Value Added Tax (VAT) is a major source of revenue for all Indian states and union territories (except Andaman and Nicobar Islands and Lakshadweep).

VAT was introduced as an indirect tax in the Indian taxation system to replace the existing general sales tax. The Value Added Tax Act (2005) and associated VAT rules came into effect beginning April 1, 2005 in many Indian states. A few states (Gujarat, Rajasthan, MP, UP, Jharkhand and Chhattisgarh) excluded themselves from VAT during its initial introduction, but later adopted the tax. Every state has its own VAT legislation, rates, taxable base, and list of taxable goods.

What is VAT?

Every commodity passes through different stages of production and distribution before finally reaching the consumer. Some value is added at each stage of the production and distribution chain: for instance, a forged metal tool is more valuable than metal, which was itself more valuable than the ore that was originally mined. Value Added Tax (VAT) is a tax on this value addition at each stage.

Under a VAT system, a dealer collects tax on his sales, retains the tax paid on his purchase and pays the balance to the government. It is a consumption tax, because it is borne ultimately by the final consumer. The tax paid by the dealer is passed on to the buyer. It is not a charge on the dealer. VAT is instead a multipoint tax system with provision for collection of tax paid on purchases at each point of sale.

How is VAT computed?

In order to understand VAT, one must first understand its two components: input and output tax.

What is output tax?

Output tax is VAT charged to the customer by a dealer making taxable sales. A dealer is an individual, partnership, or business that is registered under VAT. Any person or business making sales above the prescribed limit are required to register. When a dealer is registered, VAT becomes chargeable on all taxable sales made by that dealer.

What is Input Tax?

The tax a dealer pays for purchases is input tax. Many purchases will carry a VAT charge, but when a dealer is registered under VAT, they can normally claim a credit for VAT charges on most business purchases. Input tax includes not only the VAT on your purchases of raw materials or on goods purchased for resale but also VAT on capital goods, such as machinery or equipment.

VAT computation

A dealer pays VAT by deducting the tax paid on purchases (input tax) from his tax collected on sales (output tax).

In other words, VAT = Output Tax – Input Tax.

For example: A dealer pays Rs.10.00 @ 10% on his purchase price of goods valued Rs.100.00. He sells the goods at Rs.150.00 and collects tax amounting to Rs.15.00 (@ 10%). He will pay Rs.5.00 (Rs.15.00- Rs.10.00) as he has already paid Rs.10.00 to his seller while purchasing those goods.

How is VAT different from Sales Tax?

VAT has fewer rates, as opposed to the high number of rates for Sales Tax, and allows offsets of tax on inputs against those on outputs. VAT also does away with the tax on tax.

Claiming input tax credit under VAT ensures proper invoicing. Overall, these features of VAT encourage disclosure of complete information on sales, reducing the possibility of tax evasion.

Who will be covered by VAT?

All business transactions involving the sales of goods/commodities carried on within a state by individuals, partnerships, or companies will be covered by VAT.

VAT will not cover small businesses with sales below a certain limit. In Maharashtra, the limit is 10 lakhs or below.

What are the tax rates under VAT?

Since every state has its own VAT legislation, VAT rates, taxable base and list of taxable goods, VAT rates will differ from state to state. As an example, here are Maharashtra’s tax rates as of June 2016:

  • Schedule ‘A’ – Essential Commodities (Tax-free) – Nil
  • Schedule ‘B’ – Gold, Silver, Precious Stones, Pearls etc. – 1%
  • Schedule ‘C’ – Declared Goods and other specified goods – 5% (Rates for items other than declared goods changed to 5.5%)
  • Schedule ‘D’ – Foreign Liquor, Country Liquor, Motor Spirits, etc. – 20% and above
  • Schedule ‘E’ – All other goods (not covered by A to D) – 12.5% starting April 1, 2016.

How does VAT help trade, consumers, and government?

Trade

Uniform rates of VAT will boost trade, 100% self-assessment will reduce the need for taxpayers to visit a tax department officer.

Consumers

Removing tax on tax reduces prices of goods that the end consumer pays.

Government

Since dealers will conduct self-assessment, the resources required for this process will be fewer, and the revenue department can focus more on collection than administrative processes.

Why VAT instead of General Sales Tax?

One of the major pitfalls of the General Sales Tax (origin based Sales Tax system) was cascading. Since there was no offset of tax paid on purchases, the tax becomes embedded in the final cost, often several times.

For example:

A manufacturer purchases inputs or raw materials worth Rs.500.00 and pays tax of Rs.50.00 @ 10%. Since he is not getting any input tax credit, he will add Rs.50.00 to the cost of raw materials. If he adds Rs.450.00 towards his labor and service and other expenses to produce a commodity using the raw materials that also includes his profit (value addition), the value of his product becomes Rs.1000.00.

When he sells the product, he collects the tax, say Rs.100.00 @ 10%. This amount contains Rs.50.00 tax collected on the value of input that has already been taxed at the time of purchases, so Rs.5.00 is a tax on the tax of Rs.50.00 paid earlier. In this way, there is double taxation and tax on tax, resulting in cascading. The manufactured product may also be used as an input for manufacturing another product, further compounding the problem.

Cascading increases the cost of production and makes the product uncompetitive. Further, since the existing sales tax system is a tax on sales without provision for off-set of tax paid on purchases, it discourages ancillarisation.

Under VAT system, there is not only the provision for off-set of tax paid on raw materials, but also for capital goods.

Input tax credits and offsets of tax paid on purchases eliminate double taxation and cascading. This also reduces the cost of production. VAT creates an environment where industry can thrive and ultimately helps the economy grow.