GST input tax credit rules: How taxpayers will benefit from ITC

The change in indirect taxation regime from current taxation to GST (Goods and Services Tax) seems to be a game-changer reform. For consumers, the introduction of the input tax credit (ITC) mechanism will reduce the indirect tax burden on their purchases. It will cause a paradigm shift from individuals paying more taxes to more individuals paying taxes. So, it means an increase in the overall tax base resulting in more revenue for the government.
GST is a destination-based tax as compared to the present principle of origin-based taxation. The new indirect tax regime follows a multi-stage collection mechanism wherein tax is collected at every stage (where value addition is done to product), and the credit of tax paid (input tax credit) at the previous stage is set-off at the next stage of the transaction. Thus, it prevents double taxation, which is the essence of GST.
Under the current taxation regime, there is a plethora of taxes including excise duties, sales tax, purchase tax, entry tax and VAT (Value Added Tax). On the other hand, GST is meant to integrate taxation in India. There are five types of GST viz. Central GST, State GST, Integrated GST, UTGST and compensation cess. However, the real game changer is the introduction of input tax credit mechanism, which is one of the key features of GST. It will help in eliminating the cascading effect of taxes.
To understand the working of this mechanism, you need to have a clear understanding of input tax credit. When you buy raw materials as inputs to manufacture and sell your product, you pay tax on the material/ input. So, when you are required to pay tax on the finished good/output, you can claim the tax credit that you already paid to your vendor/supplier and just pay the balance tax liability.
Now, let us understand how taxes will work differently under the GST regime with the help of the following example.
Firstly, we will look at the mechanism of the pre-GST indirect tax system for inter-state transactions. Let us assume that a simplified tax rate of 10% is applicable on every level from the manufacturer to the retailer.
The manufacturer purchases goods worth Rs 50 and converts it into a product which adds a value of Rs 50 to it. For selling the product, he pays Rs 10 as tax on Rs 100. Hence, the distributor’s price is Rs 110. While selling, the distributor adds a profit margin of Rs 20 and pays 10% tax of Rs 13 on Rs130. Hence, the wholesaler’s price is Rs 143. Assuming that at every further stage the profit margin is Rs 20, the wholesaler will sell it for Rs 179.3 to the retailer who will further sell it to the consumer for Rs 219.23 after adding taxes and profit margins.
Now let’s see how taxes are levied under the GST regime. This time the manufacturer who had purchased raw materials worth Rs 50 will get the credit of taxes paid on the raw material purchase. Hence, when he adds a value of Rs 50 to the product, and the price of the product becomes Rs100, the taxes will work as follows. He has to pay Rs 10 @ 10% on the price of Rs 100 as GST, and he will receive a credit of Rs.5 as input tax credit paid at the time of purchase of raw materials because the raw material supplier will have to pay Rs 5 to the government (assuming that he is not taking credit on purchases). (Rs.50 x 10% = Rs 5). The tax amount at this stage will hence be Rs 5.
Similarly, at the next stage when the distributor adds his profit margin of Rs 20 (100+20), the value of goods will now be Rs 120 and the taxes @10% will be Rs 12. The input tax credit on this will again be Rs 10 that was paid to the manufacturer. Hence, the taxes at this stage will be Rs 12 – Rs10 = Rs 2.
This input tax credit will ultimately reduce the final price to the wholesaler, retailer and the consumer too. Assuming that Rs 20 is added at each stage, tax at the wholesaler stage will be Rs 2, and at the retailer stage will again be Rs 2. Hence, the final price to the consumer for the item will be (160 + 5 + 5 + 2 + 2+2) = Rs 176. This concept of GST being a destination-based tax makes it easy to calculate and carry forward. The price difference is Rs 43 for the end consumer due to the input tax credits received under the GST regime.
Hence, due to avoidance of double taxation at each level, the tax burden on consumers is way less.