lawyers in India

Analysis of value added chain Value Added Tax in India - VAT

Written by: Parikshit - Fifth year law student Symbiosis societys law college, Pune
Tax Law
Legal Service
  • VAT or Value Added Tax is, perhaps, one of the most important fiscal innovations of the 20th century. First it was introduced in France in 1954 (Taxe sur la Valeur Adjoutee). In Asia, it has been introduced by a large number of countries such as China, Sri Lanka India etc. At present, more than 160 countries including those in Latin American, Asian, Africa and the Pacific have a VAT system in place. Even in India, there has been a VAT system introduced by the Government of India for about last ten years in respect of Central excise duties. At the State-level, the VAT system as decided by the State Governments was introduced in terms of Entry 54 of the State List of the Constitution. The first preliminary discussion on State-level VAT took place in a meeting of Chief Ministers convened by Dr. Man Mohan Singh, the then Union Finance Minister in 1995. In this meeting, the basic issues on VAT were discussed in general terms and this was followed up by periodic interactions of State Finance Ministers. Thereafter, in a significant meeting of all Chief Ministers, convened on November 16, 1999 by Shri Yashwant Sinha, the then Union Finance Minister, three important decisions were taken.

    Before the introduction of State-level VAT, the unhealthy sales tax rate war among the States would have to end and sales tax rates would need to be harmonised by implementing uniform floor rates of sales tax for different categories of commodities with effect from January 1, 2000. In the interest again of harmonisation of incidence of sales tax, the sales-tax-related industrial incentive schemes would also have to be discontinued with effect from January 1, 2000. On the basis of achievement of the first two objectives, the States for introduction of State-level VAT would take steps after adequate preparation. For implementing these decisions, an Empowered Committee of State Finance Ministers was set-up.

    Through repeated discussions and collective efforts in the Empowered Committee, it was possible within a period of about a year and a half to achieve nearly 98 per cent success in the first two objectives on harmonisation of sales tax structure through implementation of uniform floor rates of sales tax and discontinuation of sales-tax- related incentive schemes.

    After reaching this stage, steps were initiated for systematic preparation for the introduction of State-level VAT. At this stage,there were certain developments, which delayed the introduction of VAT. Despite these developments, most of the States remained positively interested in implementation of VAT. By the constant efforts of the empowered committee the states have either introduced VAT act in the state or are in the process of having know the system of taxation under value added taxation system one should properly know the clear ambit of value added system so that he can give a full time cooperation to it.

    VAT: Definition
    VAT is a multi-stage tax levied at each stage of the value addition chain, with a provision to allow input tax credit (ITC) of tax paid at an earlier stage, which can be appropriated against the VAT liability on subsequent sale. VAT is intended to tax every stage of sale where some value is added to raw materials and goods, but taxpayers will receive credit for tax already paid on procurement stages. In other words the general principles, which guide the value added tax, are as follows:
    General Tax It is a general tax that applies, in principle, to all commercial activities involving the production and distribution of goods and the provision of services.

    Consumption Tax:  It is consumption tax because it is borne ultimately by the final consumer. It is not a charge on companies.
    Charged As A Percentage Of Price: 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.

    Collected Fractionally:
     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 Now while considering the taxation under vat it often comes to our mind what is value addition on which the tax is imposed and how Value Added Tax is different from the overall taxation in sales tax.

    First let us consider what value addition to a product is or in toto what is a value added chain. A value addition is an estimated market value added to a product or material at each stage of its manufacture or distribution, until it is passed on to the ultimate consumer. The chain that is formed by such value addition is called value added chain Suppose following is the value added chain to a product ; fibre-yarn-fabric-garment-retailer-consumer, then the value added tax is the tax imposed on this value addition. For example the agriculturist sells the fiber to yarn manufacturer at the price suppose 100/- and pays 10% tax on it which comes to 10/-. Total cost to yarn manufacturer will be 100/-. Now he converts into yarn and sells it to fabric manufacturer at 200/-where tax collected during output was 20/- (10%). thus market value added to this product is selling price cost price i.e. 100/- and value added tax payable would be tax on this value i.e. tax on output price tax on input price i.e. 20-10=10/-

    How to calculate VAT?
    VAT is calculated by following method -:
    A= Charge on certain Value at a certain rate
    B= Ascertained input credit available
    VAT Payable = A-B

    Illustration No.2
    How to compute the tax on this value addition? Example: (Rate of tax assumed is 10%) Purchase Price Rs.100 Tax paid during purchase Rs.10 (input tax) Selling Price Rs.150 Tax collected during resale Rs.15 (output tax) Input tax credit (Tax paid during purchase) Rs.10 VAT payable (output tax input tax) Rs.5 Total tax collected by govt. At the time of purchase by the dealer Rs.10
    At the time of resale by the dealer Rs.5 Total tax: Rs. (10+5) =Rs.15
    Benefits of VAT
    Now the next point of consideration is how how beneficial it is? This can be dealt in Shortcomings of general sales tax.

    Major shortcomings in current sales tax structure
    The major shortcomings in general sales tax, which necessitated the adoption of vat, were
    1. Cascading effect The current system is replete with weaknesses the foremost being the cascading effect. Sales tax is levied on the gross value without allowing any credit or set-off for the taxes paid on inputs (that is, tax is levied on gross value). Consequently, the cascading effect results only in increased prices for consumers. Also, the system has little control over tax incidence. Since there is no set off of tax paid on purchases, the tax paid on purchases gets embedded in cost price.

    For example: a Manufacturer purchases inputs / raw materials worth Rs.500.00 and pays tax of Rs.50.00 @ 10%. Since he is not getting input tax credit, he will add Rs.50.00 to the cost of inputs/ raw materials. If he adds Rs.450.00 towards his labour and service and other expenses to produce a commodity using the raw materials/ inputs, which also includes his profit (value addition), the value of his product becomes Rs.1000.00. When he sells the product, he collects tax, say Rs.100.00 @ 10%, which contains Rs.50.00 tax collected on value of input which has already been taxed at the time of purchases, Rs.5.00 i.e. tax on tax of Rs.50.00 paid earlier. In this way, there is double taxation and tax on tax, resulting in cascading. The product may also be used as an input for manufacturing another product, further cascading. VAT will eliminate cascading effect of sales tax.

    2. Ancillarisation discouraged Cascading increases the cost of production and makes the product uncompetitive. Further, since the existing sale tax system is a tax on sale without provision for set off of tax paid on purchases, it discourages ancillarisation. Ancillarisation means getting most of parts/ components manufactured from outside. To avoid paying tax, the large manufacturers instead of buying parts/ components from outside, manufactures the parts themselves. This discourages the growth of small-scale industry and increases concentration of economic power. The system has also an adverse impact
    on quality of the product, further reducing the competitiveness of the goods.

    3. Multiplicity of taxes A major defect in the prevailing sales tax structure, there is in several States also a multiplicity of taxes, such as turnover tax, surcharge on sales tax, additional surcharge, etc. In addition, the states levy luxury tax as also an entry tax on the sale of imported goods. Implementation of VAT in our country is a right step in this direction and to do away with multiple tax system. Under the regime of VAT, there should be no other tax such as Additional Special Tax, Entry Tax, Octroi and Central Sales Tax (CST).

    4. Multiplicity of rates Also, there is the problem of multiplicity of rates. All the states provide for plethora of rates... These range from one to 25 per cent. This multiplicity of rates increases the cost of compliance while not really benefiting revenue. Heterogeneity prevails in the structure of tax as well. Thus to sum up with the introduction of VAT, benefits can be analysed as follows: A set-off will be given for input tax as well as tax paid on previous purchases Other taxes, such as turnover tax, surcharge, additional surcharge, etc.will be abolished Overall tax burden will be rationalised Prices will in general fall There will be self-assessment by dealers Transparency will increase There will be higher revenue growth Problems in effective implementation of vat in value added chain There are certain problems, which are faced by the government of India to effectively impose the tax in this value added chain.

    Some of the important problems are stated as follows:
    1. Central sales tax and its non-vattability The revenue in the C.S.T transaction goes to the originating state and therefore the destination state is not willing to grant the input tax credit. The complications and the cascading effect are brought out through this illustration.

    X ltd manufactures automobile components in a factory located in Tamil Nadu. X Ltd purchases iron and steel, aluminium and other raw materials from Maharastra. Since these are in the nature of C.S.T purchases, X Ltd will not qualify for vat credit. Now the automobile components, which are manufactured, are sold to Y ltd in Maharastra in the course of interstate trade. Y ltd will not be able to take credit in respect of the automobile purchases. Y ltd manufactures the cars and sells the same to dealers in Tamil Nadu charging C.S.T. When the dealer sells the car in Tamil Nadu it would attract vat in the hands of the dealer without

    any corresponding credit. The cascading effect is significant in this simple transaction and which arises mainly of C.S.T and its non-vattability.This non-vattability also affects the industry adversely. Suppose there is buyer in Andhra Pradesh, he would rather prefer to purchase the goods from a local vendor who can charge vat rather than purchasing it through an interstate transaction the buyer would thus gain in the terms of cash flow while purchasing it locally. However where the market is monopolistic the buyer would either purchase it interstate or request an outstation vendor to open a branch in his state. This would in turn create an artificial supply pattern and affect market shares of number of companies.

    2. Multiple levies In theory, VAT is supposed to be a tax to end all taxes. Many of the countries that have adopted VAT do not levy excise duty, entry tax or luxury tax. This, however, is unlikely to happen in India. E.g. the white paper indicates that the states that have already introduced entry tax should make it vattable, this very fact defeats the whole system of having vat as the only tax on product.

    3. VAT in all States VAT system of taxation required to be implemented simultaneously throughout the country in all States and Union Territories at the same time. Only 20 states in India have effectively implemented vat, Chhattisgarh, Gujarat, Tamil Nadu, Rajasthan etc have not introduced vat in their taxation system. This creates serious market distortions.

    4. Uniform VAT Law and procedure India has often been described as a country with large market. But unfortunately this large market has been highly fragmented by inter-state barriers. State specific law on sale of goods further complicates it. The wide divergence in the structure and practice has hampered free flow of goods and services within the country and effected competitiveness of Indian Industry. Heterogeneity in VAT even in forms, returns & declarations creates artificial barriers and complexities

    5. Rates and Classification of goods Non-Uniform rate structure across the country helps in developing the diversion of trade from one State to another, creates an unhealthy competition and increasing tax evasion. It discourages automobile industry to plan and commit long-term investments. The classification of goods not aligned to central taxes overburdens litigation. Non- Uniform classification across all States and central taxes creates an un- favourable environment for any growth of industry

    Suggestions and conclusion
    After analyzing the whole scenario of vat it can be rightly suggested that if the following propositions are carried out effectively it will surely make the value added taxation a success. Preparedness for State VAT: It is recommended that a publicity awareness programme should be started jointly by the Central Government and the State Governments and the former should extend financial support for this, if required. Uniformity of definitions: It is recommended that an attempt should be made towards uniformity of all State legislations, procedures and documentation relating to VAT.

    VAT to unify all local taxes: It is recommended that with the introduction of VAT, all other local taxes be discontinued, and the same should be taken into account in determining the rate of taxation. Stability and continuity of the VAT regime: It is recommended that for the stability and continuity of VAT, a VAT Council or a permanent suitable alternative vested with adequate powers to take steps against discriminatory taxes and practices and eliminate barriers to free flow of trade and commerce across the country should be explored.

    In India, an Empowered Committee of the Finance Ministers of the States has been constituted for the purpose of implementing a nationwide State-level VAT. The Empowered Committee is indeed a unique experiment in federal fiscal planning and has achieved much in terms of building a consensus on many of the critical issues relating to implementation of VAT in a relatively short spell of time. Thus for more equitability i.e. tax burden shared by all, dealers, more transparency i.e. easy procedures

    and only two rates, broadly speaking, Simplicity i.e.- easy computation and easy compliance, having credit for input taxation i.e. cost efficiency, having better Compliance - through self-policing, Prevention of cascading effect through input rebate, and avoiding distortions in trade and economy uniform tax rates VAT should be adopted in this chain of value addition with proper implementation . And if this is carried out effectively for a long term then it can be said without any doubt that this would be the taxation system which will bring constant revenue to the government without creating a heavy burden of tax paying on the consumers.

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