Value Added Tax (VAT): Everything You Need to Know

VAT or Value Added Tax is an indirect tax that is imposed by the state government on goods and/or services at every stage of production or distribution. Every time the product undergoes a process that increases its value, this additional tax is applicable.

Also known as a consumption tax, VAT is designed as a multi-stage tax starting from initial production till the final retail transaction. Businesses at every stage are responsible for paying VAT on purchases and collecting due VAT tax at the time of sales. This ensures that only the end consumer of the good or service is charged the entire VAT accrued in producing the good/service.

It is an indirect tax where the emphasis lies on taxing the value added to a product before it reaches the consumer in the next stage. Manufacturers pay VAT on raw materials, or inputs that is usually recovered by them so that they owe VAT only on their own value addition.

Suppose a furniture manufacturer buys wood and pays VAT on it. This wood is then used to make a table and at the time of selling the table, the business collects VAT from the buyer but can claim credit for the VAT they already paid at the time of purchasing the wood. This ensures that double taxation is prevented and the cost of manufacturing/providing a service is more evenly.

VAT is levied at different stages, starting from the raw material supplier continuing to the manufacturer and then on to the wholesaler and retailer. At every stage, the business imposes VAT on its sales but offsets the VAT it incurred on purchases. This way, the VAT tax payable to the government is only based on the value added as part of that step.

Since introduction of GST, VAT is applicable only on select goods such as alcohol for human consumption, select petroleum products, etc.

Another well-known indirect tax that was pretty common in the pre-GST era was the sales tax. Although both VAT and Sales Tax are consumption taxes, there are some key differences between VAT and sales tax. The below table compares VAT vs Sales Tax across various criteria:

VAT registration is the formal step in which a business applies and gets a unique ID known as Taxpayer Identification Number (TIN) from the tax authority to collect and pay Value Added Tax. It is mandatory to have a valid TIN if a business exceeds a pre-determined annual turnover limit and is involved in a business where VAT is applicable. Once the TIN is generated and the company is registered, the business can add VAT to its sales invoices to collect VAT from customers and also claim VAT credits on purchase applicable inputs.

After GST implementation, relatively fewer businesses are eligible for TIN as the number of goods within the ambit of VAT has decreased significantly. Hence, it is now more common for businesses to register under GST and apply for a GST Identification Number or GSTIN instead of TIN.

There are two key components of VAT, which are termed as Input VAT and Output VAT. Input VAT can be defined as the VAT paid on purchase of inputs, while output VAT is the VAT charged on sale of the end-product (of the specific stage) to the customer.

Based on the above understanding, you can calculate VAT through the simple formula shown

VAT Payable = Output Tax – Input Tax.

Suppose a company pays VAT (i.e. Input Tax) of Rs. 50 on the raw materials its purchases and then seels the finished product for Rs. 10,000 with a VAT of 10% (i.e. Output Tax). In this case,

VAT Payable = (10% of 10,000) – 50 = Rs. 950.

This Rs. 950 is the VAT that the business will have to pay to the tax authorities.

India previously used VAT at the state level for most goods and services. Different states set their own rates and rules for applicability of Value Added Tax. This disparity in VAT rates and applicability often led to confusion, especially for businesses operating in more than one region. Despite these issues, VAT tax helped generate steady revenue for States in the pre-GST era.

When the Goods and Services Tax (GST) was introduced in 2017, most indirect taxes—like service tax, central excise, and even VAT, in most cases, were subsumed into GST. However, not all items in India are currently under the ambit of GST.

Certain products like petrol, diesel, and alcoholic beverages/alcohol for human consumption are still taxed under state-wise VAT laws. This dual approach means that some businesses have to pay both GST and VAT, depending on the nature of the products they are purchasing and selling.

For example, a restaurant that serves alcohol might either generate two separate bills with food + GST in one bill and a separate VAT bill for alcoholic beverages. Alternatively, even if both food and alcohol are shown in the same bill, separate line items in the form of GST and VAT will be visible on the bill.

In practice, VAT gets collected by businesses but eventually lands on the consumer. Each company in the product chain adds the VAT to its sale price and then recovers the tax it paid on earlier purchases. As the end consumer has no one to pass the tax on to, the end consumer pays the full VAT amount.

Below are the key advantages and disadvantages of Value Added Tax that one needs to keep in mind:

Advantages

• Minimises tax evasion risk as tax is collected at multiple stages.
• Encourages compliance due to input tax credit benefits.
• Help governments generate revenues consistently.
• The actual amount of VAT paid is proportional to the consumption.

Disadvantages

• Regressive nature as rate of tax is same irrespective of income or financial status of the consumer.
• Complex compliance requirements for businesses due to multi-stage implementation.
• Since the end user pays the entire VAT, it can increase the prices of goods and services significantly.

Considering the key limitations of VAT, let’s see how GST compares to VAT.

VAT and GST are both consumption-based indirect taxes but they differ in scope and uniformity. GST aims to simplify taxation across the country. VAT is a state-level affair, which can lead to inconsistencies

As you can from above, the main difference between GST and VAT is the uniformity of application of the former. This in turn makes compliance simpler for companies which has the potential to free up resources for various business-relevant activities.

There are some key difference regarding how different industries implement Value Added Tax:

• In manufacturing, VAT is generally levied at every stage of the production process, from acquiring raw materials to finishing the product.
• Retailers have to ensure that the price they charge customers is inclusive of VAT. However, retailers are eligible to claim input tax credit on the VAT they paid at the time of making purchases from the wholesaler.
• Depending on their state’s regulations, service providers might charge VAT on select offerings, creating a layer of complexity if those services cross state lines.
• Certain commodities, like alcohol for human consumption and petrol/diesel, still come under state VAT laws and not under the new nationwide GST system.

Perhaps the most common misconception regarding Value Added Tax is that it an additional tax you have to pay over and above the price of the good/service. This is actually not the case as it is part of the total amount you pay for a good/service.

Another misconception is that VAT and sales tax are the same thing. While both are indirect taxes applicable on consumption, VAT is applied at multiple points in the value chain, unlike sales tax, which is only applied at time of sale to the end user.

People also believe that VAT doesn’t affect small vendors. However, if the revenue of a business crosses a certain threshold, they must register for and pay VAT. Some even think VAT is optional, but that could land you in trouble if your turnover is exceeds a specified limit.

If a business meets the eligibility criteria for VAT registration, online registration option is available on the relevant state portal. Below are the steps to follow.

• 1. Visit the state’s VAT registration portal.
• 2. Set up an account using basic details like PAN number, address, and business structure.
• 3. Upload scanned copies of required documents, including proof of establishment, bank statements, applicable licenses, etc.
• 4. Pay the applicable VAT registration fee.
• 5. After submission of all this information and scrutiny of submitted documents, the business is issued a unique registration number, post approval.

This unique number, also known as Taxpayer Identification Number (TIN) is essential for issuance of VAT compliant invoices and claiming input tax credit.

VAT spreads the tax burden through the supply chain and, thus, is less likely to be evaded which enhances compliance and collections for tax authorities. For trade and business, VAT tax improves record keeping and promotes having a well-defined procedure for handling taxes on inputs and outputs. This structure also helps avoid double taxation on materials and, in most cases, makes audit procedures easier.

Additionally, consumers can also see the VAT charges clearly mentioned on their invoice, which is a plus for transparency. While the added cost might be noticeable, it ensures that taxes are distributed across various stages rather than appearing as a single lump sum payable at the final purchase point.

Small businesses have often found the paperwork related to VAT overwhelming as it is necessary to keep track of every input and output. This is further compounded by the fact tax rules can change, requiring updates on how invoices are issued.

There are also several challenges of implementing VAT when they offer services or sell products in multiple states. Thus, a small manufacturer in one state may find it difficult to comply with another state’s regulations when expanding its business in multiple states. While these are not unsurmountable issues, VAT compliance might eat up resources of small business and impact their ability to grow.