Whalesbook
### The Unintended Consequence: Blocked Working Capital
The recent Goods and Services Tax (GST) rate rationalizations, designed to provide relief to consumers and stimulate demand, have unearthed a substantial liquidity challenge for Indian businesses. While the reduction in output GST rates successfully lowers the final price for end consumers, this move has exacerbated an existing structural issue: the inverted duty structure. This anomaly occurs when the tax rate on inputs, input services, and capital goods is higher than the rate applied to the finished products. Industries such as food processing, FMCG, automobiles, and consumer durables, which often rely heavily on service inputs and capital expenditure, are now contending with a significant accumulation of unutilized Input Tax Credit (ITC).
### Regulatory Roadblock: Inverted Duty and Refund Denial
The mechanism intended to provide tax relief has instead created a financial bottleneck. Companies pay higher GST rates, often 18%, on critical operational expenses including transportation, warehousing, job work, consultancy services, and capital goods. Simultaneously, their finished products now attract significantly lower rates, frequently reduced to 5%. This stark mismatch is problematic because Indian tax laws, specifically Section 54(3) read with Rule 89(5) of the CGST Act, restrict the refundability of ITC accumulated due to higher taxes on input services and capital goods. Unlike the general provision allowing refunds when input tax exceeds output tax, this specific exclusion means credits generated from these essential operational cost components remain locked. The core promise of GST—a seamless credit flow eliminating cascading taxes—is thus disrupted, leading to substantial working capital being held up in electronic credit ledgers, which businesses cannot effectively utilize or claim back. This situation contrasts with global practices in jurisdictions like the European Union, where VAT refunds on input services and capital goods are typically permitted, ensuring smoother business operations and credit flow.
### The Path Forward: Budgetary Reforms and Global Alignment
This persistent issue undermines the very foundation of the GST framework, which was conceived as a destination-based tax system ensuring uninterrupted credit flow across the value chain. The accumulation of input tax credit, particularly from services and capital goods, strains financial sustainability for companies operating on thin margins. Experts at KPMG India highlight that this structural inefficiency risks diminishing the intended consumer price reductions and poses a significant challenge to business liquidity. The forthcoming Union Budget 2026 presents a critical opportunity for policymakers to address this well-recognized problem. By rationalizing provisions related to inverted duty structures, potentially by expanding refund eligibility for input services and capital goods or by harmonizing input tax rates, India can align itself with international best practices. Such reforms would not only strengthen the credibility of the GST system but also enhance the financial health of businesses, unlock liquidity, and ensure that the full benefits of rate rationalization are transmitted to end consumers, fostering balanced and inclusive growth.