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Pitfalls of hurried imposition of service tax
July, 13th 2007
The government is all set to implement the goods and services tax (GST) regime from April 1, 2010. Given the fact that there are parallel systems of indirect taxation at the central and state levels, and taxes like service tax and central excise operate at the central level and taxes like VAT and central sales tax (CST) operate at the state-level, there is a need to harmonise these taxes both at the central and the state levels to eventually bring in the GST. The empowered committee of state finance ministers has set up a joint working group to study various models of GST existing globally to identify the possible alternative models for introduction of GST in India and to recommend the most appropriate model. The group is expected to come out with its recommendations by September 07.

While the target date for GST is coming nearer and the government is exploring the most efficient tax model, some steps have already been taken by the government towards introduction of the integrated tax. One of these steps is the complete phasing out of the CST. Effective April 1, 2007, CST has been reduced to 3% from the prevailing rate of 4% and a roadmap has been announced for its further reduction and complete phase out by the year 2010. As abolition of CST would entail significant loss of revenue to the states, they are seeking suitable compensation for the loss of revenue. Taxation of services by the states is one of the measures contemplated to compensate the states for the loss of revenue.

Given the above background, it has become imperative to impart more clarity to the structure and provisions of service taxation in order to facilitate its ultimate integration with the GST. India has a three-tier federal structure, comprising the Union government, the state governments and the urban/rural local bodies. The power to levy taxes and duties is distributed among the three tiers of governments in accordance with the provisions of the Constitution. With the eighty-eighth amendment to the Constitution in 2003 resulting in insertion of Article 268A and insertion of Sl no 92C - Taxation of services in the Union List, the power to levy taxes on services shall continue to be with the government of India. However, the collection and appropriation of such taxes would be by the Centre and the states in accordance with the principles to be formulated by Parliament. In view of the above amendment to the constitution, the centre has offered to compensate the states for the CST phase out by offering them the revenues relating to 33 of the existing services currently being taxed by the centre and on 44 new services to be taxed in due course.

In view of the above, the empowered committee of state finance ministers, in their recent meeting in Srinagar, had identified five new services for the purpose of service taxation. These are the services provided by schools, doctors, hospitals, amusement parks and coin-operated amusement machine services. As the states do not have the power to levy tax on services, it is expected that these service taxes would be levied by the centre and the states would be allowed to collect and appropriate the same. The expectation is that the necessary changes would be made in Rule 6 of the Service Tax Rules, 1944 to operationalise the mechanism to do so.

The move of the committee has come as a surprise to trade and industry. Considering the fact that the structure of the GST is being deliberated by the joint working group set up by the same committee, one would have expected that any major decision like imposition of state service taxes would be taken after the considering the working groups recommendations. Any new taxes with a short-term perspective of raising revenues may prove counter productive if they are not designed to smoothly integrate with the proposed GST.

Further, co-existence of the central and state service taxes is likely to result in tax cascading. For example, a hospital would have an output state service tax liability but would not be in a position to offset the input excise taxes paid on goods and services taxes paid on procurement of services for rendition of these output services. This would affect the basic concept of value added taxation of goods and services.

A similar issue of inability to offset the input and output taxes could arise in cases where the service provider and the service recipient are in two different states. To obviate this, state service taxes need to be restricted to services of a local nature till the time GST is implemented.

One final issue is regarding the class of services chosen by the states for service taxation. The government of India has all along opted not to tax medical services and education on grounds of public policy. If these are to be taxed now, the reasons need to be clearly articulated. The point is that the basic scheme of state service tax needs a careful evaluation before its introduction.

R Muralidharan
The author is associate director, PricewaterhouseCoopers
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