VAT - Concepts and General Principles
Value Added Tax or VAT is a broad based tax levied at multiple stage with tax on inputs credited against taxes on output.
VAT was first introduced in France in 1954, but it remained confined to handful number of countries till the 1980's. With this imposition, France became the first European country to implement VAT on an extensive scale.
The development of VAT in other countries suggests that although it was not adopted by many countries until the sixties, over the years the tax has come to occupy an important place in the fiscal armory of nearly all industrialized countries and in a large number of Latin American, Asian and African countries. As many as 30 countries have switched over to VAT since 1980 and the total number of countries who have adopted VAT presently reached to more than 130. Thus, the augmentation of interest in VAT has been the most remarkable event in the evolution of commodity taxes in the present century. In addition, as of today, VAT is evenly distributed throughout the world, though it is particularly predominant in Europe and Latin America.
VAT has replaced the general sales tax structure with the only difference in the manner of its levy. The power to levy tax on sales transactions in the form of VAT is drawn from entry 54 in List II of Seventh Schedule of the Constitution of India by the State Governments. Under VAT, every sale transaction taking place in the course of business is taxed enabling the Government to collect revenue on value addition at every stage. The cascading effect of VAT being collected at every stage on the cost of goods is reduced by providing set off of tax paid on the purchases.
1. Evolution of VAT in India
India already had a system of tax collection wherein the tax was collected at one point from the transactions involving the sale of goods. The single point tax was collected either at the first stage or at the last stage.
The system of collecting tax at first stage had the following disadvantages:
(a) Since sales tax was levied and collected at the first stage (i.e., at the stage of the wholesale), the tax rate had to be higher. This encouraged tax evasion and sales tax became a tax on honesty, which means the honesty, more the tax liability.
(b) In case somehow the goods escaped the tax at the first stage, the goods escaped tax net altogether since there was no way by which it could be caught at any subsequent stage.
(c) There was ample scope for under-valuation of the value of the goods at first stage, since there was no tax payable at any subsequent stages, even if the goods were subsequently sold at much higher prices.
In the system of collection of tax at the last stage also, several weaknesses were witnessed:
(a) The tax evasion was maximum since the price level at the last point of sale increases, which encouraged evasion, even if the tax rates were low;
(b) It was difficult to track the goods evading tax since there was no record of their earlier movements and after the last point sale, the goods reached in the hands of the consumers;
(c) This also encouraged under-invoicing and involves generation of black money due to cash dealings at the last point of sale.
Since VAT is collected at various stages, all the above disadvantages and weaknesses have been overcome, the cascading effect of taxes is eliminated. More transparent structure is made up and compliance are improved.
India has been slow in adoption of VAT. In domestic trade taxes, it adopted excise duty at the central level and sales tax at the state level for this purpose.
The Central Government attempted reforms in the central excise duty by introducing the principles of VAT in 1986 through the introduction of MODVAT. Over the period the rates have been rationalized, exemptions have been reduced and the coverage has been extended to almost all the commodities. MODVAT has now been converted into a central VAT, coined and called CENVAT. CENVAT is now also allowed on input services.
The state governments had been indifferent in undertaking any reforms in their sales tax system, although it accounts for approximately 60% of the state's own tax revenue. The existing sales tax system of the states was confronted with many drawbacks and weaknesses.
The Task Force known as Kelkar Committee observed that presently, "each State levies multiple taxes on the same item in different names or at different stages e.g. Entry Tax, Luxury Tax, etc." However, it opined that "it is necessary that State VAT should be the tax to unify all the State-level taxes i.e. Sales Tax, Purchase Tax, Turnover tax, Works Contract Tax, Entry Tax, Special Additional Tax, etc. should all be covered under State VAT.
The efforts were initiated towards introduction of VAT since last many years. The Committees of States' Finance Ministers (in 1995 and 1998, respectively) and of the Chief Ministers (in 1999) have put forth recommendations to replace sales tax by VAT. This was ratified by the Conference of the Chief Ministers and Finance Ministers held on November 16, 1999 and introduction of State VAT in lieu of Sales Tax was finally scheduled to be made with effect from 1-4-2003.
However, the schedule had to be revised in view of agitative traders' community. The Empowered Committee of State Finance Ministers agreed upon 1-6-2003 as the revised date of implementation of VAT and it was expected that most of the State and Union Territories will implement VAT from 1-6-2003, but it did not happen.
Later, the Finance Minister deferred the implementation of VAT for some more time so that more conducive environment may be created and agitative opposition may be set to peace. Besides consensus of all the states over the model law and introduction of VAT on uniform basis was also necessary. On 30-4-2003 he announced that unless all States conform to model draft law and agreed VAT rates, introducing VAT on 1-6-2003 will not be possible. He stated that VAT should be implemented all over India. Patchwork will not serve the purpose. In this connection, the Empowered Committee of State Finance Ministers met regularly and brought out a White Paper on State level VAT on 17-1-2005.
This White Paper on State-level Value Added Tax (VAT) was presented in three parts:
Part 1: In this part, the justification of VAT and its background had been mentioned
Part 2: The main design of VAT. While doing so, it recognized that this VAT is a State subject and therefore the States will have freedom for appropriate variations consistent with the basic design as agreed upon by the Empowered Committee.
Part 3: Part 3 discussed the other related issues for effective implementation of VAT.
Justification of VAT and Background
· In the existing sales tax structure, there are problems of double taxation of commodities and multiplicity of taxes, resulting in a cascading tax burden.
· For instance, in the existing structure, before a commodity is produced, puts are first taxed, and then after the commodity is produced with input tax load, output is taxed again. This causes an unfair double taxation with cascading effects.
· In the VAT, a set-off is given for input tax.
In the prevailing sales tax structure, several States levying multiplicity of taxes, such as turnover tax, surcharge on sales tax, additional surcharge, etc. With introduction of VAT, these other taxes will be abolished. In addition, Central sales tax is also to be phased out. As a result, overall tax burden will be rationalized, and prices in general fall.
Further, VAT will replace the existing system of inspection by a system of built-in self-assessment by the dealers and auditing.
· The tax structure will become simple. That will improve tax compliance and also augment revenue growth.
The VAT will therefore help common people, traders, industrialists and also the Government. It is indeed a move towards more efficiency, equal competition and fairness in the taxation system.
All States and Union Territories have gradually introduced VAT in India except the State of Uttrakhand. VAT has not been introduced in Jammu and Kashmir due to constitutional limitation.
VAT is a tax, which is charged on the 'increase in value' of goods and services at each stage of production and circulation. It is also chargeable on the value of all imported goods. It is charged by registered VAT businesses/persons/taxpayers. VAT has replaced a number of other taxes and its introduction has not resulted in either increased prices to final consumers or reduced profitability of business. VAT is levied on the difference between the sale price of the goods produced or the services rendered, and the cost thereof __ that is, the difference between the output and the input.
In other words
· It is nothing but multi-point Sales Tax.
· It is collected on value addition only at each stage.
· Tax paid by the dealer is deducted from the tax payable collected at every point of sale and the tax already paid.
3. How is VAT different from the Sales Tax?
1. Tax levied at the stage of the first sale or at the final stage
1. Tax levied and collected at every point of sale
2. Successive sales (resale) of goods on which tax is already paid do not attract tax
2. Tax collected at every point of sale and the tax already paid by the dealer at the time of purchase of goods will be deducted from the amount of tax paid at the next sale
3. Dealers reselling tax paid goods do not collect any tax on resale and file NIL returns
3. Dealers reselling tax-paid goods will have to collect VAT and file returns and pay VAT at every stage of sale (value addition)
4. Computation of tax liability is complex
4. It is transparent and easier
5. Sales Tax is not levied at the time of purchases against statutory forms but there is misuse of such forms resulting in tax evasion.
5. VAT dispenses with such forms and sets off all tax paid at the time of purchase from the amount of tax payable on sale
6. Returns and challans are filed separately and the dealers have to give numerous details
6. The returns and the challans are filed together in a simple format after self-assessment done by the dealer himself
7. A large number of forms are required
7. At the most a few forms are required
8. Tax on goods only
8. Tax on goods and services both.
9. Assessment done by the department
9. Self-assessments by dealers
10. Penalty for defaulters/evaders not strict
10. Penalties will be stricter
VAT is calculated by deducting tax credit from tax collected during the payment period.
Further, every time the VAT is charged, it is not an expense to the person who pays it, but just an advance to the government via the supplier. This is true for all except the final customer who cannot claim the VAT deduction. Actually, he is the only one who pays the full amount.
5. Eligible purchases for availing input tax credit
The input tax credit is available only when the taxable goods are purchased for the following purposes—
(1) For sale/resale within the State;
(2) For sale in the course of inter State trade or commerce; i.e. Goods are sold to any other State or Union Territory of India;
(3) To be used as—
(i) Containers or packing materials;
(ii) Raw materials; or
(iii) Consumable stores,
and the goods so manufactured by the use of the above raw-materials, packing materials are sold within the State or in the course of inter State trade commerce;
(4) For being used in the execution of a works contact;
(5) To be used as capital goods required for the purpose of manufacture of taxable goods;
(6) To be used as—
(a) Raw materials;
(b) Capital goods;
(c) Consumable stores; and
(d) Packing materials/containers
and goods so manufactured by the use of above items are sold in the course of export out of the territory of India.
6. Coverage of Set-Off/Input Tax Credit
(1) Instant credit of input tax
This input tax credit will be given both to the manufacturers and traders for purchase of inputs/supplies meant for both sales within the State as well as to other States, irrespective of when these will be utilized/sold. This also reduces immediate tax liability.
(2) No input credit on central sales tax paid on purchases from other States
At present, there is no credit of CST if inputs are purchased from outside the State. For example if the goods are purchased by Delhi dealer from Mumbai for Rs. 1,02,000 which includes CST of Rs. 2,000, Delhi dealer will not get input tax credit of Rs. 2,000. If goods are sent outside State on stock transfer basis, credit (set off) of tax paid on inputs purchased within the State is available only to the extent of tax paid in excess of 2% e.g. if tax paid on inputs is 12.5%, input credit of 10.5% is available.
(3) Input credit on stock transfer to other States
When CST rate is reduced to Nil, full credit of tax paid on inputs will be available i.e. inter-state sales and dispatches will be 'zero rated' and not 'exempt'.
7. Purchases not eligible for input tax credit
Input credit is not be allowed in the following circumstances:
1. Purchasing from unregistered dealers;
2. Purchases from registered dealer who opt for composition scheme under the provisions of the Act;
3. Purchases of goods as may be notified by the State Government;
4. Purchase of goods where invoice does not show the amount of tax separately;
5. Purchase of goods, which are utilized in the manufacture of exempted goods;
6. Purchase of goods used for personal use/consumption or provided free of charge as gifts;
7. Goods imported from outside the territory of India or goods purchased before it reaches the custom frontiers of India;
8. Goods purchased from other States viz. inter-State purchases.
8. Input tax credit on capital goods
Input tax credit on capital goods will also be available for traders and manufacturers. Tax credit on capital goods may be adjusted over a maximum of 36 equal monthly installments. The States may at their option reduce this number of installments.
There is a negative list for capital goods (on the basis of principles already decided by the Empowered Committee) which is not eligible for input tax credit.
9. Coverage of Goods under VAT
In general, all the goods, including declared goods will be covered under VAT and will get the benefit of input tax credit.
The only few goods which will be outside VAT will be liquor, lottery tickets, petrol, diesel, aviation turbine fuel and other motor spirit since their prices are not fully market determined. These will continue to be taxed under the any other State Act or even by making special provisions in the VAT Act itself, and with uniform floor rates decided by the Empowered Committee.
10. VAT Rates and Classification of Commodities
· Under the VAT system covering about 550 goods, there will be only two basic VAT rates of 4% and 12.5%, plus
· a specific category of tax-exempted goods and
· a special VAT rate of 1% only for gold and silver ornaments.
11. Non-availability of input credit in certain cases
In the following cases credit of tax paid on inputs shall not be allowed:
1. Where final product is exempt — Credit of tax paid on inputs is available only if tax is paid on final products. When final product is exempt from tax, credit will not be allowed. If credit was availed, it will have to be reversed on pro rata basis.
2. No credit if input lost/damaged/stolen before use — Where the inputs have been lost or damaged or stolen before these have been used, credit of tax paid on such input shall not be allowed. If credit was availed, it will have to be reversed.
3. No credit on certain purchase — Generally, in following cases, credit is not available—
(a) Purchase of automobiles
(b) Fuel. However, some States are allowing input credit for the same.
12. Origin/destination principle
The following two principles are relevant for implementation of VAT—
(a) Origin principle.
(b) Destination principle.
(a) Origin principle: Under 'origin principle', value added domestically on all goods whether they are meant for exports or to be consumed in India is subjected to tax. Hence, if there is value added abroad tax cannot be levied on such value added in India. This principle confines VAT only to goods originating in the country of consumption. Whereas exports are taxable under this principle but imports are exempt. It is mostly used in conjunction with income VAT and is unpopular for obvious reasons.
(b) Destination principle: Under this principle, value added irrespective of the place of origin is taxable. All goods are taxed if they are consumed within the country. Consequently, exports are exempt while imports are subjected to tax. Destination principle is normally used along with consumption VAT. In a federal set-up like India, destination principle is preferred for taxation of products consumed within the various States of the country. A very important feature of this principle is that imported goods are treated at par with domestic products whereas in the origin principle imported goods are not taxable and hence it gives preference to goods produced abroad. In the EEC countries, origin principle was once considered for eliminating border controls and problems of valuation, but was subsequently given up as being impractical. Thus the destination principle is now being followed in those countries.
(a) Gross Product Variant
In case of Gross Product Variant, tax is levied on all sales but deductions for taxes on all purchases of raw materials and components (i.e. inputs) are allowed. However, no deduction is allowed for taxes paid on capital inputs with the result that in this variant of VAT, capital goods carry a heavier tax burden as they are taxed twice.
(b) Income Variant
In case of Income Variant, tax is levied on all sales but deductions towards purchases of raw materials and components (i.e. inputs) as well as depreciation on capital goods are allowed. Those following this variant of VAT hold incentives by classifying purchases as current expenditure to claim set-off. In this variant, gross investment minus depreciation i.e. net investment is taxed. The depreciation to be provided is dependent on the life of an asset as well as on the rate of inflation, therefore there are many difficulties connected with the variant in measuring depreciation.
(c) Consumption Variant
In case of Consumption Variant, tax is levied as all sales but deduction on all business purchases including capital assets is allowed. Thus, gross investment is deductible in calculating value added. The economic base of the tax, under Consumption Variant of VAT is equal to the total private consumption. This variant of VAT does not distinguish between capital and current expenditures hence there is no need to specify the life of assets or depreciation allowances for different assets. This form is neutral between the methods of production; there will be net effect on tax liability due to the method of production (i.e. substitution capital for labour or vice versa). The tax is also neutral between the decision to save or consume.
The consumption variant of VAT is most popular and widely used variant among the three variants of VAT. The reasons behind the preference of this variant over the other are as under:
(a) This variant is tax neutral as it does not affect decisions regarding investment because the tax on capital goods is also set-off against the VAT liability.
(b) This variant relieves all exports from taxation while imports are taxed which is harmonious with the destination principle i.e. if the destination of goods is foreign country, it should not be taxed in India.
(c) The consumption variant is convenient from the point of administrative expediency as it simplifies tax administration as it distinguishes between purchases of intermediate and capital goods on the one hand and consumption goods on the other hand.
(d) It does not cause any cascading effect.
14. Method for Computation of tax
(A) Invoice method/Tax credit method
Tax credit method involves payment of tax by the seller i.e. manufacturer or dealer at full selling price and credit of tax is allowed, which he has paid at the time of purchase. Thus, the tax is levied on full sale price, but credit is given of tax paid on purchases and effectively, tax is levied only on 'Value Added' only.
It's an easy and simple way to ensure that tax is paid. It helps elimination of cascading effect of tax on consumers.
(B) Subtraction method
Under subtraction method, the purchase price is deducted from selling price and tax is paid on the net amount only i.e. value added. Thus, when the tax is paid on net amount, dealer's margin is disclosed.
This method is unpopular and cumbersome. It is practically impossible when various inputs are used in the manufacture of numerous outputs. It is also not preferred by dealers as their margin gets disclosed.
Suppose a manufacturer sells goods to a trader for Rs. 220 which includes tax charged @ 10%. The trader sells the same goods to a consumer for Rs. 388 which also includes tax charged @ 10%. The tax in this case shall be worked as under:
Manufacturer sells the goods to trader Turnover VAT @ 10%
[220 ´ 10/110]
Trader sells the goods to consumer
Taxable turnover shall be 8
308 - 220 = 88 88 [88 ´ 10/110]
Total tax Rs. 20 + 8 = Rs. 28.
In the above system also, the incidence of tax is at each stage.
VAT being a broad based tax levied at multiple stages is generally perceived as an explicit replacement of State sales tax for raising additional revenue for the Government. The purpose of a tax system is to bring in revenues to the Government. Tax revenues can be raised in many ways. However, the main characteristic of good tax system should be—
· The tax system should be fair or equitable;
· It should cause the least possible harmful effects to the economy and to the extent possible, it should promote growth to the economy;
· It should be simple both for its compliance by the payer and for its administration by the Government;
· It should be income elastic.
Keeping in view the above objectives, VAT is being implemented in various states in place of the local sales tax payable by the seller. VAT is also expected to be more effective and efficient for every person including Government, manufacturers, traders and consumers and hold the following advantages:—
(i) It is easy to administer and transparent because of its simplicity.
(ii) There are less scope of litigation
(iii) Tax Credit on purchase of Capital Goods is also allowable.
(iv) There are no statutory forms under VAT. Therefore, all problems related to forms automatically get resolved.
(v) There is provision for Self-Assessment
(vi) It will act as deterrent against tax avoidance.
(vii) It does not have cascading (tax on tax) effect due to system of deduction or credit mechanism.
(viii) It supports Effective Audit & Enforcement Strategies
(ix) The system will be more effective because of minimum exemptions.
(x) It ensures removal of anomaly of First Point Taxation
(xi) Export can be freed from domestic trade taxes in real sense.
(xii) It is an instrument to tax consignment of goods
(xiii) Economic Advantages
(a) Buoyant Revenue,
(b) Efficient tax collection,
(c) Neutrality with minimum dist,
(d) Interference in market forces is minimum.
(i) Detailed Records are required for VAT purpose.
(ii) VAT causes Inflation
(iii) No provisions for early refund of tax in case of exempted goods or export of final goods.
(iv) There are many functional problems
(v) Dealer will be making purchases after paying tax, therefore investment in stock will go up the extent of tax paid.
(vi) No Credit for Tax paid on Inter-state Purchases
(vii) Introduction of composition scheme will obstruct the flow of audit trail and this scheme can be misutilised by unscrupulous dealer.
(viii) Financial planning by Department
(ix) Audit under vat
It will also be difficult to administer the tax systems at wholesale and retail stage as they usually deal in numerous products and commodities, which carry different rate. Thus matching of output and input taxes is difficult. Ideally VAT should have very few rates which does not seem to be possible in India due to varying and diverse fiscal and social requirements. In case matching requirement is waved off there is a possibility of tax evasion as explained hereunder:—
Purchases made by a Dealer
Amount (In Rs.)
1% 4% 8% 20% Total
1,000 1,000 1,000 1,000 4,000
10 40 80 200 330
Sales Shown by Dealer
I II III IV Total
1,200 1,200 1,200 1,200 4,800
12 48 96 240 396
Tax Liability (Rs. 396 - Rs. 330) = Rs. 66
I II III IV Total
1,400 1,200 1,200 1,000 4,800
14 48 96 200 358
Tax Liability (Rs. 358 - Rs. 330) = Rs. 28.
17. Need of audit under VAT
(A) Lack of Education among Traders Community
In our country the trading community is not educated enough therefore they face problem in understanding the requirements of tax laws. Moreover the VAT system of taxation is new to the trading community.
Due lack of knowledge and unawareness, the traders are not well equipped to understand the implications of the VAT system of taxation. Keeping these factors in view the State Government in order to arrange their business affairs to fall in line with the requirements of the State – Level VAT, calculate and discharge their exact tax liability under the VAT Law have incorporated audit provisions in VAT Acts.
(B) Lack of Resources with Taxation Authorities
The taxation authorities do not have sufficient resources to educate the tax payers and inform them about the procedural requirements and accounting changes that are required under VAT system. Due to lack of resources, the taxation authorities are also not in a position to ensure that all the requirements of VAT are being fulfilled and there is no loss of Government revenue. Therefore, it is desirable to prescribe for an audit under VAT by a qualified professional so that the taxation authorities may the procedural requirements.
(C) Self-Assessment under VAT regime
Another reason for prescribing an audit under the VAT by a Chartered Accountant, is that under the VAT system a major thrust is to be laid on the 'self assessment'. The dealer/assessee calculates its tax liability himself and thereafter pays the same. The tax payers through their periodical returns inform the Department about its business affairs. These periodic returns are accepted by and large and the tax payers are not to be called for substantiating their tax liability as shown by them in the returns by producing books of account and other relevant material. The assessments with books of account will be an exception. Therefore there is a strong need to see that the tax payers discharge their tax liability properly while filing the returns. This can be ensured only where the particulars furnished by the tax payers are verified by an independent auditor in minute details by going not only through the books of account but also by analyzing and interpreting the provisions of the State – Level VAT Laws and reporting, whether any under-assessment was made by the dealer requiring additional payment or whether there was any excess payment of tax warranting refund to the tax payer.
Due to these factors and requirements audit under VAT become essential and shall be performed on a regular basis. However, it is not possible to conduct the audit of all the VAT dealers. Therefore, the criteria for audit can be the amount of turnover or the class of dealer dealing in specified commodities.
18. General requirement for VAT System
(a) Compulsory issue of tax invoice and Retail Invoice: The entire design of VAT with input tax credit is crucially based on tax invoice, or retail invoice.
Tax invoice: Every registered dealer, having turnover of sales above an amount specified, shall issue to the purchaser serially numbered tax invoice with the prescribed particulars.
This tax invoice will be signed and dated by the dealer or his regular employee, showing the required particulars.
The dealer shall keep a counterfoil or duplicate of such tax invoice duly signed and dated. Failure to comply with the above will attract penalty.
The purchaser will get input credit on the basis of the said tax invoice.
Retail invoice: Where sales are made to a consumer or in the course of inter-State trade and commerce, the dealer shall issue retail invoice. No input credit is available to purchaser on the basis of this retail invoice.
(b) Registration: There is a compulsory registration of the dealer if the aggregate turnover exceeds a certain specified limit. It is Rs. 5,00,000 in most of the States whereas in Delhi it is Rs. 10 lakhs. Small dealers whose gross turnover does not exceed Rs. 5 lakh/10 lakh shall not be liable to pay VAT. These small dealers will not be allowed input tax credit on their purchases. Small dealers may also get voluntary registration and come under the purview of VAT provisions.
(c) Composition scheme: A small dealer whose turnover does not exceed a specified limit (say in Delhi Rs. 50 lakhs) can opt for composition scheme where he shall have to pay tax himself at a small percentage of gross turnover and in this case buyer of goods with not be entitled to input VAT Credit.
(d) Tax Payer Identification Number (TIN): There will be a taxpayers identification number of 11 digit numericals which will be unique to each dealer. First two characters will represent the State Code as used by the Union Ministry of Home affairs. The set up of the next nine characters may, however, be different in different States.
(e) Simplified return of VAT are to filed monthly or quarterly as specified by each State.
Every return furnished by dealers will be scrutinized expeditiously within prescribed time limit from the date of filing the return. If any technical mistake is detected on scrutiny, the dealer will be required to pay the deficit appropriately.
(f) Self-assessment by dealers.
Procedure of Self-Assessment of VAT Liability
· The basic simplification in VAT is that VAT liability will be self-assessed by the dealers themselves in terms of submission of returns upon setting off the tax credit.
· Return forms as well as other procedures are simple in all States.
· There will not longer be compulsory assessment at the end of each year as is existing now. If no specific notice is issued proposing departmental audit of the books of accounts of the dealer within the time limit specified in the Act the dealer will be deemed to have been self-assessed on the basis of returns submitted by him.
(g) Audit under VAT has been made compulsory by various States.
(h) No requirement of any declaration form as bill will be raised for each sale and VAT shall be levied.
(i) Comprehensive coverage as only few commodities have been exempted from VAT.