The replacement of archaic system of commodity taxation, viz., sales tax with the value added tax (VAT), has brought about significant changes in pricing structures, procurement and distribution strategies and the inventory policies of large organsations
THE replacement of archaic system of commodity taxation, viz., sales tax with the value added tax (VAT), has witnessed significant changes in the pricing structures, procurement and distribution strategies and the inventory policies of large organisations. Simultaneously, India has not implemented value added tax in its purest form, but has chosen to adopt a truncated or a two-tier taxing structure. State level taxation which was hitherto known as sales tax, has been replaced with value added tax in select states, while the central sales tax (CST) levied on inter-state transactions continues status-quo. Currently, in India, the continuance of CST by the Central Government has, to a significant extent, made an impact on the trade between the states.
Initially, the European Union too attempted to levy tax on intra-union sales on the principle of origin of goods while allowing the credit of such tax in the destination state. This set-off was proposed to be allowed through a clearing house mechanism which, to an extent, preserved the destination principle of taxation. However, due to lack of readiness on part of the member states to administer the clearing house mechanism, EU has resorted to a transitional regime of zero-rating the intra-union transactions.
While in India, the Union Finance Minister,
Mr P Chidambaram, has confirmed the phase out of CST by March 2007, the two-tier tax framework and its phasing out has certain implications which need review while designing and implementing the model for franchising and the vendor supplies.
The framework within which the VAT laws across various states operate is that only the tax paid on purchases under the respective VAT legislation qualifies as input tax credit, while CST paid on inter-state purchases, does not. In this scenario, inter-state purchases would become dearer to the purchaser to the extent it contains the CST element. As far as it relates to the distribution of goods, the CST payable on inter-state sales practically qualifies as ‘output tax’ under the state VAT laws. This implies that the tax paid on local procurement qualify for set-off against CST payable on inter-state sales. Thus, as a buyer, one would want to buy locally within the state, while he would remain indifferent on the distribution front, viz., local or inter-state sales, since the tax payable on either of them qualify as output tax. With the CST currently being four per cent and the revenue neutral rate under VAT laws pegged at 12.5 per cent, it is possible that the input tax credit would not be fully utilised at the end of any given period. With the CST proposed to be phased out, i.e. reduced to 2 per cent for the fiscal 2006-07 and zero per cent from 2007-08 onwards, the possibility of higher amounts of input tax credits remaining unutilised would also increase. At this stage, it should be noted that the benefits of CST phase out would be available when the customers furnish declaration forms. In the event, no declaration forms are produced, the existing rates of CST would be applicable, viz., 10 per cent or the rate prescribed under the local VAT law, whichever is higher. (See Table 1)
Simultaneously, an organisation which has dealt with central excise provisions would assume that such amounts would remain as excess credits in perpetuity for subsequent set-offs only, if any, and would in no circumstances qualify as refund. However, in reality each state has distinct provisions for the same.
Effect of excess credits
The whitepaper on VAT published by the Empowered Committee of State Finance Ministers on January 17, 2005 which elaborates on certain aspects of convergence that the State Governments were advised to build into their respective VAT legislations discusses on the aspect of excess credit. It has been indicated that the tax credits remaining unutilised at the end of two years should routinely qualify for refund, thus advising the State Governments to adopt a view less stringent when compared to the central excise provisions. However, what assumes importance from the business perspective is that the excess credits remain illiquid for a period of two years, thus increasing the effective cost of working capital.
A study of VAT legislations of various states indicates that this issue of convergence has not been adopted in its true sense. For instance, in the States of Maharashtra, the unutilised credits at the end of the year one would qualify for refund. The period of one year is merely the period for which the refund claim would be processed by the VAT officers. The due date for grant of refund has been pegged at six months from the end of the period in Maharashtra. The illiquidity feature of such excess credits gets further extended with the inclusion of refund processing time.
With reference to the above illustration this would mean that a working capital of Rs 496,875 would get locked for a period of at least 18 months or 545 days
in the State of Maharashtra. (See Table 2) Businesses would require to analyse the implications of these provisions from a cashflow and working capital perspective. Consequentially a high level indicator for reviewing the optimality of procurement and distribution patterns would involve a comparison of increase in the effective cost of working capital on account of unutlised credits with the additional disallowance of input tax credit on account of inter-state non-sale dispatches.
Business models: A re-look
One of the options available for the businesses would be to replace direct inter-state sales with the stock transfer and consignment transfer mechanism. Currently,
under the VAT laws, stock transfers or consignment transfer of goods to a place outside the origin state entails disqualification of input tax credit. Thus, in a transaction involving inter-state movement of goods, it may today appear that a direct sale is more viable when compared to a stock transfer. However, from the buyer''s perspective a local purchase would be more economical. Typically, a franchisee of a product business needs to source materials from, either the franchisor or a selected vendor. While designing the franchising structure, it would help to design a structure which captures an optimal balance between the cost of working capital for the respective parties including the inventory carrying cost and the taxes so that optimisation of these costs can be conceptualised and the benefits of the same be shared among the participants. Let''s assume that the franchisor, manufacturer or seller is located in Maharashtra and the franchisee, distributor or buyer in Andhra Pradesh. The franchisor would prima facie be keen to make a direct inter-state sale of goods to the franchisee since the stock transfer route would result in disqualification of input tax credit. However, the franchisee would want to buy the goods locally within the state of Andhra Pradesh since the tax paid on such purchases do not add to the effective cost of purchase.