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VALUE ADDED TAX

Vat is basically a tax on sale of goods. Vat is payable by seller who is termed
as a dealer. Powers to levy sales tax are contained in seventh schedule to
Constitution of India. After studying this chapter we will be able to
understand :
(1) Meaning of VAT.
(2) The implications of VAT.
Background of Vat in India
Tax on sale within the State is a State subject. Over the period, many
distortions had come in taxation due to unhealthy competition among States
by giving sales tax incentives and tax rate war started to attract more
revenue to State. Many steps were taken to remove the distortions and
rationalize tax structure since 1999. It was decided to introduce uniform
State Level VAT. After lot of persuasion by Central Government, all States
ultimately agreed to introduce State Level sales tax VAT w.e.f.1-4-2005.
State-wise position of VAT
Haryana was the only State to introduce VAT w.e.f. 1.4.203. 20 States
introduced VAT w.e.f. 1.4.2005,these included Assam, Andhra Pradesh, Bihar,
Delhi, Goa, Karnataka, Kerala, Maharashtra, Punjab and West Bengal.
States ruled by BJP like Gujarat, Chhatisgarh, Jharkhand, Madhya Pradesh
and Rajasthan introduced Vat w.e.f. 1.4.2006.
Tamilnadu introduced Vat on 1.1.2007. Uttar Pradesh introduced Vat w.e.f.
1.1.2008.
Uttarakhand has not introduced VAT so far. J&K is out of picture of Vat due
to constitutional limitations.
Compromised VAT
The VAT system as being introduced is result of deliberations of committee
of representatives from 29 States. Each State has its own views and
peculiarities. Hence, having uniform nationwide VAT is very difficult and
some compromises/ adjustments are inevitable. This has happened while
introducing State VAT also.
Vat works best when there is uniformity in rate and variation in rates are
minimum. However, in State Vat, the variations in rates is much higher. Many

products (like petroleum products) are kept out of Vat regime. This is
incorrect as per Vat principles.
Exemptions should be minimum if Vat is to be implemented properly.
However, there are various exemptions in Vat regime in India e.g.
exemptions to SEZ/EOU, area based incentives etc. At present, there is no
credit of CST if inputs are purchased from outside the State. Similarly, if
goods are sent outside State on stock transfer basis, credit (set off) of tax
paid on inputs is available only to the extent of tax paid in excess of 2% e.g.
if tax paid on inputs is 12.5%, credit of 10.5% is available.
When CST rate is reduced to Nil, full credit of tax paid on inputs will be
available i.e. interState sales and despatches will be zero rated and not
exempt. Each State has made changes as per their needs. Though basic
concepts are same in VAT Acts of all States, provisions in respect of credit
allowable, credit of tax on capital goods, etc, are not uniform.
Basic concept of Vat
VAT woks on the principle that when raw material passes through various
manufacturing stages and manufactured product passes through various
distributions stages, tax should be levied on the Value Added at each stage
and not on the gross sales price. This ensures that same commodity does not
get taxed again and again and there is no cascading effect. In simple terms,
value added means difference between selling price and purchase price.
VAT avoids cascading effect of a tax.
Basically, VAT is multi-point tax, with provision for granting set off (credit)
of the tax paid at the earlier stage, thus, tax burden is passed on when
goods are sold. This process continues till goods are finally consumed.
Hence, VAT is termed as consumption type tax with destination principle.
VAT works on the principle of tax credit system.
Meaning of cascading effect of tax
Generally, any tax is related to selling price of product. In modern
production technology, raw material passes through various stages and
processes till it reaches the ultimate stage e.g., steel ingots are made in a
steel mill. These are rolled into plates by a re-rolling unit, while third
manufacturer makes furniture from these plates. Thus, output of the first
manufacturer becomes input for second manufacturer, who carries out
further processing and supply it to third manufacturer. This process
continues till a final product emerges. This product then goes to distributor/
wholesaler, who sells it to retailer and then it reaches the ultimate

consumer. If a tax is based on selling price of a product, the tax burden goes
on increasing as raw material and final product passes from one stage to
other.
For example, let us assume that tax on a product is 10% of selling price.
Manufacturer A supplies his output to B at Rs.100. Thus, B gets the
material at Rs.110, inclusive of tax @ 10%. He carries out further procession
and sells his output to C at Rs.150. While calculating his cost, B has
considered his purchase cost of materials as Rs.110 and added Rs.40 as his
conversion charges. While selling product to C, B will charge tax again @
10%. Thus, C will get the item at Rs.165 (150 +10% tax). In fact, value
added by B is only Rs.40 (150-110), tax on which would have been only
Rs.4, while the tax paid was Rs.15. As stage of production and /or sales
continue, each subsequent purchaser has to pay tax again and again on the
material which has already suffered tax. Tax is also paid on tax. This is
called cascading effect.
VAT avoids cascading effect of tax
System of VAT works on credit method. In Tax Credit Method of VAT, the tax
is levied on full sale price, but credit is given of tax paid on purchases.
Thus, effectively, tax is levied only on Value Added. Most of the countries
have adopted Tax credit method for implementation of VAT. E.g.
B will purchase goods form A @ Rs.110, which is inclusive of duty of
Rs.10. Since B is going to get credit of duty of Rs.10, he will not consider
this amount for his costing. He will charge conversion charges of Rs.40.00
and sell his goods at Rs.140. He will charge 10% tax and raise invoice of
Rs.154.00 to C. (140 plus tax @ 10%). In the Invoice prepared by B, the
duty shown will be Rs.14. However, B will get credit of Rs. 10 paid on the
raw material purchased by him from A. Thus, effective duty paid by B
will be only Rs.4. C will get the goods at Rs.154 and not at Rs.165 which he
would have got in absence of VAT. Thus, in effect, B has to pay duty only
on value added by him.
Advantage of VAT over conventional system of taxation
The advantage of consumption type VAT are as follows
(a)

The tax burden is only at the last i.e. consumption stage.

(b) It becomes easier to give concessions to goods used by


common man or goods used for manufacture of capital goods
or exported goods and charge heavy duty on luxury goods.

(c) Administration control is easy due to credit method that


can be adopted.
(d) It makes no distinction between capital intensive and labour
intensive activities. Tax avoidance by classifying capital goods
purchase as revenue purchase is avoided. This simplifies tax
administration.
(e)

It is in harmony with the destination principle.

Simplicity and transparency. Simplicity is because there are


minimum variations in tax rates. Control is through transparent
audit system. Transparency is achieved as the total tax burden on a
product is as shown in invoice. There are no hidden taxes. Audit
system checks over dealers and ensures proper payment of taxes.
Reduction in tax evasion Tax evasion is reduced. Input credit is
available only if evidence of duty payment through invoice is
available. The buyer will not get input credit if sellers tax invoice is
not available. Thus, practically, buyer keeps a check on seller.
Disadvantage of consumption type of Vat
(1) All tax is collected in the State in which goods are finally consumed.
State in which goods are actually produced do not get any tax, while the
State Government has to provide infrastructure and other facilities for
production for which it has to spend huge amounts. This is the reason why
some States are insisting on imposing purchase tax in such cases, which is
obviously against the principle of consumption based tax.
(2) The States get indirect benefits like growth of employment, improved
economy etc. but no direct benefit of Vat/ sales tax.
(3)Tremendous paper work and record keeping in VAT. Vat system
can work only if record keeping is proper and reliable. The elaborate
record keeping is not possible to small businesses. Hence, an
exemption is granted to tiny businesses whose turnover is below
prescribed limits. In case of small businesses, a composition scheme
is provided where tax is paid on gross value of sales at a fixed rate.
Other related problems with VAT are:

Bogus Invoices on which tax credit is availed.

Acquisition fraud (Mission trader fraud).

Carousel Fraud.

Acquisition fraud The acquisition fraud is based on the fact


that goods imported are tax free. A dealer imports goods and makes
sale within the country. The dealer either has his own Vat
registration number or he hijacks others Vat number. He collects
the tax from buyer and then disappears without paying the collected
tax to the Government. The buyer is usually innocent and is not
aware that the seller is not going to pay tax to Government. This is
missing trader fraud of one type.
In Indian context, this fraud is possible when CST rate is Nil or is reduced to
1%. A dealer can purchase goods inter -state and makes sale within the
State. He will collect tax and then disappear. He may use someone elses Vat
number in his invoices or may himself get registered with address of some
rented premises.
Carousel fraud-Carousel means merry- go- around.This type of fraud
is difficult to trace. E.g. a dealer A imports goods without tax. He sells
goods to B and charges VAT. B avails credit of tax shown by A in his
invoice. B sells the goods to C and charges VAT. B has to pay only
differential amount as tax. C exports the goods and claims the refund of
input tax i.e. entire tax shown by B in his invoice. This is a valid
transaction. The missing link is that A actually does not deposit tax to
Government. Thus, C gets refund of tax which is not paid by A. By the
time Government traces the transaction to A, he has disappeared. The same
goods are used again and again for imports and exports. That is why the
fraud is termed as carousel fraud.
Non Availability Of Input Credit In Certain Cases
Credit or tax paid on inputs will be denied in following situationsNo credit if final product is exempt- Credit of tax paid on inputs
is available only if tax is paid on final product. Thus, when final
product is exempt from tax, credit will not be availed. If availed, it
will have to be reversed on pro rata basis.
Restricted credit if output goods are transferred to another
state If the final products are transferred to another state as
stock transfer or branch transfer, input credit availed will have to be
reversed on pro rata basis, which is in excess of 2%. In other
words, in case of goods sent on stock transfer/branch transfer out of

state, 2% tax on inputs will become payable e.g. if tax paid on


inputs is 12.5%, credit of 10.5% is available.
When CST rate is reduced to Nil, full credit of tax paid on inputs will be
available i.e., inter-state sales and stock transfers will be zero rated and
not exempt.
No input credit in certain cases- In following cases, the dealer is
not entitled to input credit(a)

Inputs used in exempted final products

(b)

Final product not sold but given as free sample

(c)

Inputs lost/damaged/stolen before use. If credit was


availed, it will have to be reserved.

Broadly, the following purchases are not eligible for Vat credit(d)

Final product is exempted from Vat.

(e)
Inter-state purchases i.e. goods purchased from outside
the state
(f)

Goods imported (obvious, since there will be no Vat


invoice)

(g)
Goods purchased from unregistered dealer (as he
cannot charge Vat)
(h)
Goods purchased from dealer who is paying Vat under
composition scheme (as he cannot charge Vat separately in
invoice)
(i)

Purchase where final goods sold are exempt from tax

(j)

Final product is given free i.e. goods not sold

(k)

Inputs stolen/lost/damaged before use/sale as there is


no sale

(l)

Proper Tax Invoice showing Vat separately is not


available

(m) Ineligible purchases like automobiles, fuel, certain capital


goods etc. as specified in relevant state Vat law i.e. items in
negative list.
No input credit if inputs lost, destroyed or damaged- Punjab
VAT Act provides that input credit will not be available if these are
lost, destroyed or damaged. In Bharat Petroleum Corporation v.
State of Punjab (2009) 19 VST 118(P&H HC DB), it was held that
this provision is consistent with scheme of the Act and valid. Credit
of tax paid on such inputs lost due to natural causes like
evaporation should be allowable.]
No credit on certain purchases- Generally, in following cases, credit is not
allowable-