Introduction to Value Added Tax (VAT)

Value Added Tax or VAT is a broad-based commodity tax that is levied at multiple stages of production. The concept is akin to excise duty paid by the manufacturer who, in turn, claims a credit on input taxes paid. Excise duty is on manufacture, while VAT is on sale and both work in the same manner, according to the white paper on VAT released by finance minister Chidambaram. The document was drawn up after all states, barring UP, were prepared to implement VAT from April.  It is usually intended to be a tax on consumption, hence the provision of a mechanism enabling producers to offset the tax they have paid on their inputs against that charged on their sales of goods and services.  Under VAT revenue is collected throughout the production process without distorting any production decisions.

VAT will replace the present sales tax in India. Under the current single-point system of tax levy, the manufacturer or importer of goods into a State is liable to sales tax. There is no sales tax on the further distribution channel. VAT, in simple terms, is a multi-point levy on each of the entities in the supply chain with the facility of set-off of input tax that is, the tax paid at the stage of purchase of goods by a trader and on purchase of raw materials by a manufacturer. Only the value addition in the hands of each of the entities is subject to tax.

For instance, if a dealer purchases goods for Rs 100 from another dealer and a tax of Rs 10 has been charged in the bill, and he sells the goods for Rs 120 on which the dealer will charge a tax of Rs 12 at 10 per cent, the tax payable by the dealer will be only Rs 2, being the difference between the tax collected of Rs 12 and tax already paid on purchases of Rs 10. Thus, the dealer has paid tax at 10 per cent on Rs 20 being the value addition in his hands.

  • Purchase price – Rs 100
  • Tax paid on purchase – Rs 10 (input tax)
  • Sale price – Rs 120
  • Tax payable on sale price – Rs 12 (output tax)
  • Input tax credit – Rs 10
  • VAT payable – Rs 2

VAT levy will be administered by the Value Added Tax Act and the rules made there-under. VAT can be computed by using any of the three methods detailed below:

  1. The Subtraction method:- The tax rate is applied to the difference between the value of output and the cost of input.
  2. The Addition method: The value added is computed by adding all the payments that is payable to the factors of production (viz., wages, salaries, interest payments etc).
  3. Tax credit method: This entails set-off of the tax paid on inputs from tax collected on sales.

India opted for tax credit method, which is similar to CENVAT.

VAT law introduces words and concepts which have a special meaning for VAT administration purposes. For business enterprises, and especially for those who must register for VAT purposes, it is important to understand and appreciate the meaning of these definitions and concepts. These are dealt with in Section 2 of the Act. The following concepts are the most important.

Many states in India have started asking the professionals (sometimes Chartered Accountants only) to carry out a VAT audit similar to the Tax audit as envisaged under Income Tax. This is a move towards distancing the tax administration form the erstwhile hold of the Sale Tax officers also a move to trust the tax payers more. In central excise regime the self assessment scheme which has been working for some time now has result, which indicate that 97 % of the monies are collected on voluntary compliance by tax compliant assesses. A mere 3% is out of the audits/ investigation etc.

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