly basis, at a discounted rate, which is equivalent to the NPV value of the benefit otherwise available under exemption. For this purpose, the period of deferment may be suitably extended so that benefit in NPV terms remains the same under both schemes as can be seen from the illustrations given below. For the illustration purpose we have assumed that a discounted rate of 32%, which is based on, the present value of an amount received by the government after 10years (i.e. deferment period) @12% discounting factor. It is also assumed that at the time of shifting from exemption to deferral, out of the total tenure of ten years, five years are already over and hence in order to equal NPV the tenure of deferral shall be extended to 8 years.

In the illustration given above, the NPV value of the benefit to unit is slightly higher than under exemption scheme ie. 90.22 under the proposed deferral at discounted rate as against 85.15 under the present exemption scheme. This can be further adjusted to arrive at equal NPV benefit. Under the above preposition it can be seen that government will start receiving the revenue from the beginning as against no revenue under exemption, in addition to the tax collected on value addition on subsequent sale under VAT regime.

This option will ensure recovery of the government revenue since quite often the units turn sick after the end of the scheme and fail to pay back the deferred tax. Such a scheme will be beneficial to the government and the units as both can have the revenue from the first year itself.

3) Extended deferral and repayment period

As already stated earlier a shift from exemption to the present deferral scheme without any mechanism to balance the NPV factor, would result in substantial loss of NPV to the industry ( i. e. from an NPV benefit of 85.15 under exemption scheme to 36.89 under deferral scheme) whereas the government would gain 28.01, as shown in the illustration given below. It is assumed that the deferred taxes are invested yielding a return @9%.

Hence in order to make the deferral scheme more attractive for the industry, the deferment as well as repayment period should be stretched to the extent, which would yield same NPV of return on the investment of the deferred taxes. In the above case where the annual growth of business is assumed to be 10% per annum, to match the NPV under deferral scheme with that of the exemption scheme, the repayment and deferment period has to be extended to minimum 12 years as explained in the following table. If the annual growth is less than 10% the tenure needs to be extended more than 12 years . The government on a case-to-case basis, based on the above method may work out the actual period.

Comparison of the three options:

The comparison of all the three models as discussed above give us the following picture:

Though, each of the above options may be an alternative to the present exemption, we suggest that the remission model merits consideration over other options. This is because under VAT regime, it is ideal to phase out all incentive schemes as fast as possible and remission model does not require any extension in its tenure. The other options if the extension of tenure beyond a period will take away the benefit of revenue factor to the government. Moreover, both under the last two options the government have to make extra efforts to administer the extended deferrals. These options also run the risk of default by the dealers in repayment of the deferred taxes. Considering the potential risks we recommend that the remission model would be the most ideal option to replace the present exemption scheme, as it is easy to administer and has the potential of meeting the expectations of the industry and the government.