CA Final Course Paper 8 Indirect Tax Laws Chapter 10 CA. Prashanth Agarwal

Value Added Tax (VAT) as the name suggests is tax on value addition

VAT involves levy of tax at each leg of a business model and provides for credit of tax paid on procurements to the vendors

In the context of goods, VAT law involves levy of VAT on each leg of sale transaction with availability of credit of tax paid on inputs purchased

For example, A purchases goods from B and sells the same to C who further sells the goods to the final customer D.

In this example A would be able take credit of VAT charged by B and pay VAT in cash only on the margin earned. Similarly, C would be able to take credit of VAT charged by A and would pay VAT in cash to the tax authorities only on the margin earned from sale to D

VAT being a tax on value addition helps in removing cascading effect of taxes levied

Historical Background - Global • Although different forms of VAT was being suggested across the world

since early 20 century, it was first introduced in France in 1954 covering only the Industrial sector

• Ever since then VAT (being less distortive) has been adopted across the globe by over 130 countries

VAT has been introduced across the globe and has been revenue productive as well as less distortive

VAT in Indian Context

India is a federal structure ie both Centre and State derive power to levy tax from the Constitution of India

Constitution through Union List, State List and Concurrent List provides clearly specified areas where Center and State can respectively exercise power. Illustrative table below

Key State Levy Key Central Levy VAT/ Sales Tax - Applicable on sale of goods

Customs duty – Applicable on import of goods

Entry Tax/ Octroi - Applicable on entry of goods from outside a local area

Excise Duty – Applicable on manufacturing

State Excise - Applicable on specific goods (such as Alcohol)

Central Sales Tax – Applicable on inter-state sale of goods

Entertainment Tax Service Tax – Applicable on services

Luxury Tax Income Tax – Applicable on income earned

Both Center and State substantially depend on the revenue earned from taxes levied

In India, VAT was first introduced as Modified Value Added Tax (MODVAT) in 1986

Indian MODVAT was firstly limited to Indian manufacturing sector wherein a manufacturer was allowed to avail credit of Excise duty paid on inputs and utilise the same against its output Excise duty

Scope of Modvat has since been modified with the Introduction of Service tax law in India and is now referred to as Central Value Added Tax (CENVAT)

Given the Constitutional constraint, CENVAT has been applicable on manufacture of goods and provision of Services

Till early 21st Century (ie till 2004), State across India levied Sales Tax and concept of VAT was not introduced at State level. State Sales Tax was a single point taxation and involved varied tax rates in each State

To uniform the Sales Tax regime with the ultimate aim to introduce VAT across India at State level, a Committee of State Finance Minister was constituted in May 1994

VAT in Indian Context - Recommendations by Committee of State Finance Ministers

• Rationalisation of rate structure: Adoption of four general floor rates (0, 4, 8, 12) and two special floor rates (1 and 20) in place of multiple tax rates being levied by different states In India, VAT was first introduced as Modified Value Added Tax (MODVAT) in 1986

• Minimisation of exemptions granted by State Government • Preparing list of exempted goods and setting a deadline post which no state would

exempt any goods other than those mentioned in the exempt good list • Doing away with sales tax incentive for Industrialisation. No new tax incentive should

be given after 1 April 1997 and the existing ones should be allowed to lapse in due course

To implement the above recommendations Empowered Committee of State Finance Ministers was formed

Above recommendations aimed at simplifying rate structure, minimisation of exemptions granted by State Government and enhancement of transparency

VAT in Indian Context - Steps taken by Empowered Committee

• Harmonisation of Sales Tax rate structure and discontinuation of Sales tax incentives

• Systematic preparation for countrywide introduction of State level VAT. This included: • Designing a harmonsied VAT structure • Ironing out basic concerns with regard to VAT keeping in mind the interest

of all the States • Steps taken for necessary training, computerisation • Detailed discussion with trade and industry for their inputs and concerns

VAT in Indian Context - Dr Vijay Kelkar’s recommendations in 2002

• To immediately initiate public awareness programme jointly by Central and State Government, with Center providing financial support for the same

• Aim towards uniformity of all State VAT legislations, procedures and documentation

• Compensation to State must be achieved by adopting a mutually acceptable mechanism of additional resource mobilisation through Service tax instead of budgetary support

On introduction of VAT, all other local taxes should be discontinued and the same should be considered for deciding a Revenue Neutral Rate under VAT

Additional duties of excise may continue on textile till 2005, it may continue even thereafter on cigarettes, which should not be subjected to VAT

Importing state should allow credit of duty paid in the exporting state, in respect of sale involving inter-state movement of goods

VAT Council should be setup with adequate powers to take steps against discriminatory taxes and practices and eliminate barriers to free flow of trade

VAT in Indian Context - White Paper on VAT by Empowered Committee

• Empowered Committee issued a White paper on VAT in 2005 • The White paper outlined the basic design of the VAT regime and was used as a

base for preparation of State VAT legislations • Being a State levy, States had the freedom to provide for variations in VAT

legislation consistent with the basic design of the VAT regime • White Paper consist of the following:

• Justification of VAT and Background • Design of State Level VAT • Steps taken by the States for implementing VAT regime

State level VAT (on sale of goods within a state) was implemented on 1 April 2005 by majority of the States. Some of the states implemented the VAT regime in subsequent years

Each State has based its VAT legislation on the basic design outlined in the White paper with appropriate variations depending on the needs of the State

With the introduction of State level VAT, phase out of Central Sales Tax (CST) was proposed.

However, since States would lose large revenue, CST has yet not been completely phased out. A compensation mechanism is being discussed to compensate States for the lose of revenue

To completely overhaul the Indirect tax regime in India both at Central and State level, Goods and Service tax (GST) regime has been proposed. Basic groundwork for implementing GST is underway

States/ Union Territories where VAT already implemented From 1st April 2003

From 1st April 2005 During F.Y. 2005-06

From 1st April, 2006 onwards

From 1 Jan 2008

Haryana

Andhra Pradesh Arunachal Pradesh Daman & Diu Dadra & Nagar Haveli Himachal Pradesh Jammu & Kashmir Karnataka Kerala Maharashtra Mizoram Nagaland West Bengal

Bihar Delhi Goa Orissa Punjab Sikkim Tripura

Assam (01-05-2005) Meghalaya (01-05-2005) Manipur (01-07-2005) Uttaranchal (01-10-2005) Chandigarh (16-12-2005)

Chhattisgarh Gujarat Madhya Pradesh Rajasthan Jharkhand Tamil Nadu Pondicherry

Uttar Pradesh

1 19 5 7 1

VAT is tax on value addition and helps in removing cascading effect of taxes levied It involves levy of tax on each leg of sale transaction and allows for credit of tax paid

on inputs VAT has been introduced in more than 130 countries globally In India, concept of VAT first introduced at Central level in the form of MODVAT (later

referred to as CENVAT) with respect of Excise duty and Service tax For introducing VAT at State level, following steps taken: ◦ state finance ministers committee was formed which provided recommendations ◦ To implement the recommendations, Empowered committee of state finance

ministers was formed ◦ Dr Vijay Kelkar also provided his recommendation with regard to VAT structure ◦ Later the Empowered committee issued a white paper on VAT which provided the

basic framework for State VAT law In early 21st Century, concept of VAT introduced at State level on sale of goods.

Each state has formulated its State VAT law

Variants of VAT

Gross Product Variant Allows deduction/

credit of raw materials, spare parts, components No credit/ deduction

available on capital goods like plant and machinery

Income Variant Allows deduction/

credit of raw materials, spare parts, components Depreciation on capital

goods also allowed

Consumption Variant Allows deduction/ credit of

both raw materials and capital goods – all business purchases Does not impact

investment decisions as tax on capital goods also available as set-off Administratively simpler

Widely used – Adopted in several countries in Europe and other continents

Methods of computation of VAT

Addition Method All factor payments including

profit added to compute value addition at each stage

VAT rate applied on value addition to compute VAT liability

Drawback – Does not facilitate matching of purchase invoice for detecting evasion

Invoice Method Tax paid on each stage of

sales – on entire sales value Tax paid on earlier stage

allowed as set-off/ credit from gross VAT liability Most common/ popular

method – Also followed in India Also referred to as ‘Tax

credit’/ ‘Voucher’ method

Subtraction Method Tax charged on value

addition at each stage Value Addition taken as

difference between value of sales and purchases

Simple Method – No requirements for tax set-offs

Direct Method – Value addition computed by deducting purchase

(exclusive of tax) from value of sales (exclusive of tax)

Intermediate Method – Value addition computed by deducting purchase (inclusive of tax) from value of sales (inclusive of tax)

Total VAT liability deposited in cash at all stages = X1 + X2 + X3 = 125 + 25 + 37.50 = 187.50

Final VAT charged on invoice raised by C = 187.50

Thus, under VAT regime, tax is collected by government at various stages

Description Amount (Rs)

Stage 1:

‘A’ sells goods to ‘B’ – Sales Value 1,000

Gross VAT Liability (assumed rate – 12.5%) – Rs 1,000 X 12.5% 125 (charged on invoice from B)

Less: VAT credit NIL

Net VAT Liability (to be deposited in cash, denoted as X1) 125

Stage 2:

‘B’ sells goods to ‘C’ – Sales Value 1,200

Gross VAT liability of ‘B’ – Rs 1,200 X 12.5% 150 (charged on invoice from C)

Less: VAT Credit (paid to A by B in stage 1) 125

Net VAT liability (to be deposited in cash, denoted as X2) 25

Stage 3:

‘C’ sells goods to ‘D’ – Sales Value 1,500

Gross VAT liability of ‘C’ – Rs 1,500 X 12.5% 187.50 (charged on invoice from D)

Less: VAT credit (paid to B by C in stage 2) 150

Net VAT liability (to be deposited in cash, denoted as X3) 37.50

* VAT liability = [Taxable Turnover (inclusive of taxes) X VAT rate]/ (100 + VAT Rate) **VAT liability under Subtraction and Invoice method would be same if VAT rates on all inputs,

finished goods are same. If VAT rates vary, final VAT liability under two methods would differ

Description Amount (Rs)

Stage 1:

‘A’ sells goods to ‘B’ – Sales Value (inclusive of tax) 1,125

Taxable Turnover – Value Addition (Value of sales – Value of purchase) 1,125

VAT Liability*(assumed rate – 12.5%) – Rs 1125 X 12.5% (X1) 100 + 12.5

125

Stage 2:

‘B’ sells goods to ‘C’ – Sales Value (inclusive of tax) 1,350

Taxable Turnover - Value Addition (Value of sales – Value of purchase) 225 (1,350 – 1,125)

VAT liability of ‘B’ – Rs 225 X 12.5% (X2) 100 + 12.5

25

Stage 3:

‘C’ sells goods to ‘D’ – Sales Value (inclusive of tax) 1,687.50

Taxable Turnover – Value Addition (Value of sales – Value of purchase) 337.50 (1,687.50 – 1,350)

VAT liability of ‘C’ – Rs 337.50 X 12.50% (X3) 100 + 12.5

37.50

Total VAT liability at all stages (X1 + X2 + X3) 187.50**

No Tax Evasion • Without proper records for

purchases, not possible to avail input VAT credit. Hence, suppression of purchases difficult as it would lead to loss of revenue

Better accounting systems • Need for proper records

promote better accounting systems

Neutrality • Anti-tax cascading. Hence,

does not interfere with choice of purchases

Transparency • Both Buyer and Government

clearly know the tax component out of consideration charged at each stage. Aids in decision making

Better revenue collection • Reduced possibility of tax

leakage as tax credit given only if proof of tax paid at earlier stage available.

Cheaper Exports • As VAT paid at earlier stage

could be refunded or be availed as credit

Impact on prices • Full tax credits available

hence, reduced tax cascading and consequent costs

Certain • Applicable on all sales,

hence, less scope for different interpretations

Distortions due to exemptions, composition schemes, differential rates • Due to same, merits of VAT regime do not accrue fully

Differential treatment for purchases made from different States •VAT regime not integrated across States. Tax credits available only for purchases made within a State

Increase in working capital requirements and interest burden •As tax required to be paid at various stages and not on last stage.

Increase in accounting costs for business •As proper accounts and records need to be maintained. Burden for smaller businesses

Increase in administrative costs for the State •Significant increase in number of dealers liable to pay tax as compared to single point levy regime

VAT is regressive •Being a consumption tax, burden lies more on ‘poor’ as they proportionately spend more than ‘rich’ people

Three variants of VAT: ◦ Gross product variant ◦ Income variant ◦ Consumption variant: Widely used across the globe

Methods for computing VAT liability: ◦ Addition method – Computes taxable turnover by adding relevant value addition

factors including profit margin ◦ Invoice method– VAT computed on total value of each sales and net VAT liability

computed by adjusting input tax credit: Commonly used method ◦ Subtraction method – Computes taxable turnover by reducing purchases from

sales Merits of VAT: Removes cascading effect of taxes, Allows transparency, Cheaper

exports, better documentation, less tax leakages Demerits of VAT: Distortion on account of exemption, composition scheme, Credit not

available of inter-state purchases, increases administration cost for government and business

Input tax is a tax paid on goods purchased from a registered dealer of the state. Such goods are either resold as such or are used as raw material, capital goods or are used directly/ indirectly in relation to business

Output tax is the tax payable by a dealer under relevant State VAT law on sale of goods in the course of business

Input tax is the tax paid on inputs procured from within the state. Output tax is the tax paid on goods sold from the state

VAT involves tax on value addition ie a dealer selling the goods would be allowed to claim set off of the VAT paid earlier on procurement and would need to discharge output VAT only on the value addition.

To give effect to this aspect, concept of input tax credit is introduced under VAT law. Input tax credit allows a dealer to avail credit of the VAT paid on inputs procured from within the state and adjust the same against its output tax liability

Input tax credit is available in respect of goods purchased from within the state from a dealer registered under State VAT law. Credit is available to a manufacturer as well as trader

Credit can be utilised against output VAT/ CST liability (ie against tax payable on sale within the state or on inter-state sale from the said state). In case of stock transfer credit in excess of 2% is generally allowed but the same could vary from state to state. Some states may provide partial input tax credit in respect of inputs used for manufacture of exempt goods (which is generally not available)

A dealer is eligible to claim input tax credit on goods purchased, if such goods are meant for any one of the following purposes:

► For sale/ resale within the state or to other parts of India in the course of inter-state trade or exported outside India

► To be used as: ► Raw material ► Consumable stores; or ► Containers or packing material required for the purpose of manufacture of taxable goods or in packing of such manufacture goods intended for sale within the state or in the course inter-state trade or export outside India

► To be used as capital goods required to manufacture goods or resale of taxable goods within the state or inter-state sale or export outside India

► To be used in the execution of works contract

► For making zero-rated sale other than exports (this depends from state to state)

Input tax credit may not be available in following circumstances:

► Purchases from unregistered dealer ► Purchases not supported by tax invoice ► Purchase of goods which have been specifically notified as ineligible by State government ► Purchase from dealer who has opted for composition scheme under VAT law ► Invoice for the purchases is not as per requirements of State VAT law such as not

mentioning tax amount separately ► Purchase of goods which are utilised for manufacture of exempted goods other than

exports ► Goods in stock which suffered tax under earlier Act but are exempt under VAT law ► Purchase of goods used for personal use/ consumption or provided free of cost ► Goods imported from outside India ► Goods purchased from outside the state ie inter-state purchases ► Goods like motor vehicle, toilet articles, furniture, air-conditioner which are neither meant

for manufacture or resale

► In case the inputs are used for both eligible and ineligible purposes, credit of tax paid on such inputs would be available in proportion to the extent such inputs are used for eligible propose

► Net VAT liability payable by a dealer for a period is computed as total tax payable minus the input tax credit available as per records

► Input tax credit needs to be first utilised against output VAT liability. In case the credit is in excess of VAT liability, the same can be adjusted against CST liability (on the inter-state sales made from the said state). Still if credit is in excess, the same can be carried forward to the next month and can be carried forward to end of next year (this depends from state to state)

► In case of excess credit at the end of second year, the same is eligible for refund. In some of the states, excess credit at the end of first financial year is also eligible for refund

Description Amount (Rs)

Inputs purchased from within the state during the month @ 4% (A) 1,000

Input tax paid (B) = Rate * A 40

Goods sold by the dealer during the month @ 12.5% (C) 2,000

VAT payable during the month (D) = (C)*Rate (12.5%) 250

Less: Input Tax credit (E) 40

Net VAT liability (to be deposited in cash) (F) = D-E 210

Description Amount (Rs)

Inputs purchased from within the state during the month @ 12.5% (A) 10,000

Input tax paid (B) = Rate * A 1,250

Goods sold within the state by the dealer during the month @ 12.5% (C) 4,000

Inter-state sale during the month liable to CST @ 2% (D) 10,000

VAT payable during the month (E) = (C)*Rate (12.5%) 500

CST payable during the month (F) = (D)*Rate (2%) 200

Less: Input Tax credit (G)=B 1,250

Net VAT liability (to be deposited in cash) (H) = E-B Nil

Excess Credit (I) = B-E 750

Net CST Payable (J) = (F-I, 200 – 750 ) Nil

Excess credit carry forward (750-200) 550

► White paper provides for grant of refund of input tax credit if the goods are exported. Such refund should be granted within 3 months from the date of export

► Units located SEZ or EOU are granted either exemption from payment of input tax or refund of input tax paid within 3 months. States may reduce the period below 3 months

► States also grant refund to specialised agencies of United Nations Organisation, Consulates, Embassies of any other country located in the State

ITC shall be available on capital goods to traders as well as manufacturers. Each state VAT law generally defines capital goods. Per the White paper, input tax credit of capital goods can be availed over a period of 36 equal monthly installments

States have the option to reduce the installments. Generally the states allow input tax credit of capital goods over 2 financial years (ie half of the credit can be availed in the year of purchase and balance in the next year). State of Maharashtra has allowed full input credit of capital goods in the year of purchase

A negative list of capital goods has been prescribed basis the principles laid down by Empowered committee. Each state VAT law generally provides its own negative list of capital goods. No input tax credit can be availed in respect of such capital goods by any class of dealer

Each dealer would need to follow the procedural requirements stated in VAT law to claim input tax credit on capital goods (which includes purchase should be supported by tax invoice). Other requirements could include claiming credit in installment, seeking prior permission etc

Input tax credit (ITC) refers to availment of credit of VAT paid on inputs procured from within the state

ITC available to both trader and manufacturer ITC available in respect of raw material as well as capital goods Special procedure generally prescribed for availment of credit in respect of capital

goods ITC can be utilised for payment of VAT liability and CST liability in a state. Excess

ITC can be carry forward to next month State VAT law prescribes scenario in which a dealer can avail ITC and also scenarios

when a dealer would not be eligible to avail ITC Refund of excess ITC available at the end of year depending on state to state Refund/ Exemption from input VAT also available in case of exports, procurement by

SEZ unit, EOU, Embassies or UNO

White paper recommended that Small dealer with annual turnover below INR 5 lakhs (which was revised to INR 10 lakhs by Empowered Committee) would not be required to obtain registration under VAT

For dealers whose total turnover exceeds INR 5 Lakhs but does not exceed INR 50 lakh should have an option to pay VAT at a composite rate on total turnover or taxable turnover (as State VAT law may provide) subject to prescribed conditions and restriction

Restrictions include the dealer would not be entitled to input VAT credit or to issue vatable invoices / charge VAT separately from the customer

Similar composition scheme has been recommended for business where it is not possible to maintain elaborate records or many activities are sub-contracted (such as execution of works contract)

Per White Paper, VAT law should not spare high value tax payers whereas Small dealers should not be bothered by numerous compliance procedures

Every registered dealer who is liable to pay VAT under relevant State VAT law whose turnover does not exceed INR 50 lakh in last financial year is generally eligible to avail composition scheme

Following dealers are not eligible for Composition scheme:

• A manufacturer or a dealer who sells goods in the course of inter-state trade or commerce; or

• A dealer who sells goods in the course of import into or export out of India; or • A dealer transferring goods outside the State otherwise than by way of sale or for

execution of works contract

Small dealer has the option to opt for composition scheme. Such option can be exercised for a financial year by intimating in writing to the Department

Composition scheme simplifies the tax computation and also compliances required to be undertaken under VAT law

Under composition scheme, VAT would be payable at lower rate (normally 4% or lower)

Dealer is required to file a simple return form covering a longer period and maintain basic records for purchase, sale and inventory (instead of elaborate statutory records)

Following restrictions would be imposed on dealer opting for composition scheme:

• Ineligible to avail input VAT credit. Hence VAT paid on procurement would be a cost • Ineligible to issue VAT invoice or pass credit of VAT to its customer • Some state may impose other restrictions such as prohibition on procurement of goods from outside the State

Given the restrictions imposed, it is important for dealer to assess whether Composition scheme be beneficial for its business before opting for such scheme

Impact on seller and purchaser • Impact on Seller: Under composition scheme, the seller is not

eligible to avail credit of VAT paid on procurements. Accordingly, such VAT paid is a cost for the dealer and the same results needs to be factored in the price of the goods sold by the dealer

• Impact on Purchaser: In case a purchaser procures goods from a dealer who has opted for composition scheme, it is not eligible to avail VAT credit. Therefore, as soon as a dealer opts for composition scheme, the VAT chain will be broken and the benefit of tax paid earlier will not be passed on to the subsequent buyer

Given the restrictions, it is important for dealer to assess whether Composition scheme be beneficial for its business before opting for such scheme

Per White Paper, small dealer having with turnover of not more than Rs 5 Lakhs (later increased to Rs 10 Lakhs) not liable to obtain registeration under VAT law

Also, dealers with turnover between Rs 5 Lakh and 50 Lakh allowed to opt for composition scheme to discharge VAT in a particular state

Composition scheme allows a dealer to pay VAT at a lower rate on its total turnover. It simplifies the compliances required to be undertaken by the dealer in the state

States impose restriction on dealers who can opt for composition scheme

Dealer opting for composition scheme cannot avail input VAT credit, issue tax invoice (ie its customer cannot avail credit of VAT charged), or in some states procure goods from outside the state

Given the restrictions, important for the dealer to assess the pros and cons of a composition scheme for its business before opting for the scheme