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Indirect tax reforms: Challenges and concerns
June, 25th 2009

Today, with the indirect tax regime poised at possibly its biggest structural reform since Independence, viz: the move towards GST, the various concerns and challenges within the present service tax structure needs to be addressed prior to introduction of GST.

Some of these challenges include:

Centre versus state conflicts on levying taxes on intangibles

Any economic transaction deals with a tangible or an intangible asset. For example, manufacturing and sale of goods involves an economic transaction of tangible assets. On the other hand, when services are provided, it is intangible in nature. While globally, transactions of intangibles are generally considered as services, India has tried to separate intangibles into transactions in goods and transactions in services.

Historically, the Indian indirect tax regime has tried to capture the economic value of transactions in intangibles by classifying such transactions as goods and assuming the transactions in such goods to be a deemed sale.

For example, permitting commercial exploitation of a copyright is considered as a transfer of the right to use intangibles or goods and accordingly, state-VAT is applicable on such transactions.

However, there are no distinguishing features clearly spelt out for identifying which transactions in intangibles may be considered as sale of goods. This matter has, over the past few years, assumed increasing importance in light of the higher contributions made by economic transactions in intangibles to the Indian economy.

The central government, appreciating the potential to earn tax revenues from intangibles has regrettably also tried to capture such transactions within the ambit of the service tax laws. As a result, any transaction in intangibles would need to be evaluated both from a state-VAT as well as from a service tax perspective. This dual levy is causing a lot of concern since trade and industry are unclear as to the more specific levy and the manner in which they are required to comply with the same. This duality has also ensured higher amounts of litigation with central and state tax authorities.

It is apparent that such conflicts between Centre and the state governments on tax jurisdictions are counter-productive to the economic growth. The Centre should consider either clarifying more precisely the nature of transactions sought to be covered under the service tax law or a redressed mechanism should be put in place to settle such Centre versus state conflicts that the industry is facing presently.

Taxability of services

From 2001, service tax has assumed increased importance. From a levy on 30-odd taxable service categories, it has rapidly expanded to close to 105 taxable service categories, with several overlaps for the purpose of tax levy.

Unintended ambiguity arises as a result of:

* Classification of a single service transaction into one or more taxable service categories (e.g. insurance premium received from ULIP policy-holders taxable under life insurance services as well as under fund management of ULIP Scheme services);

* Classification of a transaction series into more than one category of taxable service (e.g. logistics services are taxable under cargo handling, storage & warehousing, transportation services (road/rail/air), business support services, etc)

* Ambiguity on which of the taxable service categories are applicable to a transaction (eg providing advice for a merger/acquisition to a company by a bank whether taxable under management consultancy or under banking or other financial services)

* Transactions that are not ordinarily considered as service are sought to be covered as taxable under the service tax law (such as foreign exchange trading, renting of commercial property, etc) resulting in issues for identifying taxable event and taxable value.

The above ambiguities are partly resolved by the central board of excise & customs (CBEC) issuing guidelines or clarifications on taxability. Further, Section 65A of the Service Tax law has also attempted to draft certain principles of classification that attempt to mitigate the above problems. However, grey areas continue as regards the taxability of services, the effective date when a particular activity is taxable, etc.

Ancillary issues like identifying the appropriate taxable value, the manner in which service tax should be computed for certain services, etc also co-exist with the above ambiguity. For example, in foreign exchange trading services, the Central government has provided an option to either pay service tax on the fees collected by banks and authorised dealers for providing such forex trading services or, in the event that no fees are charged separately, pay service tax at 0.25 percent of the purchase or sale value of foreign exchange traded.

A possible solution to the above issue is for the Central government to rationalise the taxing statute by nominating all services as taxable other than a defined list of non-taxable or exempt services (i.e. the negative list). This would also mean enacting a separate legislation for taxing services which could also include a common valuation code and taxability code for all services performed in India.

Cross-border transactions in taxable services

The present structure of identifying import of services and export of services does not seem to follow the mirror principle (viz: the rules to identify import and the rules to identify export should be mirror images of each other). As per the Taxation of Services (Provided from outside India and received in India) Rules, 2006 (the Import Rules), a taxable service is identified as an import into India if such service is either (a) related to immovable property located in India, or (b) on part or whole performance of such service occurring in India or (c) if the recipient of the service is in India. Depending on the identifying criteria, the service is said to be an import if the service provider is located outside India and the service recipient located in India. On the other hand, the Export of Services Rules, 2005 (the Export Rules) adds two other conditions to the above viz: the consideration should be received in convertible foreign exchange and the service should be provided from India and used outside India. These additional conditions result in a taxable service imported from outside India by an Indian service recipient to be taxable under service tax, but if it is provided from India by the service provider to a recipient located outside India, it may not qualify as an export of services.

It may, therefore, be relevant for the government to either consider relaxing conditions for identifying export of services as provided under the Export Rules or add the same conditions applicable on export transactions to imports as well in order to bring parity to the Import/Export Rules for cross-border transactions.

Fractured CENVAT credit mechanism

Although the Central government has increased the scope and ambit of service tax over the years, it has also provided various exemptions and abatements to specific sectors, depending on economic and other needs. Thus, the banking sector is generally liable to pay service tax only on its fee income, the construction industry does not pay service tax on revenues earned from sale of goods, any taxable services provided to diplomats or to SEZs are exempt from tax, etc. These exemptions/abatements are awarded as an incentive to the service provider. However, the CENVAT Credit Rules, 2004 (the CCR) restricts availability and utilisation of CENVAT credits of duties or taxes paid on inputs, capital goods and input services that are used while providing such exempted services. Thus, while the Central government may have its best intentions in awarding concessions, the service providers face denials/ restrictions of eligible CENVAT credits. This defeats the very purpose for which exemptions/ abatements were awarded in the first place.

The Central government may consider, as an alternative, in relaxing the CCR for permitting credits of inputs. Input services and capital goods used for providing certain exempted services. Alternatively, the government may also consider increasing the list of 16 specified services listed under Rule 6(5) of the CCR (permitting unrestricted credits of such services used for providing taxable and exempted services) to also cover additional categories of services such as support services in relation to business or commerce, etc.

SEZ exemptions

SEZ exemptions is a typical issue facing service providers under the service tax laws. As per the Special Economic Zones Act, 2005, any taxable service provided to an SEZ developer/unit is exempt from service tax. However, Notification 4/2004-ST implied a condition to claim such exemption. It stated that only such services that were consumed within the SEZ would be eligible for exemption. Further, the service provider claiming such exemption would face restrictions on his claim for CENVAT credits, thus increasing the implicit cost for providing services to the SEZ. As an alternative, and in order to address the concerns expressed by the service providers, the Central government replaced the exemption notification with a notification permitting the service providers to tax services provided to SEZ developers/units. However, the SEZ developer/unit could claim a refund of such service taxes charged by their service vendors. However, this alternative was not an ideal solution since it shifted the emphasis for claiming concessions from the service provider to the service recipient (viz: the SEZ developer/unit) who would now need to first pay the Service Tax and subsequently claim refunds. The recent changes in the SEZ Exemption that introduces both an exemption from service tax (for services that are wholly consumed within the SEZ) and a refund (for service tax charged on services not wholly consumed within the SEZ) further creates confusion since the service provider may not be entirely aware of what constitutes wholly consumed within the SEZ and accordingly, may adopt a conservative approach of charging service tax on all services provided to the SEZ developer/unit, thus keeping the status quo.

Claiming Refunds

The Central government has allowed service providers who are exporting services outside India to claim a refund of the accumulated CENVAT credits that are relatable to such export activity. However, on the ground, the claimants are facing several difficulties in receiving refund orders from the Department. One historical reason has been the periodic changes in the conditions for identifying an export of service. Additionally, the department has raised several technical questions such as refund application not complete, input services used for providing export services need to demonstrate a direct nexus, etc. Such questions frequently lead to litigation that eventually gets resolved at the tribunal level.

The CBEC may consider issuing comprehensive guidelines or clarifications to take into account all concerns and queries raised by the Department officials. The CBEC should also consider issuing deadlines or time limits within which decisions on awarding refunds need to be made. Such measures would enable the claimants to predict the timelines for receiving refunds on valid claims as well as keeping the entire process transparent and non-discriminatory.

Paving the way for Goods & Services Tax (GST)

The above concerns must be dealt with. Only then can there be an integration of Service Tax Laws with Central Excise and other indirect tax laws, thereby removing some of the road-blocks to introduce GST in India. Introducing a separate service tax legislation, rationalising credit rules for service providers, and appropriately identifying what constitutes an Import or an export of services are some of the essential ingredients for a seamless transition to GST in India at the Central Level. Further, providing administrative guidelines and clarifications from the policy-makers (such as the CBEC) should also ease in the compliance and administration of the Law, thus providing a platform for building a more proactive working relationship between the department and the taxpayers.

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