Credit loss on process loss: Is this the real intention of the legislation? 

While there are numerous grey areas in the availability of credit under GST law, one common area of concern has been credit availability on process loss. Generally, there are certain raw materials which are damaged or become unusable in the process of manufacture. This is typically known as “process loss” in trade and industry. Some common examples of such process loss are end cuttings in the textile industry, side cuttings of packaging materials and floor sweepings in food industry.

In this backdrop, the question to ponder is whether credit is available on such raw materials which are damaged or destroyed or which become unusable in the production process and are thereafter either disposed of or destroyed by the taxpayer without any corresponding proceeds.

The entry point for availing of credit under GST law is the use of goods or services in the course or furtherance of business and thereafter, all supplies are also required to pass through the litmus test of not falling under any of the restricted categories.

It is worth noting that “business” under GST law is of wide import including within its ambit any activity, whether or not the same is for a pecuniary benefit. As far as the nexus with business is concerned, it is possible to take a stand that since the raw materials are put to use in manufacture, the same are used in the course or furtherance of the business.

The restricted category which is causing a dilemma in the minds of the taxpayers is the restriction vis-à-vis goods lost, stolen, destroyed, written off or disposed of by way of gift or free samples.

The question is whether the raw materials which are damaged or destroyed or become unusable during the production process and are thereafter disposed of without any corresponding consideration are “goods destroyed or lost”. If the answer is in the affirmative, then the credit is barred under the above restriction.

At first blush, it appears that the legislature intended to deny credit where goods were destroyed, stolen or disposed of irrespective of the manner in which such goods were destroyed, stolen or lost or disposed of. Moreover, it is interesting to note that the barring provision starts with a non-obstante clause requiring reversal irrespective of the manner in which such goods were lost, stolen or destroyed.

It is worth noting that in certain other clauses of the barring provision, specific exceptions have been carved out by the legislature such as the exceptions provided for availing credit on motor vehicles. Such is not the case with the instant clause.

Before taking a final call, it is pertinent to note a recent Advance Ruling wherein it was held that credit on inputs used in manufacturing expired food items such as cakes and pastries which were thrown away was not admissible and was required to be reversed in terms of Section 17(5)(h) of the CGST Act, 2017 as the same were in the nature of destroyed goods.

In view of this, a possible interpretation of Section 17(5)(h) would be that the legislature intended to deny credit where goods were destroyed, stolen or disposed of irrespective of the manner in which such goods were destroyed, stolen or lost or disposed of.

Alternatively, it can be contended that if the intention of the legislature was to deny credit of goods which have been lost during the manufacturing activity or destroyed/disposed of post the manufacturing process, the same would have been provided for in the CGST Act as was provided for in the erstwhile VAT legislations[7].

Additionally, on application of the principle of noscitur a sociis, meaning can be derived for the word ‘disposed’ from the specific context in which the words ‘lost’, ‘stolen’ or ‘written off’ are used. When the goods are lost or stolen, it is not in the ordinary course of business and such loss of goods is not expected to occur in the general course of business. An argument can be advanced that the barring provision intends to disallow credit where goods though purchased for use in business are not used for the eventual business use, that is, in manufacture or trading or use in provision of services.

It is worth noting a recent decision of the Madras High Court has dealt with a case wherein there was a loss of a portion of the inputs, that is, MS Scrap, inherent to the manufacturing process of MS ingots and billets produced by the petitioner. The High Court held that the loss that is occasioned by the process of manufacture cannot be equated to any of the instances set out in the restricted categories of credit. The situations as set out in the restricted category indicate loss of inputs that are quantifiable and involve external factors or compulsions. A loss that is occasioned by consumption in the process of manufacture is one which is inherent to the process of manufacture itself. Accordingly, the High Court had set aside the impugned order requiring reversal.

On similar lines and relying on the aforesaid decision, the Madras High Court in another recent decision has also allowed credit on the process loss arising during the manufacture of ghee.

While reliance can be placed on the abovementioned decisions of the Madras High Court to support non-reversal of credit on process loss or goods damaged or destroyed during production process which are not further supplied, adopting such a stand is not free from dispute. The issue remains far from settled in light of the contrary possible interpretations.  

Considering the lack of clarity on this issue, since process loss is inherent in all manufacturing processes, clarity is awaited from the government by way of a positive clarification to avoid future disputes and put an end to the disputes raised.

Shivam Mehta is a Partner and Rohini Mukherjee a Joint Partner at Lakshmikumaran & Sridharan Attorneys