Sukumar Mukhopadhyay:Breaking the VAT chain

A highly regressive amendment has taken place quietly in the Union Budget 2005-06. Quietly because it has gone practically unnoticed. It is the amendment of Section 5A of the Central Excise Act, which provides the power to grant exemption from excise duty.

According to the amendment: "(1A) For the removal of doubts, it is hereby declared that where an exemption under sub-section (2) in respect of any excisable goods from the whole of the duty of excise leviable thereon has been granted absolutely, the manufacturer of such excisable goods shall not pay the duty of excise on such goods."

This means that if there is a full exemption, no duty can be paid. Earlier the situation was that even if there was an exemption, duty could be paid and the value-added tax (VAT) chain could be continued. If the chain breaks, then down the line, nobody can claim the credit. That would bring back the cascading effect, which VAT intends to avoid.

A question that has often been asked is whether a factory can pay the duty even if there is an exemption and, thereafter, claim the credit of duty paid so that the VAT chain is complete? Some companies do want to pay the duty even if there is an exemption "" for instance, paying the duty for some electrical equipment for power generation. There may be some exemptions on the equipment.

In effect, this doesn't help the power industry. The input duty for the electrical equipment manufacturing factory comes to, say, 9 per cent of the total price of goods made by it, but the duty is nil, though the general rate would have been, say, 16 per cent. So when the equipments were sold, the factory has to bear 9 per cent duty on the goods being exempted.

But if the duty of 16 per cent was imposed, the factory would pass on the full burden of the input duty as well and not have to bear even 9 per cent. This is the reason why many factories do not want exemptions, so that they can pass on the full burden of taxes on the inputs to the next consumer. In fact, there are many instances where the firms do not want exemption and want to pay duty and claim input credit.

An original purist legal view was that any duty paid when the goods are exempted (and so the duty is not due to the government), is not duty in the eye of law but only an ex-gratia payment. They quoted Article 265 of the Constitution to justify this. It follows that, not being a duty it cannot be given credit as duty. However, this is not supported by judicial pronouncements to the effect that an exemption couldn't be forced upon an assessee if it does not suit him (*1,2). The argument of the Tribunal was that it is for the party to claim the exemption and if it does not claim it, there is no way of forcing it on down the party. In another judgment, the Tribunal held that the option lies with the manufacturer to either avail of exemption or pay duty under Section 4 of the Central Excise Act under the normal procedure(*3). This view has now found place in two Supreme Court judgments (*4).

The Supreme Court has upheld in these cases the plea that if there are two exemptions, the taxpayer can choose the one, which suits him. On the basis of this general principle, the view has now once again been reiterated recently in another Tribunal judgement(*5), where the decision is clearly that the option to pay duty and claim Cenvat credit is legally valid.

And in another judgment, the Tribunal has held that the assessee can claim benefit on some of the items in an exemption, while not claiming exemption on some other items(*6).

The two other Supreme Court judgement namely, CCE vs Narayan Polyplast, 2005(179) ELT20 (SC) and CCE vs Narmada Chematur Ltd, 2005(179) ELT276 (SC), the Supreme Court upheld the payment of excise duty on exempted goods and taking modvat credit thereof. This establishes the optional nature of an exemption. This legal exposition has now enabled the VAT chain to continue and not fall apart. But now, the amendment of Section 5A has undone this continuation of the VAT chain.

By legally breaking the VAT chain with this amendment, the cause of a continued chain of value-added transactions has been hampered. Breaking of the VAT chain has several bad effects, which economists have agreed to universally. Exemption makes serious inroads into the tax base(*7), compromises with the neutrality (which is one of the well-accepted virtues) of VAT (*8), and distorts the allocation of resources, for instance, shifting from more capital-intensive to labour-intensive ventures or vice versa (*9).

Even the white paper has recognised the need to continue the VAT chain. It says under the heading, 2.15 Incentives, "Under the VAT system, the existing incentive schemes may be continued in the manner deemed appropriate by the States after ensuring that VAT chain is not affected."

This shows that the empowered committee is keen to maintain the VAT chain. The Central government has legislatively and deliberately broken the Cenvat chain without any apparent provocation.

In the interest of clear thinking, it is necessary to recognise that it was a wrong economic policy so that it can be corrected in the next Budget.

* 1 Garg Industries vs CCE 1996 (86) ELT 495 (T)

* 2 Everest Converters vs CCE , 1995 (80) ELT 91 (T)

* 3 CCE vs Johnson & Johnson 1997 (95) ELT 234 (T)

* 4 CCE vs Indian Petro Chemicals 1997 (92)ELT 13 (SC); HCL vs CC 2001 (130) ELT 405 (SC)

* 5 Harita Grammer Ltd vs CCE, 2004 (164) ELT 37 (T)

* 6 Kinjal Elctrical vs CCE 2004 (165)ELT 300(T)

* 7 Sijbren Cnossen-in VAT""Lessons from Europe, p.55, edited by H J Aaron.

* 8 Alan A Tait "" Practice & Problems, p.221 and also Humming and Kay: VAT Lessons from Europe

* 9 Govt of Canada, Report of Royal Commission, 1966, Vol. II, p.11