Input Tax Credit and New GST Slabs: A double-edged sword for small businesses

The recent rationalisation of India's Goods and Services Tax (GST) structure, which has replaced the old four-slab system with a simplified two-slab model (5 per cent and 18 per cent), is being widely celebrated. With a reduction in tax rates on a wide range of everyday essentials, consumer durables, and agricultural goods, the GST 2.0 aimed at boosting consumption and easing the tax burden on the common man.

On paper, it appears to be a win-win situation. However, in practice, it seems to be more complicated. For certain small and medium enterprises (SMEs) such as Textiles (Man-made fibres), Footwear & Leather Goods, Agro-processing, Handicrafts & Toys, etc,  this simplification comes with a new set of complex challenges. While the intent is to streamline the tax process, many small businesses, particularly manufacturers, may find themselves facing an adverse situation known as an inverted duty structure.

The core of the problem lies in the concept of input tax credit (ITC). Under GST, a business can claim a credit for the tax it has paid on its raw materials and inputs (input GST) and use that credit to offset the tax it collects on its finished goods (output GST). In a typical scenario, the input and output GST rates are either the same or the output GST rate is higher. This allows the business to claim a full tax credit and pay only the difference to the government. However, an inverted duty structure occurs when the GST rate on the raw materials (inputs) is higher than the GST rate on the finished product (output). This new GST structure, despite its overall benefits, inadvertently creates this problem for many small manufacturers.

Consider a small business engaged in the production of an item currently taxed at 5 per cent (the new "merit" rate). For its production, this business might procure raw materials still classified under the 18 per cent "standard" slab. Consequently, the business incurs 18 per cent GST on all its acquisitions but can only levy 5 per cent GST on its sales.

This disparity results in the accumulation of substantial unutilised ITC by the business. They possess an excess of tax credit that cannot be utilised. This surplus is not automatically refunded; instead, it becomes trapped within the system, necessitating the small business to initiate a refund application. This mismatch between input and output GST rates is what gives rise to the inverted duty structure.

For small manufacturers, the result is an excess of input tax credit that remains locked in the system. Instead of easing cash flows as intended, the mechanism ends up straining working capital and slowing down day-to-day operations. This new GST framework, despite its benefits, creates a huge problem for small manufacturers. 

The accumulation of unutilized Input Tax Credit (ITC) can significantly impact the operations and financial stability of small businesses. This unutilized tax credit represents funds remitted to the government that remain inaccessible to the business. For small enterprises operating with narrow profit margins, this constitutes a substantial drain on working capital. These funds, which could otherwise be allocated to operational expenses such as salaries, raw material procurement, or capital investments in machinery, are effectively withheld by the government and are not subject to direct refund.

The process for obtaining a refund on accumulated ITC is often burdensome and protracted, necessitating the submission of specific refund applications, comprehensive documentation, and frequent interactions with tax authorities. Consequently, some businesses may attempt to offset the trapped tax credit by increasing their prices.

This strategy, however, can diminish their competitiveness compared to larger corporations that may possess the capacity to absorb such costs or benefit from optimised supply chains. This situation ultimately counteracts the intended economic benefit of reduced goods prices, as enterprises are compelled to maintain current price levels to recover their ITC.

While the overall rationalisation of GST is a welcome step towards simplification, the concerns of small businesses must be addressed. The government has already shown a commitment to simplifying compliance for MSMEs with a new simplified registration scheme and by correcting some inverted duty structures. However, for the full benefits of the new GST regime to be realised, the issue of unutilised ITC must be solved with an efficient, quick, and automated refund process. Only then can small businesses truly benefit from this new chapter in India's tax history and continue to be the engines of our economic growth. Unless refund bottlenecks are fixed, the new GST will remain a double-edged sword, cutting taxes for consumers, but cutting deep into the cash flows of small businesses.