Demystifying challenges in embracing Goods and Service Tax in India – Part II

In continuation from the previous blog, in this blog we will some more areas which impact the business

3. Contract renegotiation

The second important thing when GST is rolled out is contract renegotiation. All the business contracts are based on the assumption of continuity of business and with a clause of, “All applicable taxes will be extra as on date of delivery.” If the contracts are drafted in the above fashion then they are not required to be renegotiated as the existing taxes like Excise, Service, VAT and CST will be replaced with the CGST, SGST and IGST Taxes since the wording ‘applicable’ tax is used in the contract with respect to taxes.

Cost being a crucial element in the business, it determines the bottom line. Some organizations are entering into contracts to pass on the tax implications to the seller; the organizations are more interested in the supply of the goods and services at a pre-determined price inclusive of taxes. Such contracts are normally for the taxes which are not recoverable in nature like the CST and some costs like freight, insurance, packing, etc.

Under GST, the taxes are based on value addition and all taxes being recoverable, will have an impact on such contracts. The impact can be on the selling side or on the buying side based on the party to the contract. If it is on the buying side, there would not be much impact as the taxes are inclusive; hence the cost of procurement will be low, thereby reducing the cost of production and cash outflows. On the selling side, it has a huge impact on the transaction value as well as on the bottom line.

For example, considering A and B are from different States and if A agrees on a contract to supply item X to B, at a price of Rs. 10,000 on following terms: exclusive of Excise Tax, inclusive of all other applicable taxes and other costs like packing, freight and insurance. Packaging based on B’s Specifications.

Based on the contractual terms, the tax applicability under the current tax regulations for the transaction will be, Excise Duties @ 12.5% and CST of 2% against ‘Form C’ and packing cost based on B’s specification is Rs. 500. Excise duties are recoverable as A & B are registered dealers and item X is excisable.

The invoice values will look like this pre GST implementation:

In this case, the extra cost for Dealer A is Rs736 (Rs500 for packing plus Rs236 on account of CST). B, on the due date will pay only Rs. 11,313 (Rs. 12,052– Rs. 736) to A

Now let’s extrapolate the same example when GST is rolled out, keeping in abeyance the actual rate, assuming IGST of 18% (when GST is rolled out it may be less). When GST is rolled out the transaction will be like this:

Since the contract says ‘exclusive of Excise’, there are no  Excise Taxes under GST as  Excise Tax is subsumed with CGST when GST is rolled out. And A Ltd cannot charge IGST to B Ltd on this transaction, as it says ‘inclusive of all other taxes and costs’. As per the contractual terms IGST is to be borne by the seller A Ltd. This means an additional cost on the transaction for Rs. 1,654, which is the difference of IGST plus packing charges CST [Rs. 2,390 (Rs. 1,890 + Rs. 500) – Rs. 739]. This will straight away have a huge impact on the bottom line of B Ltd.

When GST is rolled out all sellers like A Ltd will have to review their contracts and re-negotiate them, if they do not do that, then they have to take a huge hit on their bottom lines, which will in turn impact the stock prices on the stock market if they are listed companies.

If A Ltd wants to amend the contract, it has to renegotiate, and say that ‘all applicable taxes will be extra’ and including costs like packing, freight, etc. This activity has to be done much before the rollout of the GST so that there are no last minute surprises.

Even the service contracts have to be re-negotiated as there will be a service component levy by the State Governments. Apart from the sale and purchase of goods contracts, the service contracts as well as the Annual Maintenance Contracts have to be re-negotiated if they are have contractual term of inclusive of applicable taxes or Service Tax.

Say for Example X Ltd is service provider and Y Ltd is service receiver. X Ltd enters into a contract with Y Ltd for servicing of machinery on annual basis in business parlance called Annual Maintenance Contract (AMC) with the contract term as “inclusive of all applicable taxes for service component only and for material at actual costs and taxes on them if any applicable on the date of servicing”. The contract is valued for Rs. 10,000. During the course of the year, X Ltd renders the services and he does not replace any material so the invoice is only for the Service Tax and X Ltd issues an invoice as given below

On the due date Y Ltd pays Rs.10,000 to X Ltd only for the cost of service as it is inclusive of Service Tax based on the contract terms. In this case X Ltd treats the Service Tax as is cost.

Now let’s see if the same contractual terms are applicable once GST is implemented. For academic purpose let’s take CGST on services @ 10% and SGST @ 8%. The invoice under GST will be like this

On due date, Y Ltd pays X Ltd Rs. 10,000 only as it is inclusive of taxes. Under GST, X Ltd has to pay total tax of Rs. 1,800 (Rs. 1,000 for CGST Service & Rs. 800 for SGST Service). It means his total tax cost on this contract is additionally for Rs. 350 (Rs. 1800 under GST – Rs. 1450 under previous tax regime). If X Ltd does not renegotiate the contract, it has to take additional burden on his profit for Rs. 350. There will be many such contracts, this will ultimately reduce the profits of X Ltd.

Rewriting of contracts is not a simple task; it will take lot of time and require lots of negotiations and approvals from various operations heads. The earlier such things are put in place, the better from the organization point of view.

In most cases when the contracts are re-negotiated, the same has to be sent for approval to the legal teams also, apart from the operations heads. This is done to safeguard the interests of the company in the long run.

4. Change in business process

In the current taxation the levy of incidence of taxes is different for different taxes and as result the treatment for taxes is different. Excise is levied on manufacturing, service tax on completion of service or raising of invoice, VAT on supply of goods etc.

Some of the business process have to be revisited or re-engineered keeping view of the changes   under GST. The business process which need change are

a.Branch / Depo Transfers

In the current tax regime while moving goods from factory to depo / branches excise duty is paid and goods are removed based on the excise valuation rules in place. Going forward in GST, the same is applicable but it is not only for CGST but also for IGST. This process of tax defaulting on the transaction has to be redesigned and also keep track of the same. In case if the transfer of goods between the factory and the depo / branch in the same state, the treatment may be different. In case of different state, IGST will be applicable and charged on the transaction.

b.Trading

Under the current tax regulations for central excise, the taxes on purchases are passed on the sales and also a register to be maintained. Going forward under GST the same is not required as it is on supply of goods and services, so the taxes have to be applied on the supply price. This means that that credit of taxes on purchases is applicable and the same can be used for payment of output tax.

There will be no longer required to maintain the registers.

c.Job Work

Another import decision which the business have to take care is regarding the job work i.e make or buy when goods and service tax is implemented. Under the current tax regulations, the material is sent for job processing under a challan. Tax is levied on the value addition and goods are received back under the same challan and no excise duties are paid if the same are received back in 180 days else duties are liable to be paid. Based on the available information in the public domain, the process is not clear under goods and service tax. The following are the possibilities

• Current business process may be continued, if this is the case, then there is no need to make any change in the business process.
• As goods and service tax is on supply of goods and services, job work can be also be considered as supply, if this is the case then taxes have to be paid on shipment of goods for job work, the job worker will take credit of the same and ships back the goods when processing is done along with taxes. This involves lot of changes in business process as well as additional outlay of funds for tax payments.

If the second option is followed then the business have to take a call on make or buy decision.

d.Deemed Exports

In the current business process, exemptions are available for deemed exports but going forward under GST, exemptions are no longer applicable and refund process has to be followed. This means additional cash outflow initially and also wait for the refund. With the approach, the business have to take call to make supplies for deemed exports houses like EOU’s / SEZ’s etc.

5.Impact on Costing of Products and Services

Input costs of goods and services are the key in determining the cost of products or services apart from the overheads which contribute to it indirectly. For any manufacturing unit, all the items or components will not be available for procurement from the same State. They have to procure the same from other States. When they are procured from other States, the organizations have to pay Central Sales Tax and this is not recoverable in nature. When GST is rolled out, the organizations still have to procure the same from other States, but the only difference now is that the CST, which is2% against Form ‘C’, will be replaced with IGST, which can be about roughly 18%. For this, the manufacturer has to pay the seller for the item price along with the increased taxes, which in turn increases the working capital; this leads to increase in the interest leading to higher overheads.

Another paradigm shift in GST is, taxes will be based on the destination principle unlike the current principle of origin-based. In the current scenario, the procurement is made from a vendor who gives the lowest price coupled with the percentage of non-recoverable taxes. Under GST, the credit is available only when the seller remits the taxes. The challenge is now on how to prepare the monthly costing statements which are used for various decision making process in the organization. Material cost has to be considered after taking the relevant credit on assumption basis? If this is the approach and down the line if the seller does not remit the taxes then it has to be added to material cost and this will increase the cost of the product but decision is taken on assumption that credit is available and such situations can lead to a huge impact on the bottom lines of the organizations.

In case of services, under GST the States are also given the power to levy the same. If the service provider is not a registered dealer with the tax authority, then credit cannot be taken, if registered, credit can be availed. This will again have an impact on the costing of the product or service as the tax will be treated as expense and added to the landed cost. If the service provider adopts or goes for the composite scheme, then the final impact will be known only when the actual bill is announced. In most cases, the credit for the taxes is not available if the supplier or service provider opts for the composite scheme and this will increase the cost of the products or services. In order to survive in today’s competitive market the inputs costs have to be minimum, to attain this again the contracts have to be revisited and if required change the supplier or service provider to maintain the cost competitiveness.

There will be certain services on which credit cannot be taken, like Service Tax on banking charges; though the amount may be less, the total cost will go up on account of introduction of Service Tax by States also. All these have to be observed and the costing details have to be reworked before fixing the prices in the new tax regime else there will be an impact on the bottom line for the organization be it a listed company or an unlisted entity.

Now it is clear that under GST, the credit for the input taxes is available only when the supplier remits the taxes to the government. This means there is a time lag between the receipt of the material and credit availment i.e. the input tax credit cannot be utilized for making the payment of the output tax immediately. Which means output tax liability has to be paid through cash, which means increase in working capital costs, resulting in increased overheads.  The buyer will come to know about this only when the government rejects the invoices for which claim is made and submitted but the same is not paid by the seller. This means that while purchasing goods or services, the seller’s history of tax payments also has to be considered else the tax will be treated as non-recoverable thereby impacting the bottom line of the organizations.

To be continued ………….

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