INTRODUCTION TO VALUE ADDED TAX (VAT)

Nishant Agarwal, Aurangabad

The public hue and cry against the introduction to Value Added Tax has posed a great problem in its implementation. The traders and businessman have projected VAT as the root cause of increase in prices of goods. The public sentiments have been aggravated blatantly to exert pressure on administration to stop its implementation for the general interest of the public. HISTORICAL BACKGROUND OF SALES TAX AND VAT Sales tax was first introduced in 1939 by the Tamil Nadu Government and was subsequently adopted by many states. As the economic rationale wasnt considered behind its implementation, administrative problems were faced. The problems of inter-state trade and double taxation were also posed since the economic circumstances of the states were heterogenous. Consequently, CST as an origin-based tax was introduced in 1956. If the Government had given a thought of VAT at that time, the story of Indias tax structure would have been completely different. The law of CST took India away from VAT which ideally must be destination based. Till 1980s sales tax was a multipoint levy with no set off which resulted into inflation because of cascading effects of taxes. Later the states resorted to single point tax system at higher rates of tax to generate the required revenue. The system of sales tax suffered from many problems. The need for fiscal reforms in indirect taxes became highly imperative and somehow inevitable because of the irrationality and distortions in the overall

tax structure and also the poor tax revenue mobilizations. VAT was the solution to the above problem. It is to be noted that France was the first country to adopt VAT in 1954. Subsequently, about 130 countries including Pakistan, Bangladesh, Sri Lanka and Nepal have introduced VAT as one of the most fabulous tool of fiscal policy. In 1999, the Empowered Committee of State Chief Ministers opened up the subject of VAT. Though VAT was going to be introduced in 2003, certain developments including a careful study of the problem of CST delayed its introduction. Finally, in Jan 2005 Mr. P Chidambaram unveiled a White Paper on VAT, documenting a roadmap to levy uniform state-level tax across majority of the states from April 1st 2005. VAT: WHAT IS IT? The term "value added" refers to increase in value of goods and services at each stage of production or transfer of goods and services. Thus Value Added Tax is basically a tax to be levied on the value added by an organization at each stage of its rendering services or producing goods. The VAT is a tax on the final consumption of goods or services and is ultimately borne by the consumer although it is collected at every stage of production or distribution and a tax credit is granted at each stage for tax paid at the earlier stage in the chain of transfer/ sale of goods or services till it reaches the final consumer.

VAT METHODOLOGY

Primary producer: Farmer Sale of wheat to miller Rs.100 VAT Payable@10% Rs. 10

Secondary producer: Miller Input Value Added Sale to Baker VAT@10% Less: Input tax credit VAT payable Rs. 100 Rs. 200 Rs.300 Rs. 30 Rs. 10 Rs. 20

Government VAT collection = Rs ( 10 + 20 + 60 ) = Rs. 90 (actually borne by the customer)

Secondary producer: Baker Input Value Added Sale to Customer VAT@10% Less:Input tax credit VAT payable Rs.300 Rs.600 Rs.900 Rs. 90 Rs. 30 Rs. 60

Customer Gross value of purchase Rs.900 Add: VAT@10% Rs. 90 Total purchase price Rs.990
Let us assume that farmer is a primary producer who sells wheat to the miller, he in turn sells flour to the baker and the baker sells bread to the final consumer. Now the farmer sells wheat at Rs.100 on which tax liability arises at Rs.10 ( Assume the VAT rate to be 10%). The miller has to pay Rs.110 to the farmer who will pay Rs.10 to the Govt. Similarly the miller incurs some expenses and sells flour at Rs.300. On this sale VAT will be Rs.30 for which the baker will pay Rs.330. But millers actual VAT liability will only be Rs.20 since he will get an input tax credit of Rs.10 on purchase from the farmer. Similarly, bakers VAT liability is Rs.60. Ultimately, the tax liability of Rs.90 (10% on 900) is borne by the customer which is equal to the VAT paid by the individual producers. Thus, because of the in-built shifting ability of VAT, the ultimate VAT liability is borne by the customer though tax is collected at different stages of production. It also proves that VAT liability does not multiply despite its several collections at different levels.

FEATURES OF VAT VAT is multi-point sales tax with a set off on purchases. Following are its features: a. Registration In each State there is a threshold limit for all dealers. Voluntary registration is permissible. b. Incidence, levy and collection of tax Every registered dealer or a dealer liable for registration is required to pay tax under the VAT Act on sale of goods. A registered dealer is also liable to pay for VAT goods purchased by him from an unregistered dealer. Every registered dealer effecting sales of taxable goods is required to collect taxes separately in the Tax Invoice and reflect such taxes collected separately in the books of accounts. c. Input tax credit Input tax is the tax paid by the Dealer on purchase

from a VAT-registered dealer in the same state. The input tax credit will be available for set-off on tax payable against local sales. Input tax paid on goods that are exported will be eligible for refund. Input tax paid on purchase of notified capital goods used in the business is eligible for setoff in the manner as prescribed by various states. In respect of goods that are manufactured and stock transferred outside the State, input tax paid will be eligible for set-off in excess of 4%. The net tax payable is to be remitted each month after appropriate set-off. However, where the Input tax exceeds Output tax, the Dealer would be entitled to a refund or carry forward as prescribed. d. Rates of taxes The White Paper on VAT has made a roadmap for levy of a uniform state level tax on over 550 items. VAT can be classified into four categories as under:
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by a customer on return to a supplier, additional discount, change in prices etc. The contents of a Credit/ Debit note are similar to that of Tax Invoice. g. Books and Records Every registered dealer is required to maintain true and correct accounts for a period of 5 years after the end of the year to which they relate. He shall also maintain commodity-wise stock, purchase and sale accounts and production records. In case the dealer maintains his accounts electronically, he must retain such documents and record in an electronically readable format. h. Audit The VAT laws of most States provide for Audit of accounts if the taxable turnover exceeds the prescribed limits. i. Returns and Assessments Every dealer is required to file a monthly return under the VAT Act in the prescribed manner and in the prescribed form for the prescribed period. Such returns shall be accompanied with the tax challans for tax paid after taking rebate/ set-off as provided in the Act. All the States have provided for payment of interest on short payment of taxes under specific circumstances. ACCOUNTING FOR VAT (AS PER GUIDANCE NOTE OF THE ICAI) Treatment for VAT credit on input-taxAs per AS2, only those taxes have to be included in cost of purchase which are not subsequently recoverable from the taxing authorities. Since the tax paid is available for set-off against the tax payable on sales, the input tax paid should not be included in cost of purchase. Hence, such tax credit should be debited to " VAT Credit Receivable (Inputs) Account". Following would be the entry for purchases: Purchases AccountDr. VAT Credit Receivable (Inputs) Account...Dr. To Suppliers/ Bank Account. Treatment for VAT on SalesSince VAT is collected from customer on behalf of the VAT authorities, its collection is not an economic

Category 1: Items such as natural and unprocessed products, petrol, diesel, liquor etc are exempt from VAT. Category 2: Special rate of 1% is applicable to gold and silver ornaments etc. Category 3: It covers the largest no. of items and are mainly basic necessities. A rate of 4% is applicable on such items. Category 4: A general rate of 12.5% VAT is applicable to remaining commodities. Composite dealers -

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e.

These are registered dealers under VAT who have opted to pay tax on sales at a flat rate as provided in respective state VAT legislation, provided their turnover does not exceed certain limit. They do not have to issue Tax Invoice nor avail tax credit. f. Tax Invoice and Debit/ Credit notes VAT Invoices form the cornerstone for administration in a VAT regime and is issued by a registered dealer in respect of taxable sales in the same State. VAT rate and VAT amount is to be mandatorily specified in such Tax Invoice. A VAT dealer is required to issue a Credit/ Debit note drawing nexus to a sale or purchase in case of return

benefit and should not be recognized as income of the enterprise. Similarly, VAT payment is not an expense. The VAT collected from customers should therefore be credited to " VAT Payable Account". Following would be the entry for sales: Bank/ Customers Account..Dr. To Sales Account. To VAT Payable Account. Adjustment EntryAs and when VAT credit is actually utilized against VAT payable on sales, the following entry would be passed: VAT Payable Account.Dr. To VAT Credit Receivable (Input) Account. The debit balance in VAT Credit Receivable Account at the year end is shown on the Asset side of the Balance-Sheet under the head "Loans and Advances". On the other hand, the credit balance of the VAT Payable Account is shown on the Liabilities side under the head "Current Liabilities". RATIONALE OF INTRODUCING VAT In the existing structure, before a commodity is produced, inputs 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 as well as tax paid on previous purchases. Also, there is a multiplicity of taxes in several states, and such taxes include turnover tax, surcharge on sales tax, additional surcharge, etc. With the introduction of VAT these other taxes will be abolished. CST is also going to be abolished in a phased manner. As a result, overall tax burden will be rationalized and the prices in general will tend to fall. The trading community in India had exploited the Governments by misutilising the existing sales tax system in adopting loopholes in the system administered by the Center or State. If a welladministered system comes in, it will close avenues for traders and businessmen to evade paying taxes. They will also be compelled to keep proper records of their sales and purchases.

ADVANTAGES OF VAT Introduction of VAT has some sparkling advantages. It provides an edge over the earlier sales tax system as mentioned under: VAT ? Multi point tax ? Broad based ? Automated administration ? Self-regulatory ? No cascading effect of taxes ? Transparent system ? Tax evasion curtailed SALES TAX Single point tax Narrow based High administrative costs Need of intensive controls Double taxation, tax on tax No transparency Problem of tax evasion

Other important advantages of VAT are : 1. Uniform rates of VAT will boost trade activities and will create a favorable atmosphere for the expansion and economy. Helps amassing tax revenues to finance the fund necessary for socio-economic growth of the economy. It has the in-built capacity to raise more tax revenues without distorting the existing tax structure and is yet able to widen the tax-base. Since VAT is mostly based on 100% selfassessment, it will reduce the taxpayers hazards to visit tax offices frequently and lead to better tax compliance. With 0% VAT on exports and availability of credit on input tax, it will foster export promotion and help amass foreign exchange wealth. Since there is no tax on tax, price escalation is avoided and will make prices more competitive with the foreign counterparts. This matter is very important in present era of globalization and economic liberalization. The VAT will therefore help common people, traders, industrialists and also the Government. It is indeed a move towards better efficiency,

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healthy competition and fairness in the taxation system. VAT: PROBLEMS AND ISSUES Almost three-fourths of India has adopted the VAT regime, switching off its age-old sales tax system that had existed for more than 50 years. However, due to certain political and other considerations, some of the states have not joined the bandwagon of VAT that came into force w.e.f. 1st of April 2005. Such a fractured implementation of VAT has raised many issues causing concern for the trade and industry. Also, there are some gray areas in White Paper on state-level VAT that have raised certain fears among the traders. Following are the important shortcomings : a. Continuance of CST under VAT regime The rate of CST at present is 4% against C-form. Though it is a Central Sales Tax, the Central government does not get any revenue and is totally a revenue receipt of the selling State. The CST at present contributes a substantial amount exchequer to the States and is deep rooted in the tax structure. Also, we have an unbalanced state wise economy in which some states have considerable revenue from CST but majority are consumer states. It was for all such reasons that CST is continued in the VAT regime. The Government has proposed to reduce CST to 2% in 2006 and ultimately abolish it in 2007. However, CST and VAT are not compatible. CST has not been made VATable. That is, CST paid cannot be claimed for credit under present VAT system. Today, all the business units needs to find a local sourcing of materials for a temporary period of two years, which would not be possible for many traders who have been dealing on inter-state purchases for the last several years. The additional tax burden have to be ultimately borne by the final consumer. Until CST is abolished, the main objective of VAT will be lost and will seriously undermine the benefits of VAT in rationalizing the supply chain management and removing distortions in inter-state movement of goods. b. Differential tax treatment -

another tax by various names such as resale tax, turnover tax, etc. this may lead to a situation, where a business unit having its business spread across the country would not be able to maintain a uniform pricing system. The margins of various businesses would also get affected. c. Movement of goods Where the goods move from a VAT state to a non-VAT state, a credit of locally procured material would be available against the CST that is required to be paid. On the contrary, movement of goods from non-VAT State to a VAT State, the dealer would not be able to set off the tax paid on purchases. d. Incentive schemes. With the decision of the implementation of VAT, all the state governments have put the incentives schemes aside. All the businesses, which were granted the benefits of various incentive schemes, need to find a way out to sustain and survive, as all their financial projections need to be adjusted so as to suit the requirements of the current legislations across various states e. Exemption schemes As the basic idea of VAT is to ensure uniformity across various sections, it is imperative that there should not be any schemes permitting exemptions for specific dealers. This would result in a situation where the VAT chain breaks in between in case there are dealer specific exemptions, as they exist today. The so called fractured implementation would now make the VAT states less competitive compared to non- VAT states, as they would not be in a position to avail any of the exemption schemes. f. No uniformity in the rates Even among the states that have implemented the VAT, there is no uniformity in the rates that is being followed. The Empowered Committee covered only 550 commodities in two schedules of 4% and 12.5% VAT, leaving out many items to the whims and fancies of the State tax administration. There are certain critical items where there is a wide disparity in the rates of taxes across neighboring states. g. Sweeping powers given to commissioners The legitimate fear of dealer is that of harassment by the officials. Today the main reasons of India having

While the states following the VAT regime allow the credit of all the taxes paid at an earlier stage, the states following the sales tax still follow the single point levy, exempting subsequent stages of sale or imposing

poor GDP is on account of the fact that there is gross miss trust between the department and the dealer. If the relationship is not built on trust it will breed corruption and evasion attitude. What is really needed in India is not the tax reform but tax administration reform. h. Poor quality of adjudication orders For the successful VAT implementation, all the 130 countries who have adopted it had to revamp their judicial systems. In India, this issue has not been suitably addressed yet. i. Other problems

people also argue that VAT would lead to price rise and as such it is unconstitutional to replace it with the existing sales tax. However the real reason is different. There is less scope of tax evasion under VAT and there will be stricter compliance. The trading community wants to retain the scope of tax evasion, as it existed under the sales tax structure. STEPS NEEDED TO STABILIZE VAT It is necessary that the empowered committee should have periodic meetings with the State Finance ministers on all transition issues and continue to persuade NonVAT States to get on board at the earliest. Also the States should not levy any tax, which is not VATable and check that the benefits pass on to the final consumer. The dealers have to play a vital role to be transparent and keep the records clean and avail the credit what is really due to him. They should fine-tune their accounting entries as per the guidance note issued by the ICAI. Finally, the philosophy of VAT and its noble intentions should be highlighted in an unambiguous manner to seek the whole-hearted acceptance of VAT of the common people. IT
IS ONLY WHEN THERE IS UNIFORMITY IN THE TAXATION SYSTEM THROUGH PROPER IMPLEMENTATION, THE PROPOSAL TO INTEGRATE THE VARIOUS INDIRECT TAXES BY EVOLVING A UNIFORM GOODS AND SERVICES TAX POSSIBLE.

The VAT Bills of States do not contain any clause to delete relevant acts empowering State Governments to collect these taxes. The trading community has apprehension about continuity of such taxes in future also. A well-diversified and integrated tax administration is highly needed to adopt VAT. (Also, the harmonization of Input Tax Credit, which is essence of VAT system, requires a well formulated and compact computerbased networking on a large scale throughout the country. This is, however, not readily available in India due to the lack of necessary infra structure facilities.) WHY OPPOSITION TO VAT? The possibility of harassment by the tax inspectors is the outward reason for opposition by the trading community. Also proper records are required to be maintained which is very cumbersome job. Some

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WOULD BE

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