At a time when state governments are asking for higher compensation to offset the revenue loss due to the reduction in the rate of central sales tax (CST), which has been brought down to 2%, Tamil Nadu has opted to provide a further CST cut as a fiscal incentive to German auto major BMW, which runs a manufacturing plant in Chennai.

The Tamil Nadu government, in March this year, reduced the CST rate on passenger cars and components manufactured by BMW India Ltd by 1%, citing public interest. The auto company now has to pay only 1% CST.

BMW India president Peter Kronschnabel said, The 1% tax relief was a standard proposal from the state government in the negotiation for the memorandum of understanding with the company earlier in 2005. The company does not absorb the tax relief in its margins but passes it on to its customers, he added.

While CST is essentially a state subject under the Constitution, which allows state governments to take individual decisions on the tax rate and exemptions, the Centre is not too happy with states providing such tax benefits.

The Union finance ministry has made it clear that it will only compensate states for the losses that accrue to them due to the 1% cut on CST under its phase-out plan, and not for such exemptions, an official source said.

The state governments decision on BMW was made at a time when the phase-out process of CST was stalled by nearly two months as states had objected to increasing the rate of value added tax (VAT) and had, instead, pushed for a higher monetary compensation from the Centre. While the Centre decided to notify the tax cut last month, the stalemate still continues.

In fact, Tamil Nadu, Karnataka, Maharashtra and Gujarat have been the most vocal opponents to a hike in the VAT rate to compensate for their revenue losses, sources close to the development said.

Although Ford Motors, with manufacturing facilities in Tamil Nadu for several years, also enjoys a similar tax concession from the state government, it was awarded much before the VAT regime came into place.

In 2008-09 states are expected to get about Rs 6,000 crore as compensation from the Centre for reducing the CST rateless than half of their original demand of monetary support of Rs 13,000 crore.