White Paper May 12

UDYOG WHITEPAPER
MAY-2012
Input tax credit – the journey from ‘proforma credit’ to GST
By Radha Arun, Consultant to Udyog Software

Input tax credit – the journey from ‘proforma credit’ to GST

A finished product comes to the consumer after multiple stages of manufacture, and taxes are levied on the
product that emerges at every stage. The tax at one stage becomes part of the price of the product that is
the input for the next stage, and the tax paid at the next stage will therefore include an element of tax on
tax. Naturally the multiplicity of occurrence of tax on tax at different stages of manufacture of a product
would add up to substantially inflate the price to the consumer if not neutralised in the intermediate stages.
Input tax relief in some form, designed to neutralise this cascading effect of tax on tax, has been on the
statute book in various forms since the inception of ‘proforma credit’ in 1962. It has successively mutated
into ‘set-off’, Modvat, and Cenvat, and is poised to take another large stride under GST, which will provide
for inter-state neutralisation of VAT on sale of goods. A quick look at this journey will show us how far we
have come.

Proforma credit
‘Proforma credit’ was introduced in 1962 under Rule 56A
of the then Central Excise Rules 1944. The rule
underwent many modifications, but its essence was
that
 in respect of finished products that were
notified for the purpose, and
 if the inputs fell in the same tariff item as
the finished product,
duty paid on inputs could be taken as a credit and used
for payment of duty on the finished product. Thus input
relief was allowed in a limited way. It was intended to
obviate a plurality of duty payments under the same
tariff item in the course of manufacture of a product.

(An unexpected throwback to this concept came in the
form of the Service Tax Credit Rules 2002, which
allowed credit of service tax paid on input services only
if they were in the same taxable category as the output
service!)

Set-off
Proforma credit under Rule 56A was limited to the
notified items. Change came fifteen years later, when
the scope of input tax relief was expanded by providing
‘set-off’ for input excise duty, under two notifications
that ruled the roost till the advent of Modvat in 1986:
Udyog Software (India) Ltd (www.udyogsoftware.com)
Phone: 022-67993535, Email: sales@udyogsoftware.com
The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual
or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is
accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information
without appropriate professional advice after a thorough examination of the particular situation. Page 1

178/77-CE – set off of input duties, with one to one correlation
In 1977 the government issued notification 178/77-CE dated 18 June 1977, which provided for ‘set-off’ of
duty paid on specified inputs, in the form of exemption notification. The substantive part of notification
178/77-CE read as follows:

“In exercise of the powers conferred by sub-rule (1) of rule 8 of the Central Excise Rules, 1944, the
Central Government hereby exempts all excisable goods (hereinafter referred to as the ”said goods")
on which the duty of excise is leviable and in the manufacture of which any goods falling under Item
No. 68 of the First Schedule to the Central Excises and Salt Act, 1944 (1 of 1944) (hereinafter
referred to as the inputs) have been used, from so much of the duty of excise leviable thereon as is
equivalent to the duty of excise already paid on the inputs:

Provided that where the duty of excise leviable on the said goods is less than the amount of duty of
excise paid on the inputs the extent of exemption shall be restricted to the duty of excise leviable on
the said goods."

Thus the notification exempted excise duty on the finished product to the extent of excise duty paid on
inputs used in their manufacture, if the inputs fell under tariff item 68 of the central excise tariff schedule (a
residual entry that covered products not specified in items 1 to 67). At that time the concession appeared to
be intended to soothe the public outcry on massive expansion of the excise duty net to cover items ‘not
elsewhere specified’ as a residual item 68 of the tariff
schedule.

A substantive requirement of one to one correlation of
input to finished product was implied in the words of
the notification that exempted the finished product
“from so much of the duty of excise leviable thereon as
is equivalent to the duty of excise already paid on the
inputs”. This was subsequently inserted as a procedural
condition by notification 295/77-CE dated 28 Sept
1977. The amendment required that the manufacturer
must submit a statement showing the quantity of
inputs used in every unit of the finished product.

Much litigation regarding this notification 178/77-CE
and its successor notification 201/79-CE revolved
around factual disputes as to whether the input was
actually used in the manufacture of the finished
product, classification disputes as to whether the inputs
fell under item 68 or otherwise, and procedural issues
like prior filing of input-output ratios. In those days
exemption had to be claimed in the ‘classification list’
and approved by the Assistant Collector. So the item 68
inputs would be listed against the finished product in
the classification list, giving a statement of how much
of each input was used per unit of finished product, the
AC would verify and approve the statement and the
exemption.


201/79-CE: set off of input duties by credit mechanism
Notification 177/78-CE was superseded by notification 201/79-CE, which used a different methodology for
giving the input tax relief. It replicated the ‘proforma credit’ mechanism, which was already being used
under Rule 56A, to operationalise the set-off of duties. The procedure under this was prescribed in an
Appendix to the notification, which required, inter alia, as follows:

“1. A manufacturer of the said goods shall give a declaration to the Superintendent of
Central Excise having jurisdiction over his factory, indicating the full description of the said
goods intended to be manufactured in his factory and the full description of the inputs
intended to be used in the manufacture of each of the said goods.

2. A manufacturer may take credit of the duty already paid on the inputs which are received
by him after submitting the declaration, and utilise such credit for payment of duty of excise
on the said goods."

Thus the requirement of a declaration of input-output ratio remained as in notification 178/77-CE, but a
substantive difference introduced by notification 201/79-CE was that the duty paid on the inputs could be
taken as a credit, and the credit would be utilised for payment of excise on the goods.

The department’s interpretation of notification 201/79-CE was that the requirement of one-to-one
correlation remained even at the stage of utilisation of credit and that the manufacturer had to take and use
the credit in product-wise silos. In general, industry conformed with this. However the Supreme Court in the
case of H.M.M. Limited [1996 (087) ELT 0593 (SC)] negated this stand, and observed that the credit could be
used for payment of excise duty on any finished product for the manufacture of which the inputs were
brought into the factory.

This position was explicitly notified by the central
government in 1986, in the form of the Modvat credit
rules, which required no declaration of input-output
ratios, and also brought in further concessions as
discussed below.

Modvat scheme – wider coverage, dealer credit, capital
goods credit
iTAX is combo of Indirect
The year 1986 ushered in one of the cataclysmic changes
in central excise, with the introduction of the MODVAT
scheme. This was incorporated as a series of new rules Taxation For Gobal &
added into chapter V of the Central Excise Rules 1944. The
Modvat scheme provided a table of inputs and finished Local ERP’s vendors or
products and provided that credit could be taken on any
of the specified inputs if used in any of the specified customers who desire a
finished products. Furthermore, it did not restrict the use
of the credit to product-wise silos, but made it available local taxation modules
across categories, for payment of excise duty on any of the
eligible products. Thirty seven chapters of the central for their ERPs
excise tariff were covered initially, and the scope of
Modvat was expanded over the years and extended to
capital goods also.

In Modvat, the correlation of the input with the finished product was required only to establish eligibility to
credit at the threshold stage. An initial declaration of inputs and corresponding final products was required
for this purpose (- however ratios were not asked for). Once the credit was taken, it could be used to pay
excise duty on any of the eligible finished products. Modvat credit, unlike credit in the earlier schemes, could
be passed on through dealers. Also, unlike earlier schemes, excise duty or equivalent customs duty paid on
capital goods was also available as a credit to be used to pay excise duty on the finished product. These two
steps, of passing credit through dealers, and allowing credit of duty paid on capital goods, represented
significant progress in beating the cascading effect of taxation.

Separate Cenvat credit rules
Till 2001 the input credit provisions were part of the Central Excise Rules 1944. In 2001 the provisions for
input credit contained therein were separately notified as the Cenvat Credit Rules 2001, and then as the
Cenvat Credit Rules 2002.

Service tax credit
Services were first taxed under the Finance Act 1994, and the scope of service tax was extended to cover
more services each year. In 2002 the Service Tax Credit Rules 2002 were notified, by which the service tax
paid on an input service could be taken as a credit and used to pay service tax on the output service, if the
input service was in the same taxable category as the output service.

Amalgmation of service tax and central excise credit: Cenvat Credit Rules 2004
The Cenvat Credit Rules 2004 represented a paradigm shift in input tax relief. The rules allowed credit of,
inter alia:
(i) central excise duty paid on indigenously manufactured inputs and capital goods;
(ii) additional duty of customs (CVD) equal to excise duty, paid on imported inputs and capital
goods;
(iii) special additional duty of customs (SAD) equal to VAT, paid on imported inputs and capital
goods; and
(iv) service tax paid on input services, which included services unrelated to manufacture, like share
registry, audit, and credit rating.


Moving forward from input relief only for excise duty paid towards excise duty payable, the Cenvat Credit
Rules 2004 embodied the first attempt to give input tax relief for a plurality of duties and taxes, to further
reduce the cascading effect of taxation. Till these rules were notified, there was no input tax relief for the
customs duty equivalent to VAT, or for service tax for manufacturing, or even for provision of services in a
different category from the input service. Thus the Cenvat Credit Rules 2004 gave relief to industry on an
unprecedented scale.

The Cenvat Credit Rules 2004 provided, as did all the earlier versions of input relief, that credit was not to be
taken on inputs / services related to exempted finished product or exempted supply of service. In the case of
capital goods, the bar applied only if the capital goods were exclusively used for exempted supply of goods
or services – partial use for exempted supply was not a disqualification.

Input relief in VAT
The states passed their respective VAT legislations, to replace sales tax, from 2005 onwards. The VAT Acts
provide for input tax credit on tax (VAT) paid on goods purchased from a registered dealer within the same
state and used in business. The goods must not be for personal use and must not be on the ‘negative list’. In
VAT, no input tax relief is available for tax paid on inter-state supply of goods.

GST expectations
At present there are three levels of tax on tax.
(i) On the one hand, central excise duty is paid on a value that generally includes VAT on inputs.
(ii) On the other hand, VAT on the finished product is paid on a value that includes excise duty on
the finished product: the line items of an invoice show price, excise duty, sub-total for VAT, and
finally VAT calculated as a percentage of this sub-total.
(iii) Finally, tax (at present, Central Sales Tax) paid on inter-state sale is not eligible to be taken as a
credit.

It is hoped that GST will eventually remedy the cascading effect at all three levels. At the outset, however,
the second and third levels are being addressed, while about the first level the discussion paper circulated by
the Ministry of Finance has this to say in the context of input tax credit (ITC):
Cross utilization of ITC between the Central GST and the State GST should not be
allowed except in the case of inter-State supply of goods and services under the
IGST model which is explained later.


The IGST model refers to interstate GST credits. It is proposed that the centre will tax interstate movement
of goods and allow credits of this tax to be taken in the state that receives the goods. This addresses level
(iii) of the cascading effect of taxation, as mentioned in the foregoing paragraphs. However, cross utilisation
of credit of VAT (state GST) and excise duty / service tax (central GST) is not proposed.

Regarding level (ii), the good news is that GST will eliminate the problem. As it is envisaged that there will
concurrently be a state GST and a central GST on the same taxable transaction; both will be computed as a
percentage of the base price and will form different line items in the same invoice. Therefore the situation of
VAT on excise duty, as subsists at present, will be remedied.

The issue of VAT on inputs forming a part of the price for the purpose of central GST (conversely, the issue of
cross utilisation of credits of state and central GST) is a complex one that can be addressed only by political
will, as there are state revenues and central revenues involved in the same transaction. However,
commonsense suggests that if the credit of input VAT (or input state GST, as it will be known) is completely
used up in paying output VAT (or output state GST), then it is no longer a cost that inflates the price of the
input for excise duty (or central GST). The problem of cascading effect will arise only if state GST is exempted
on a product or there is a skewed duty structure that results in accumulation of input VAT credits. Perhaps
the structure of duty and exemptions will be worked out with this in view.

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