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Economy

A High Service Tax Means Do Not Make In India, Buy From Abroad

Service Tax was hiked to 14% in this budget. The FinMin folks seem to think this is just a gradual move towards the GST rates of 20% or so, since manufacturing is charged over 24% right now (12% VAT, 12% excise).

This is ludicrous. Telling us to pay 20% on every service to the government is clinically insane. Whether we get a GST or not, we should have much lower taxes, not higher ones, and definitely not so much for services.

The Saving Grace for Physical Products: CVD

Tell us this. Why you buy something from an Indian company rather than from a foreign import? Because the Indian product is either better, or it’s cheaper, or it’s more easily available. The cost of just transporting certain things, like cement, makes it unviable for foreign producers to sell into India, as the price differential is not so much.

And then, we have excise duty. If excise is at 12%, then the cost to make something locally is higher by 12%. But if you import the same thing, the customs folks charge you a countervailing duty  (CVD) of 12%. Which means you have a level field with a foreign player. Therefore the transportation costs could hurt him more, and thus you buy from a local brand instead.

In some cases, our local manufacturers have no scale at all (like in laptops) so you prefer to import – the differential is so much that even with any duty extras, this import is cheaper.

Services, Specifically Technical Services Don’t Get This Advantage

Let’s say you have a person who does graphic design. He will charge you 14% service tax on top of his bill. This applies to all services, from accountants to software services to what not.

Now, if you got the same graphic design from a person in Russia, you will not pay the 14%. There is no “countervailing service tax” that applies on such payments. Which means the service provider located abroad gets the 14% advantage. They get to provide a service from abroad, and all else being equal, they have a 14% advantage over you.

Technically there is a “withholding tax” – where you have to pay a part of the money to the Indian tax authorities (typically 25%, reduced in 10% for technical services in this budget). But most of us startups pay using credit cards; we just pay the bills on individual cards, and the company reimburses the money. And withholding taxes are different for different countries especially with those we have a free trade agreement with.

For a service tax of 10% it really didn’t make sense to outsource our work abroad – you could pay that extra 10% locally, and for smaller amounts (like logo design or such) the extra cost was miniscule.

But at 20% it will be ridiculously expensive to buy services made in India. It’s much cheaper to get work done abroad, and to pay using things like Bitcoins or even through a credit card.

This will prompt the use of a “tax-avoidance” business model. Imagine a new startup in Singapore, which can pay into your Indian account through, say, Bitcoins. You provide services to your customers in India, but through this Singapore entity; your customers, even a company in your city, pay that Singapore entity and it pays you, for a small fee of say 5%. Since 5% is so much cheaper than 20% local service tax, it’s just easier to do the Singapore route, even for customers located in India.

Note: As a startup model, this will be very short lived, but can be lucrative. (It violates the GAAR principles, but GAAR applies only after 2017) Singapore has a free trade agreement that disallows withholding tax for technical or advisory services, so a round trip is easy to do and legal today, IMHO.

The Only Option: Keep Service Tax Low

With an increasingly free world, the concept of charging high taxes for services should be avoided. At 10% you’re pretty much at the limit, in my opinion. A high tax just forces people to look at alternatives that can be provided through the internet, from abroad. What’s the point, then, of asking us to Make in India? We would rather buy from abroad, or Make for Abroad, since service taxes don’t apply in either scenario.

From accounting services, to software design and development, to consultancy to more, there will be a “service tax arbitrage” by going abroad, that we should absolutely avoid. In general, asking service companies to pay their income taxes property is better than an over-the-top heavy tax on services.

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