GST issues around reversal of credit

“Do I have to reverse the credit proportionate to the interest I earn on my fixed deposits?” A friend who is a finance manager asked me that question. Sounds strange on the face of it, and the logic often baffles many. So let’s take a closer look.

Many companies put fixed deposits with banks as a part of their treasury operations. Giving fixed deposits on interest is treated as exempt under the Goods and Services Tax (GST) law, and therefore is seen as an exempt service provided by the company to the bank. GST law requires that whenever one makes a taxable supply and an exempt supply (or, in this case, service), input tax credit (ITC) pertaining to the exempt supply, or service, needs to be reversed. Thus the question from my friend.

To reverse this ITC, my friend may have to travel through a maze of complex formulae in the rules.

A basic concept in any value added tax (VAT) is allowing credit of tax paid on the inward supplies (or purchases), which then can be used to discharge tax on the outward supplies (or sales). As a corollary, when outward supplies are exempt, credit is not available. In some cases, like exports, tax may not be levied on the outward supply, but credit is still allowed. These are called zero-rated supplies in VAT terminology. It must also be noted that if a company performs an activity that is not a business activity (e.g., using a company car for private purposes), credit with respect to such activity is not available.

Though this looks very logical and easy, implementation of this principle is not. Any business will have myriad transactions, some of which are exempt, and some of which are covered under non-business activities. The reversal is required in respect of inputs, input services, and capital goods.

Besides the examples of reversals mentioned above, GST law contains another single line in its credit provisions that also requires reversal of ITC. This small line could be a big cause of disagreement in the coming days when companies and tax officers scan the business transactions.

A provision under Section 17(5)(h) of the Central GST (CGST) Act states that “input tax credit shall not be allowed in respect of goods lost, stolen, destroyed, written off, or disposed of by way of gift or free samples.” Let us look at how this provision could impact us.

Very often companies send free samples to their customers or business partners. This is more prominent in certain industries, such as pharmaceuticals. No tax needs to be charged on such samples, which are cleared to the distributors or other players in the supply chain. However, companies cannot claim ITC for these samples.

Since it is difficult to determine which goods and services will be supplied as free samples at the time of taking credit, ITC may need to be reversed in respect of these samples. Sometimes samples may not be in the same size as the goods actually sold, and in such cases the computation will be more complex and subject to disputes. It is, therefore, necessary to have clear records right from the start to ensure clarity on the amount of ITC to be reversed.

Reversal of ITC on samples can also result in a double hit in some instances. For example, I have seen a case in which a manufacturer supplied free samples to a distributor on the reversal of credit. The distributor supplied these samples to his depots in other states on payment of tax, as the law requires it, depots being related persons. The depots further distributed these samples to the sub distributors/retailers by reversing the credit once again.

Therefore, on one sample, the law required credit to be reversed twice. Businesses may need to tweak their processes to avoid such unnecessary leakages of credit.

One of our clients is in the business of fish products. These products are perishable and at times the fish could go stale at the distributor’s or retailer’s place and need to be destroyed. This is also true for many other food products or medicines. In most of these cases, the manufacturer compensates the distributor/retailer for the losses due to products going stale or crossing the expiration date. The process of ITC reversal starts when the distributor returns goods to the factory or warehouse of the manufacturer.

Sometimes the distributor may destroy goods on behalf of the manufacturer, as it may not be economical to transport the goods back to the factory. In such cases ownership is usually transferred back to the manufacturer, even though possession is retained by the distributor who arranges the destruction. After this destruction, the law requires the manufacturer to reverse the ITC in his books.

To economize on transport cost, a manufacturer may also consolidate expired products at different locations in the country and have them destroyed at different warehouses or through a third-party.

In each of these scenarios, companies should map a proper process for reversing the ITC to ensure that only the relevant person reverses the credit. The documents accompanying the goods as they move to different locations (invoices, delivery challans, and way bills) also need to be clearly specified to the concerned staff so that everyone will follow the formal procedures.

When a company provides gifts to persons outside the organization, GST law treats the reversal of ITC similar to gifts, as described above.

Gifts can also be given to employees, however, and because GST law sees employees as distinct from the organization where they are employed, gifts to them are treated differently.

Gifts valued at up to Rupees 50,000 per employee in a year are not to be treated as supply. Though tax is not payable on such gifts, would related ITC be reversed as it is not available ab initio? Or, can one take a position that no reversal is required where it is not a supply?

Maintaining meticulous records of gifts to each employee to monitor the 50,000 limit can be an accounting nightmare, especially in large organizations like IT/ITES companies. Moreover, companies need to clearly understand what constitutes a gift and what does not. Whether a performance reward or a 10-year anniversary reward constitutes a gift is also a debatable issue. Companies need to take stock of all benefits given to employees and decide which are gifts and which are not.

Very often companies supply advertising material or other supplies to the distributors or channel partners. Often the ownership of such material rests with the manufacturer, and only the possession is handed over to the distributor.

This may even happen in the case of an apparel business where the brand owner may supply a mannequin to the franchise, who would then drape it in the clothes of the brand owner. The mannequin would be returned once the franchise agreement ends or the mannequin can no longer be used for some other reason.

One view is that such supplies should not be supplies or disposal of assets, but mere transfer of possession, and therefore should not require reversal of credit. However, where the material supplied is not likely to come back, it should be seen as a disposal of business assets.

In terms of Schedule I of the CGST Act, disposal of business assets where credit is already taken will be treated as supply, and would, therefore, attract tax. If the tax is paid on such supplies, the law does not require reversal of ITC.

The FAQs released by the government for the gems and jewelry sector, however, have opined that supplying advertising material (banners/hoardings/posters) to distributors will not attract tax, as it is not supplied, but credit will have to be reversed. Perhaps the thought behind this view is that supplying such advertising material is not a disposal of a business asset, but a revenue expense, and therefore does not attract tax. However, reversal of credit is necessary.

Quite often goods are sold with a warranty. The warranty cost is also included in the cost of goods when they are sold in the first place. Supplies to fulfill a warranty obligation should not be seen as free supplies covered under this clause, as these are neither gifts nor disposal of assets, but are supplies whose consideration is received in advance at the time of initial sale. FAQs by the government on the IT/ITES sector take a similar view, stating that no reversal is required.

Often clients ask whether they can discharge tax on the exempt activity to get out of the clutches of the credit reversal provisions. Section 11 of the CGST Act makes a specific provision that when goods or services are exempted absolutely (without any condition to be satisfied) the taxpayer does not have an option to charge tax without claiming an exemption. The government may have to rethink this provision, which is a legacy borrowed from excise law. I feel such freedom to choose between an exemption and payment of tax would bring much ease to the business with very little impact on government revenue.

Taking credit is the mainstay of any value added tax like India’s GST. However, reversal of credit is much more complex than it looks on the face of it. Businesses need to take a hard look at their expenses to identify transactions that might require reversals. Answers may not be easy in some cases, but we can hope that more clarity and certainty will come in the future.

Avalara is an experienced application service provider (ASP) and partner of authorized GST Suvidha Providers (GSPs). To understand how our cloud-based application, Avalara India GST, can help you with GST compliance automation, contact us through  https://www.avalara.com/in/products/gst-returns-filing