Doing business in India has typically been a challenge for multinationals and local companies alike, due to the many indirect tax laws and regulations that are in force. The average indirect tax incidence on goods made and sold in India is one of the highest in the world and varies from 30% to 40% of their value. It is less so in relation to services but is nevertheless significant.

India has in a sense always had a greater reliance on indirect taxes than direct taxes. It has historically been easier to tax the consumption of goods and services indirectly than trying to tax incomes. The trend of the tax GDP ratios in India over the past six years is shown in the chart below and bears out the point on the reliance placed on indirect taxes:-

Diagram 1

Nature of indirect taxes

Indirect taxes in India typically apply to all activities and transactions across the supply chain in relation to both goods and services. They extend from procurement to manufacturing to final consumption, and also apply to trading activities and on imports into the country. It is therefore essential for businesses to obtain a comprehensive understanding of the total indirect tax costs on goods and services, and to try to optimise the aggregate incidence of the tax through structuring the business models so that they are able to retain their competitive position in the market. The Government of India has been aware of the need to reform indirect taxes both in terms of their incidence (tax rates) as well as their structure. The fiscal reform process that has been in place since 1991 is geared to realising an indirect tax structure that is simple to understand, easy to administer and is based on the principles of moderation and rationality in tax rates.

The constitution of India envisages the governance of the country as a federal structure, comprising the Union Government at the centre, and state governments in the different Indian states. Under the constitution, Central Government is empowered to impose taxes in the form of excise duties on the production or manufacture of goods, as well as taxes on the provision of services. The Central Government can also authorise and regulate the imposition of taxes on inter-state sales and purchases of goods, although such taxes may be levied and collected by the states.

The states themselves are empowered to impose taxes on intra-state transactions concerning the sales and purchases of goods. The states are also authorised to impose certain other local taxes such as entry tax. Finally, local authorities and municipalities impose local taxes.

In addition to all of the above, the Central Government is also empowered to impose customs duties on the importation of goods into the country.

To summarise, there exist today the following indirect taxes relating to the field of commodity and service taxes, commonly known collectively as consumption taxes.

• Customs Duty – customs duties or import duties are levied by the Central Government of India under the Customs Act, 1962 (CA) and the Customs Tariff Act, 1975 (CTA). These duties are imposed on goods imported into India.

• Central Value Added Tax (Cenvat) – a tax on the manufacture or production of goods in India, imposed by the Central Government. Cenvat has replaced the excise duty regime.

• Service Tax – a tax on identified services rendered by persons defined in the statute, imposed by the Central Government.

• Central Sales Tax (CST) – a tax on the inter-state sales and purchases of goods, imposed by the originating state.

• States Sales Tax / Value Added Tax – a tax on the intra-state sales and purchases of goods, imposed by the states.

• Entry Tax – a tax on entry of goods into the state, imposed by the states.

In addition, local levies, such as octroi or local area taxes, could be imposed by municipal or local authorities.

Overview

A brief overview of the aforesaid regulations and taxes is given below:

Customs duties are imposed on goods imported into India in terms of the CA and the CTA. Because India is a signatory to the WTO agreements, the Indian Custom's tariff classifications are aligned to the eight-digit harmonised system of nomenclature (HSN) followed internationally. The customs duties are computed on the value of the imported goods. The imported goods are valued in terms of the CA read with the Customs Valuation Rules (CVR). The CVR is based on Article 7 of the General Agreement of Trade and Tariff (GATT – now WTO). A set of fresh rules has just been notified (to be effective from October 10 2007) for this purpose.

The types of customs duties that are applicable on imports are as follows:

• Basic Customs Duty (BCD) – this is calculated at the effective rate applied on the landed value of the goods, which comprises of the CIF value and the landing charges. The rate of BCD depends on the classification of the imported goods under the customs tariff. The typical rate is 10%.

• Additional Customs Duty or Countervailing Duty (CVD) under section 3(3) of the Customs Tariff Act, 1975 – this is equivalent to the excise duty applicable on like goods manufactured in India. This is calculated on the total of the landed value and the BCD. The typical rate is 16%

• Additional Customs Duty (ACD) under section 3(5) of Custom Tariff Act, 1975 – introduced March 1 2006 on goods imported into India to countervail the sales tax, value added tax, local tax or any other charges levied on like goods on its sale, purchase or transportation in India. ACD is levied at 4% on the aggregate of the landed value of goods and all customs duties.

• Educational cesses are charged on these duties at an aggregate of 3%.

In general, the cumulative incidence of customs duties on import of goods into India is about 34%. Offsets are typically available with regard to the additional duties and hence only the basic duty is typically a cost.

Further, the Central Government has the power to generally exempt goods of any specified description from the whole or any part of the duties of customs leviable thereon. There are several such exemptions. In addition, preferential and concessional rates of duty are also available under the various trade agreements entered into by India with specified countries and regions for various products covered by such agreements.

Cenvat is a duty of excise levied by the Central Government on the manufacture of movable and marketable goods in India. The duty is levied at the rates specified in the excise tariff, based on the classification of goods. This classification is again based on the HSN and is eight-digit level. The rate of excise duty is generally 16%. However, for certain goods like cars, the rate of excise duty is 24%. Exemption from duties are also available on a limited set of products. In addition, an education cess of 3% on the aggregate of the excise duty is levied.

The Cenvat is a modified VAT wherein a manufacturer is allowed credit of the excise duty paid on locally sourced goods and the additional duty of customs on imported goods. The Cenvat credit can be utilised for payment of excise duty on the clearance of dutiable final products manufactured in India. In addition, with effect from 2004, an integration of Cenvat credits paid on goods and the service taxes paid on input services, used or consumed in the manufacture of goods and rendition of services, is now in place. Consequently, manufacturers can utilise all input Cenvat credits and service taxes to discharge their output excise duty liability.

Service tax is the most recent of the indirect taxes in India. It has now been in force for 13 years and is fast becoming one of the main contributors of indirect tax revenues.

Service tax is levied by the Central Government on specified taxable services at the rate of 12% of the gross value of taxable services. In addition, the education cess at 3% is leviable on the services. Input credits are now available across both goods and services. Consequently, a service provider can avail credit of excise duties paid on capital goods and inputs used for providing output services, apart from availing credit of the service taxes paid on input services.

The scope of taxable services has recently been expanded. Services provided from outside India to a recipient in India would be deemed to be taxable services provided in India and hence subject to service tax. Further, no service tax is chargeable on export of services from India. Alternately, the service provider could discharge the service tax on exports and claim a rebate of the service tax paid.

Sales tax and Value Added Tax

The sale or purchase of movable goods in India is subject to sales tax. Imports into and exports out of India do not attract sales tax, nor is it levied on services. Sales tax is levied under the following legislation:

• Central Sales Tax Act, 1956 (CST Act), which regulates the sale or purchase of goods between two states (inter state sales); and

• State Sales Tax Act and state VAT Act, which regulates the sale or purchase of goods within a particular state (intra state sales).

This is a transaction tax applicable on sale transactions between two states involving the movement of goods from one state to another. Although the CST is centrally legislated, the authority to collect and use the tax proceeds has been transferred to each originating state. Accordingly, it is levied and collected by the seller in the one state from the buyer in the other. Because the CST is an origin-based tax, no input credit of the CST charged by the seller is available to the purchaser as a set-off against the output CST or VAT payable in the other state. It is recognised that the CST is an anachronism and is intended to be phased out over time, in a gradual manner.

The typical rate of CST is 3% against the provision of statutory declaration forms (form C). In the absence of such forms, the local VAT rate on the product, as applicable in the state from where the goods are supplied, will apply.

State sales tax or state VAT is a tax which regulates the sale or purchase of goods within a particular state (intra-state sales).

India introduced the state VAT with effect from April 1 2005 in a majority of the states and union territories. Subsequently, five other states transitioned with effect from April 1 2006. With effect from January 1 2007, VAT was also introduced in the state of Tamil Nadu. Currently, only the state of Uttar Pradesh continues to operate under the erstwhile sales tax regime. The draft Uttar Pradesh VAT Act and rules are already in the public domain and the date of implementation is awaited.

The state VAT operates as a typical multi point tax with an offset of the input taxes paid at each previous stage. This is unlike the sales tax which typically operated as a single point tax, primarily first point but occasionally last point. The two main VAT rates are 4% and 12.5% and most goods would be covered under either of these rates. The input VAT can be used to offset this output VAT liability.

Entry tax

Entry tax is levied by the state governments on entry of goods into the state and is payable by the purchaser. There are currently two categories of entry taxes; one which is imposed in lieu of the octroi and is hence not eligible for tax credits and the other which is not in lieu of octroi and is hence eligible as an offset against the VAT payable in that state.

Technology, compliance and anti-avoidance

Both the federal and the state governments have recognised that information technology has a crucial role to play in the delivery of the reform agenda. Therefore, at the federal level taxpayers are now able to (and indeed for larger taxpayers are mandated to) file returns and pay taxes electronically. This ability and stipulation applies equally to direct and indirect taxes.

Information technology has played a significant role in achieving the transition from sales tax to VAT at the state level and there are ongoing developmental efforts to improve internal processes within the state tax offices and to enhance the ability for taxpayers to file returns and pay taxes electronically. Technology is seen as a powerful enabler of the tax reform process. This is a major tax related initiative in India today.

There is a significant amount of indirect tax-related litigation in India. Historically, the pro-revenue stance of the tax administration has led to taxpayers relying on the legal system to achieve solutions to their tax-related business problems. India's robust legal framework enables businesses to make use of the courts in order to validate their tax positions. The concept of advanced rulings is still in its infancy and is not as pervasive and robust as perhaps it needs to be. It therefore remains to be seen how far businesses will be prepared to seek advanced rulings in preference to their current first impulse, which tends to be to seek recourse in litigation.

There has been considerable progress in the levels of voluntary compliance seen in India. Tax rates have moderated over time and with the introduction of IT, the threshold levels for non-compliance have moved up significantly and penalties have been considerably strengthened. A combination of these factors has generated a greater willingness to comply and this, along with the revenue authorities' increasingly sophisticated audit capabilities, means that compliance is at demonstrably higher levels than it was even a few years ago.

Despite rising levels of compliance, fraud and tax evasion continue to provide cause for concern. India operates with a significant informal economy from which no taxes are paid. The Government is trying to address this in a number of ways. For example, it is ensuring that there are robust audit and anti-fraud mechanisms in place and revenue authorities pay particular attention to those sectors of the economy where tax fraud and evasion are most rampant. Special audit teams have been created that are fully supported with dedicated laws providing them with considerable powers to enter premises and seize property.

Introduction of the Goods and Services Tax in India

At the federal level, there has been a concerted effort to integrate the excise and service taxes. A step in this direction was taken with the integration of credits across goods and services with effect from September 2004. As a further step towards a unified VAT system, the state VAT replaced the state sales taxes with effect from April 2005 in a majority of the Indian states. The introduction of a VAT at the state level, to replace the existing sales tax, has been the most significant tax reform measure in India till date. Currently, India prefers to maintain a distinction between the taxes on goods and the taxes on services. As discussed earlier, there is also a distinction between the taxes imposed by Central Government and those imposed by the states. The relative complexity surrounding the dual VAT has accelerated the progression to a nationally-unified Goods and Services Tax (GST) that will replace both the state and federal VAT by April 2010.

The Union Finance Minister, in his Budget speech of 2006, said:-

"It is my sense that there is a large consensus that the country should move towards a national level goods and services tax (GST) that should be shared between the centre and the states. I propose that we set April 1 2010 as the date for introducing GST. World over, goods and services attract the same rate of tax. That is the foundation of a GST. People must get used to the idea of a GST."

In the 2007 budget announcement, the finance minister reaffirmed the commitment to introducing the GST by the deadline of 2010 and announced that the appropriately named Empowered Committee, which was tasked with the work relating to the GST, would work towards achieving the deadline. The Empowered Committee in consultation with the Central Government has constituted a Joint Working Group (JWG) in May 2007 to lay out the road map for the GST. The JWG has been entrusted with the task of studying global GST models and identify alternate models for introduction in India. Based on a study of the alternate models regarding India's federal structure, the JWG will suggest the best model for introduction of GST in India. The JWG is likely to present its report by early October 2007.

India has been moving slowly and steadily towards a GST regime. Excise duty rates continue to be rationalised every year. Moreover, service tax rates are gradually increasing and it appears that the integration of the goods and service tax at the central level into one central VAT will soon see the light of day. Additionally, the state VAT has now been in place for upward of 18 months and it is likely that it will soon be prevalent throughout India.

Given that much work has already been done in terms of integration of the goods and service tax, at the input credit stage, it is reasonable to expect this integration to conclude by 2008. Independently, the integration of the state taxes, along with the phased elimination of the CST, must also commence. Here also, it is reasonable to expect that this process will conclude by 2009. Consequently, it is fair to suggest that India would be in a position to implement the GST on a national basis by April 2010. The proposed timelines to the GST are shown below in a diagram 2:

Diagram 2

The diagram represents a possible scenario of integration of the twin federal taxes of Cenvat and service tax into a central VAT by 2008 and the subsequent integration of the state VAT and other state taxes into one state VAT, together with the corresponding elimination of the CST. Thereafter, the integration of the central and state VAT into one unified GST is likely to take place. It is therefore true to suggest that a dual VAT comprising the central VAT at the federal level and the state VAT at the state level will be in place in India for some time, and appropriate steps need to thereafter be taken in order to move from the dual VAT regime to a unified GST regime. It is equally possible that the dual VAT could itself evolve as a hybrid form of the GST. Several alternate models of GST are being discussed and debated at the time of writing.

The diagram also posits the relevant central VAT rate of 16%, the state VAT (on both goods and services) of 12.5% and a possible 20% national GST April 2010.

It is clear that the government of India is keen to accelerate the progress towards the national GST. As a corollary, states will be granted more taxation powers, as described above, and the inter-state CST will be phased out, possibly replaced with an import VAT on inter-state sales, upon the introduction of the national GST. The clear implication for businesses is that they now need to analyse their business models and their supply chains, from procurement to production through to distribution, to ensure that the impact of this taxation reform process is adequately factored in, and so that their models or supply chains continue to be the optimum indirect tax.

The introduction of the GST in India is both an opportunity and a threat for businesses and companies need to manage the process of transition so that they realise the opportunities, and minimise the threats.

Biography
		S Madhavan PricewaterhouseCoopers Executive Director PricewaterhouseCoopers Pvt. Ltd Sucheta Bhawan (Ist Floor) 11-A, Vishnu Digamber Marg, New Delhi - 110 002, India Tel: +91 (11) 41150505 Fax: +91 (11) 23210594 Email: s.madhavan@in.pwc.com Madhavan is an executive director in PricewaterhouseCoopers, and heads the indirect tax practice in India. He is a fellow member of the Institute of Chartered Accountants of India and a management graduate from the prestigious Indian Institute of Management, Ahmedabad. Madhavan has a total experience of 25 years that includes six years industry experience in Hindustan Lever, India's largest multinational and subsidiary of Unilever UK, and he has acquired comprehensive experience on the application of indirect tax laws in industry. He has had practice experience of over 19 years serving a broad range of international and Indian clients on all aspects of indirect taxes ranging from customs duties to excise law to service taxes and sales taxes. Further, he has been significantly involved in the recent introduction of the VAT in India. He has advised state governments in the implementation of VAT and has also carried numerous VAT impact assessment studies for clients. Madhavan is a member of the International Fiscal Association. Besides this, he is also a member of the Indirect Tax Appellate Tribunal Bar Association and the Delhi Management Association. Madhavan has made numerous presentations on indirect tax matters at various forums, particularly on VAT and service taxes, and is a regular contributor of articles in the national press. He is also a frequent panelist and participant in indirect tax issues on national TV.