We will be soon celebrating the 5th anniversary of GST implementation in India and with the completion of this period, a significant source of revenue being received by the States will come to an end. We are of course talking about the compensation that the States have been receiving during the transition period of 5 years, from the Centre, post introduction of the GST regime. As the law stands today, from 1 July 2022, the States will not receive funds from the Centre in the form of compensation for the revenue loss, however, the levy and collection of compensation cess will continue till March of 2026.

Let us delve into the background of compensation cess, its origins, legal provisions for the extension of levy, and analyse the necessity behind extension of compensation to the States. The article also intends to cover some issues in the way forward.

What is compensation cess?

GST is a comprehensive destination based indirect value added tax levied on the supply of goods and services. It was introduced in India on 1 July 2017 replacing most of the indirect taxes which were levied by the Centre and the States. GST subsumed most of the taxes into one tax which is predominantly collected by the Centre and then, as per the rates prescribed, distributed to the concerned States. This means that now the States do not have the power to levy their own taxes on most of the goods and services. This led to a serious yet legitimate apprehension by the States that with the advent of GST, they may lose a large chunk of their revenue.

Section 18 of the Constitution (One Hundred and First Amendment) Act, 2016 was implemented with a view to compensate the State Governments for a period of five years for the loss incurred by them due to the implementation of GST. To give effect to this, the Goods and Services Tax (Compensation to States) Act, 2017 (‘Compensation Act’) was enacted. Section 7(1) of the Compensation Act provides that compensation shall be payable to any State during the transition period. The ‘transition period’ means a period of five years from the transition date.

The Centre hence compensates the States by levying a cess on top of the GST on certain luxury and sin goods which is called the compensation cess. These goods include aerated water, pan masala, cigarettes, tobacco products, vehicles etc. This cess is also leviable and collectable on these goods imported into India.

Meeting the shortfall

The proceeds under the cess were rising steadily till 2019-20. In fact, the Compensation Cess Fund saw a surplus during the last quarter of FY 2019-2020 and the compensation in full could be released till March 2020. However, due to the impact of Covid-19 on GST revenues, the compensation requirement for 2020-21 increased and at the same time the cess collections dropped. This created a huge gap in the resources available for payment of compensation to States. As the Compensation was to be provided from the Public Account Fund only, Centre needed to come up with another method to provide the mandated compensation to the States.

In the 41st GST Council meeting it was thus pointed out that the compensation to States can only be paid from the Compensation Fund and not from any other source. The compensation fund shall be credited with the compensation cess. On the issue of Central Government’s liability to release compensation from Consolidated Fund of India over and above the amount of Cess collected, Ld. Attorney General of India opined that,

‘There is no express provision in the Compensation Act for the Government of India to bear the liability of making good the shortfall. It is the GST Council which has to decide on making good the shortfall in the GST Compensation Fund, by providing for sufficient amounts to be credited to it.’

To make up the difference, the Centre borrowed INR 1.1 Trillion in FY21 and INR 1.59 Trillion in FY22 from the market under a special borrowing window set up by the Reserve Bank of India with low interest rates and passed them on to the States on a back-to-back basis.

Extension in levy of compensation cess

For the specific purpose of repayment of loan extending the levy on collection of cess proceeds beyond the initial period of five years became necessary. Various legal aspects, the budgetary status of the Centre and States, and solutions available to handle this eventuality were discussed at the 41st GST Council meeting. The Ld. Attorney General of India opined that,

‘The cess cannot be collected for adding to the general revenues of the Central Government. … the GST Council would recommend the continuance of the cess beyond the transition period of 5 years only in a situation of shortfall during the transition period, which would necessitate the raising of funds for paying the compensation to the States after the 5-year period is over.’

Finally, at the 43rd GST Council meeting, it was agreed that the cess must be collected beyond July 2022 for repaying the loans taken. After working out the detailed financial statements, the Finance Minister, during the press briefing on the outcome of 45th GST Council meeting, announced that the compensation cess collection would be continued till March 2026.

Certain issues in way forward

In the upcoming 47th GST Council meeting scheduled in June end, compensation to the States will be a hot topic in discussion. States, especially those which are heavily dependent on the compensation, like previous occasions, may demand an extension in granting compensation for another five-year period. They may argue that the expected growth through GST collection has not been achieved.

An interesting point to note here is that, though the levy as such is being extended as noted above, till date there is no mention of the extension either by any Bill introduced in the Parliament or through any notification by the Central Board of Indirect Taxes. In this regard it may be noted that provisions of Section 8 of the Compensation Act provide that the levy is ‘for a period of 5 years or for such period as may be prescribed on the recommendations of the Council’. Since the recommendations are in place for the extension, in our understanding these recommendations will soon be implemented also.

An absence of a law regarding the extension in levy (to service the loan) but continued collection could open doors for legal disputes. Now with less than a week left for expiry of the compensation period and the parliament currently not in session, it needs to be seen whether the Government will issue an Ordinance to give effect to the extension of levy. In either case, extension in the levy is exigent.

Even if we assume that the Centre would agree to further compensate the states beyond the initial five-year period, a million-dollar question is what would be the source of revenue for that compensation, considering that clearing of debt only requires an extension in levy for approximately four more years. It is also very likely that the cess rates would be subsumed into the GST rate only post clearing of debts. That way the revenue of states through GST may increase more than through compensation. But this may happen only after March 2026.

As the extension of compensation seems extremely unlikely to occur, the States are now required to come up with ways to upsurge their revenue. There are already instances where certain authorities levying certain charges and those charges are also being upheld by the Courts. One recent example is the case of Hubballi Dharwad Advertisers Association v. State of Karnataka in respect of advertisement tax by a Municipal Corporation. It is also likely that after the Kerala Flood Cess, we may even see similar cess in certain North Eastern States and for that matter even a ‘drought cess’ in few States.