Understand the basic concepts of VAT

Last Updated: 2 Jun 2023

The value added tax (VAT) in India is a state level multi-point tax on value addition which is collected at different stages of sale with a provision for set-off for tax paid at the previous stage i.e., tax paid on inputs. It is to be levied as a proportion of the value added (i.e. sales minus purchase). VAT system is more transparent, uniform and less prone to tax evasion VAT is a consumption tax because it is borne ultimately by the final consumer. VAT is not a charge on companies. It is charged as a percentage of price, which means that the actual tax burden is visible at each stage in the production and distribution chain.

It is collected fractionally, via a system of deductions whereby taxable persons can deduct from their VAT liability the amount of tax they have paid to other taxable persons on purchases for their business activities. This mechanism ensures that the tax is neutral regardless of how many transactions are involved.

In other words, it is a multi-stage tax, levied only on value added at each stage in the chain of production of goods and services with the provision of a set-off for the tax paid at earlier stages in the chain. The objective is to avoid ‘cascading’, which can have a snowballing effect on prices. It is assumed that due to cross-checking in a multi-staged tax, tax evasion will be checked, resulting in higher revenues to the government.

Advantages of VAT

• To encourage and result in a better-administered system
• To eliminate avenues of tax evasion
• To avoid under valuation at all stages of production and distribution
• To claim credit on tax paid on inputs at each stage of value addition
• Do away with cascading effect resulting in non distortion of the business decisions
• Permits easy and effective targeting of tax rates as a result of which the exports can be zero-rated
• Ensures better tax compliance by generating a trail of invoices that supports effective audit and
• Enforcement strategies
• Contribution to fiscal consolidation for the country. As a steady source of revenue, it shall reduce the Debt burden in due course
• To stop the unhealthy tax-rate war and trade diversion among the States, which had adversely affected
• The interests of all the states in the past.

Methods of computation

VAT can be computed by using any of the three methods

• Subtraction method:

  Under this method, the tax rate is applied to the difference between the value of output and the cost of input

• Addition method:

  Under this method, value added is computed by adding all the payments that are payable to the factors of production (viz., wages, salaries, interest payments, etc.)

• Tax credit method:

  Under this method, it entails set-off of the tax paid on inputs from tax collected on sales. Indian states have opted for tax credit method.

VAT is a multi-stage tax on goods that is levied across various stages of production and supply with credit given for tax paid at each stage of value addition. VAT is the most progressive way of taxing consumption rather than business.

Procedure

The VAT is based on the value addition to the goods and the related VAT liability of the dealer is calculated by:

Deducting input tax credit from tax collected on sales during the payment period.

This input tax credit is given for both manufacturers and traders for purchase of input/supplies meant for both sales within the state as well as to the other states irrespective of their date of utilization or sale. If the tax credit exceeds the tax payable on sales in a month, the excess credit will be carried over to the end of the next financial year.

If there is any excess unadjusted input tax credit at the end of the second year then the same will be eligible for refund.

For all exports made out of the country, tax paid within the state will be refunded in full.

Tax paid on inputs procured from other states through inter-state sale and stock transfer shall not be eligible for credit.

VAT has been introduced by 30 states / UTs. However, Central Sales Tax will continue to govern inter-state sales and exports.

Rates of tax

• VAT will have four broad type of rates.
• 0% (Exempted) for unprocessed agricultural goods, and goods of social importance.
• 1% for precious and semiprecious metals.
• 4% for inputs used for manufacturing goods, capital goods and other essential items.
• 20% for demerit/luxury goods.
• The rest of the commodities are taxed at a revenue neutral rate of 12.5%.