Everything to Know: About Compensation Cess to States in GST

Compensation to States is always in news for one reason or another. In this article, we will discuss each and every aspect about Compensation Cess including Possible MCQs relevant for Exams (given in the End).


As we know that before GST came into picture, States were having right to impose tax on Purchase and Sale of Goods (Entry No. 54 of State List). For GST to see the light of the day, States were required to forego this right in the favour of GST Council. Hence, there was apprehension among States that they might lose their revenue once GST comes into picture.


Therefore, to assuage these concerns of States, States were promised protection of revenue for five years in the form of compensation for any shortfall of Revenue.


Legal backing to provide for Compensation to States

  • Section-18 of the 101st Constitution Amendment Act, 2016 provides for compensation to the States for loss of revenue arising on account of implementation of the goods and services tax for a period of five years.

  • Accordingly, The Goods and Services Tax (Compensation To States) Act, 2017 was passed by the Parliament on the recommendation of GST Council.

How to Calculate Loss of Revenue to States

  • 14% Growth in Revenue was promised on the base of Financial Year 2015-16.

  • For instance, in 2015-16 if Revenue of One State was Rs.100, then the State is being assured Revenue of Rs.100(1+14/100)^3 for the year 2018-19 i.e. Rs.148.15

  • So, if Actual Revenue of a State is Rs.120 in the year 2018-19, then the State will be compensated by Rs.28.15 in 2018-19.

  • For 2017-18, Shortfall/Revenue Loss will be calculated in little bit a technical way as explained in the end of the article.

  • It may be noted that Centre has not been given any revenue protection by the Constitution.

Time Period for which States are Ensured Protection of Revenue

  • Five Years from Date of Transition i.e. 01.07.2017 to 30.06.2022.

Source of Revenue for Compensation to States: Compensation Fund

  • For collecting the revenue for compensating the states, Cess is being imposed on luxury and Demerit Goods & Services as decided by GST Council like Automobiles etc.

  • Compensation Cess is Collected in Compensation Fund created as Non-Lapsable Public Account of India under Centre Control.

  • Thereafter, Centre releases funds to States every two months.

Current Situation: Way-out when Compensation Cess is inadequate to fund Compensation to States

  • Law does not provide for the situation as no one could predict coming of Covid-19.

  • As advised by the Attorney General of India that Centre is not constitutionally liable to compensate the States for shortfall in Revenue on account of Covid-19 since constitution provides for compensation for shortfall in Revenue on account of implementation of GST.

  • Therefore, after detailed deliberations, it was decided by GST Council that Centre will borrow from market and in turn lend (Not compensate) to States against this shortfall of Revenue.

  • Thereafter, these loans will be repaid through imposition of Compensation Cess since as per Law Compensation can only be provided by way of imposition of Compensation Cess.

  • That’ why imposition of Compensation Cess has been extended by GST Council till March, 2026. (Originally planned to be imposed till 30.06.2022) to repay loans along with interest.

  • It may be noted that, only imposition of Compensation Cess has been extended till March, 2020 to repay the loans but Compensation to States is assured only till 30.06.2022.

  • It may also be noted that In 2017-18 & 2018-19, Cess Collected under Compensation Fund was more than Compensation paid to the States.

What all Taxes be Considered for Calculation of Revenue of Base Year

  • It is quite logical to consider all those taxes which were accrued to States are subsumed into GST including:

  • VAT, Central State Tax on inter-state movement of goods (CST was levied by Centre but was collected and retained by States) and other taxes imposed under Entry-54 of State List (Tax on Sale & Purchase of Goods),

  • Entry Tax, Octroi and other taxes imposed under Entry-52 of State List (Taxes on Entry of Goods)

  • Entertainment Tax, Amusement Parks, Betting etc. Entry-62 of State List (Taxes on Luxuries), Taxes on Advertisement (Entry-55), Duties levied under Article-268 (levied by Centre but collected and retained by States).

Taxes not included:

  • Taxes on Petroleum Products, Alcohol for Human Consumption, Taxes imposed by Local Authorities like House Tax etc.

What will Happen to the amount remaining in the Compensation Fund remained at the end of Transition Period

  • At the end of March-26, if after payment of compensation to States, any amount remained in Compensation Fund, it will be distributed between Centre and State (50:50).

Possible MCQ Statements

  • Borrowing by Centre to Compensate the State will increase Fiscal Deficit of Centre: False, because on hand it is borrowing and on other hand it is lending to States, so net impact is zero on the Fiscal Deficit of Centre. However, it will increase Fiscal Deficit of States.

  • Compensation to States in GST has no Constitution Basis: Wrong

  • Compensation for any shortfall in Revenue is assured to States Only: Wrong as also to UTs with legislature.

  • Compensation Fund is Non Lapsable Public Accounts: True

  • Balance Amount in Compensation Fund at the end of transition period will be equally shared between Centre and State: True

Calculation of Compensation for the year 2017-18

Particulars

Amount

Base Year (2015-16)

100

Projected Revenue (100*(1+14/100)^2

129.96

Actual Revenue of State

a) Under Existing Law (VAT, CST, Entertainment Taxes etc.) (01.04.2017 to 30.06.2017)

20

b) Under GST (01.07.2017 to 31.03.2018)

90

Total Actual Revenue

110

Shortfall of Revenue

19.96

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