The application of goods and services tax (GST) in different countries and regions has thrown up a loosely defined 80:20 rule, which shows that applying GST to about 80% of the sectors is smooth and easy.
It is the remaining 20% that is complex. These sectors typically include land and real property, financial services and supplies by public bodies and non-profit organizations. India would need to iron out possible challenges in these before it can transition smoothly to a GST regime.
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Traditionally, in the older value-added tax (VAT) jurisdictions, such as the European Union, supplies in all of these three sectors have been exempted from VAT. Real estate transactions have been excluded partly on the grounds that they are already subject to stamp duties and registration charges and partly because the levy of VAT would lead to an excessive burden. The exemption also reflected the view that land is neither produced nor consumed like other goods and services. Land is not created through use of labour or capital. It is available as a gift of nature. Land is also non-depreciable, which does not reduce in quantity with consumption.
Similarly, financial services in the European Union are exempted from VAT, not on account of any social or economic reason but because of difficulties in taxing transactions where the consideration for the service is not an explicit fee but a margin—for example, the interest margin or the spread between interest received on loans and interest paid on deposits. Such exemptions have turned out to be a source of complexity and distortions.
Interestingly, the practice in the modern VAT jurisdictions, such as Australia, New Zealand, Canada and South Africa, is to do away with such distortions by applying the tax to these sectors as to any other goods or services. In all these countries, real property sales are taxable like other goods and services. The reason for this is that real estate supplies consist of land, goods and construction services and these are inseparable and indistinguishable from other supplies of goods and services.
There is more variation in the treatment of financial services and supplies by public bodies and the non-profit sector, but the trend is to minimize exemptions. For example, financial services having consideration in the form of an explicit fee—as opposed to an interest margin—are taxed. This approach has ensured a more neutral application of tax.
India should follow the modern approach. It would be appropriate to include land and real estate in the GST base. To exclude them would, in fact, lead to economic distortions and invite unnecessary classification disputes as to what constitutes supply of real estate.
Any exclusion of commercial and industrial land and buildings would also result in tax cascading due to blockage of input taxes on construction materials and services.
Even though state VAT and service tax already apply to construction materials and services, respectively, their application is complex, uncertain and filled with disputes regarding allocation of the sale price towards land, goods and services. Extending the GST to all real property supplies, including land, construction material and services, would bring an end to such disputes, simplify the structure and improve the economic efficiency of tax.
Regarding financial services, these have been brought under the service tax net in India wherever the consideration is in the form of an explicit fee. As there are no compelling economic or social policy reasons to exempt financial services, it would be appropriate to continue this approach under GST.
However, certain technical flaws in measuring consideration need to be addressed before switching over to GST. For example, in insurance, the tax applies to gross premiums and excludes the savings element, whereas the proper base for GST is net underwriting income of the insurer—which means premiums less claims.
India could also consider taxing the interest margin on loans, but careful consideration needs to be given to determine the correct and most appropriate method of applying the tax to such transactions. The margin cannot be readily computed for individual transactions. Financial institutions do compute the margin on aggregate basis, which could be included in the tax base.
Another area of distortion on account of exemption is supplies by non-profit organizations and government bodies. Under older VAT jurisdictions, supplies by such entities are exempt from VAT on the grounds that such entities are not engaged in a business and their activities are not commercial in nature.
Public bodies mainly provides three types of services—services for no cost such as defense, sanitation, law and order, public parks and amenities; services provided at a price below cost, such as health, education in government institutions and postal services; and goods and services supplied more or less on a full-cost recovery basis such as railways and supplies by state-owned enterprises. The supplies under the third category are taxable but the first two categories are exempt because these supplies do not compete with private suppliers.
Following the principles laid down in various modern VAT jurisdictions, India can also consider taxing such supplies fully or zero rating them. In both cases, the input tax charged to these bodies is fully refunded.
Ideally, the tax should be levied on all goods and services at a single rate to achieve the objectives of simplicity and economic neutrality. However, governments often deviate from this ideal on account of concerns about distribution of tax burden.
These concerns are likely to be paramount at both the Centre and the states and there will inevitably be calls to exempt, or tax at a reduced rate, items of importance to the poor or other particular groups.
In the Indian context, these considerations are paramount mainly in the treatment of food. Bringing these sectors within the ambit of GST should thus warrant serious consideration.
Satya Poddar is tax partner, policy advisory group, Ernst & Young.
This is the second in a four-part series on the goods and services tax.
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