Ch 9 - VAT Concept and Its Application in GST | GST Saral by CA Dhruv Aggarwal PDF Download

 Page 1


CA DHRUV AGRAWAL – National Chairman Taxation Committee-All India Confederation of Small & Micro Industries Association  
 
 
 
 
 
 
 
 
 
 
 
 
CHAPTER 9 - VAT Concept  and i ts appli cati on i n GST 
 
 
 
 
 
 
 
 
 
9.1 Background of Vat 
 
Vat in core concept in GST. 
CHAPTER 9 
 
VAT Concept and its application in GST 
 
Concept of Vat (Value Added Tax) was first proposed in 1918 by German Industrialist Dr. Wilhelm von 
Siemens. 
 
France was the first country to introduce VAT on 10th April 1954. European countries introduced Vat on 
goods and services, after 1977 when European Union made adopting VAT regime as condition precedent to 
joining European Union. Vat Rate in Europe varies between 19% to 25%. 
China introduced Vat in 1984 and fu l fledged Vat was implemented in China in 1994. The rate is about 17%. 
In Japan, there is 'consumption tax' of 5% [4% national levy and 1% regional levy]. 
About 130 countries have introduced Vat. USA has not introduced Vat since in USA, income tax is major 
revenue at Central level and there is retail tax at State level. 
 
Concept of VAT was developed to avoid cascading effect of taxes. VAT was found to be a very good and 
transparent tax co lection system, which reduces tax evasion, ensures better tax compliance and increases tax 
revenue. 
Modvat (modified value added tax) was introduced in India in 1986 (Modvat was re-named as Cenvat w.e.f. 
1-4-2000) at Central level. The system was termed as Modvat, as it was restricted upto manufacturing stage 
and credit of only excise duty paid on manufacturing products (and corresponding CVD paid on imported 
goods) was available. 
System of VAT was introduced in service tax w.e.f. 16-8-2002. 
 
Credit of excise duty and service tax was made inter-changeable w.e.f. 10-9-2004. Thus, partial integration of 
goods and service tax has been achieved at Union level. 
Cenvat was not extended to sales tax, as sales tax is under jurisdiction of State Governments. 
However, State Governments have introduced sales tax VAT after 2005. 
9.2 Basic Concept of VAT 
 
Genera ly, any tax is related to se ling price of product or value of services. In modern production technology, 
raw material passes through various stages and processes ti l it reaches the ultimate stage. Output of the first 
manufacturer becomes input for second manufacturer, who carries out further processing and supply it to third 
manufacturer.   This   process   continues   ti l   a   final   product   emerges.   This   product   then   goes   to 
distributor/wholesaler, who se ls it to retailer and then it reaches the ultimate consumer. 
For example, steel ingots are made in a steel mi l by 'A'. These are ro led into plates by a re-ro ling unit 'B', 
while third manufacturer say 'C' makes furniture from these plates. He sales it to 'D' who is final consumer. Of 
Page 2


CA DHRUV AGRAWAL – National Chairman Taxation Committee-All India Confederation of Small & Micro Industries Association  
 
 
 
 
 
 
 
 
 
 
 
 
CHAPTER 9 - VAT Concept  and i ts appli cati on i n GST 
 
 
 
 
 
 
 
 
 
9.1 Background of Vat 
 
Vat in core concept in GST. 
CHAPTER 9 
 
VAT Concept and its application in GST 
 
Concept of Vat (Value Added Tax) was first proposed in 1918 by German Industrialist Dr. Wilhelm von 
Siemens. 
 
France was the first country to introduce VAT on 10th April 1954. European countries introduced Vat on 
goods and services, after 1977 when European Union made adopting VAT regime as condition precedent to 
joining European Union. Vat Rate in Europe varies between 19% to 25%. 
China introduced Vat in 1984 and fu l fledged Vat was implemented in China in 1994. The rate is about 17%. 
In Japan, there is 'consumption tax' of 5% [4% national levy and 1% regional levy]. 
About 130 countries have introduced Vat. USA has not introduced Vat since in USA, income tax is major 
revenue at Central level and there is retail tax at State level. 
 
Concept of VAT was developed to avoid cascading effect of taxes. VAT was found to be a very good and 
transparent tax co lection system, which reduces tax evasion, ensures better tax compliance and increases tax 
revenue. 
Modvat (modified value added tax) was introduced in India in 1986 (Modvat was re-named as Cenvat w.e.f. 
1-4-2000) at Central level. The system was termed as Modvat, as it was restricted upto manufacturing stage 
and credit of only excise duty paid on manufacturing products (and corresponding CVD paid on imported 
goods) was available. 
System of VAT was introduced in service tax w.e.f. 16-8-2002. 
 
Credit of excise duty and service tax was made inter-changeable w.e.f. 10-9-2004. Thus, partial integration of 
goods and service tax has been achieved at Union level. 
Cenvat was not extended to sales tax, as sales tax is under jurisdiction of State Governments. 
However, State Governments have introduced sales tax VAT after 2005. 
9.2 Basic Concept of VAT 
 
Genera ly, any tax is related to se ling price of product or value of services. In modern production technology, 
raw material passes through various stages and processes ti l it reaches the ultimate stage. Output of the first 
manufacturer becomes input for second manufacturer, who carries out further processing and supply it to third 
manufacturer.   This   process   continues   ti l   a   final   product   emerges.   This   product   then   goes   to 
distributor/wholesaler, who se ls it to retailer and then it reaches the ultimate consumer. 
For example, steel ingots are made in a steel mi l by 'A'. These are ro led into plates by a re-ro ling unit 'B', 
while third manufacturer say 'C' makes furniture from these plates. He sales it to 'D' who is final consumer. Of 
CA DHRUV AGRAWAL – National Chairman Taxation Committee-All India Confederation of Small & Micro Industries Association  
 
 
tax on a product is 10% of se ling price, the transaction would go as fo lows. 
 
Details                                                                                    A                     B                    C                     D 
 
Purchase                                                                                   -                 110                 165                 220 
 
Value Added                                                                       100                   40                   35                   30 
 
Sub-Total                                                                            100                 150                 200                 250 
 
Add tax 10%                                                                         10                   15                   20                   25 
 
Total                                                                                    110                 165                 220                 275 
The value added by B is only Rs 40 while he is paying tax on Rs 100 on which A has already paid the tax. He 
is also paying tax on Rs 10 which is actua ly tax paid by A. Similarly, C is paying tax on material on which A 
and B have already paid the tax. Thus, tax is paid again and again on the material which has already suffered 
tax. There is also tax on tax. 
Similar situation arises when one service provider uses another service as his input service. 
 
This is ca led cascading effect or 'snow ba ling effect' of taxes. 'Snow ba li ng' means suppose a sma l ice ba l 
starts ro ling from top of Himalaya, it accumulates ice as it ro ls down and become very big piece by the time it 
reaches bottom of hi l. 
This has the fo lowing disadvantages— 
 
(a)   Computation of exact tax content di fficult 
(b)   Varying Tax Burden as tax burden depends on number of stages through which a product passes. If 
same product passes through 5 stages, tax burden will be less. If same product passes through 10 
stages, tax burden will be more. 
(c)   Discourages  Anci larisation  and  growth  of  sma l scale  industries,  since  manufacturer  tends  to 
manufacture himself instead of buying the parts from outside. This increases cost of production. 
(d)   Concessions on basis of end use is not possible. For example, Government wants to exempt product 
of D as it is for flood relief or for common man's consumption. Now, even if Government gives tax 
exemption to D, the product or service does not become tax free as relief of taxes earlier paid by A, 
B and C cannot be given. 
(e)   India is member of World Trade Organisation (WTO). As per WTO, there should be free and fair 
competition. Hence, no country can give export incentives, but exported product or service can be 
made tax free. In aforesaid example, if D is exporting his product or his service, such exports cannot 
be made tax free, since Government does not know how much tax was paid earlier and cannot give 
relief. Thus, exports cannot be made tax free. 
9.2-1 VAT to avoid the cascading effect 
 
VAT was developed to avoid cascading effect of taxes. The basic principle is that at every stage, tax should 
be paid only on value added at that stage and not on entire sale price. 
'Value added' is the di fference between sale price and cost of material and other inputs on which tax has been 
paid. 
In the aforesaid example, 'value added' by B is only Rs 40 (150–110), In VAT, the idea is that B will pay tax 
on only Rs 40 i.e. value added by him. 
Then, it would make no di fference whether a product passes through 5 or 10 stages or even 100 stages, as at 
Page 3


CA DHRUV AGRAWAL – National Chairman Taxation Committee-All India Confederation of Small & Micro Industries Association  
 
 
 
 
 
 
 
 
 
 
 
 
CHAPTER 9 - VAT Concept  and i ts appli cati on i n GST 
 
 
 
 
 
 
 
 
 
9.1 Background of Vat 
 
Vat in core concept in GST. 
CHAPTER 9 
 
VAT Concept and its application in GST 
 
Concept of Vat (Value Added Tax) was first proposed in 1918 by German Industrialist Dr. Wilhelm von 
Siemens. 
 
France was the first country to introduce VAT on 10th April 1954. European countries introduced Vat on 
goods and services, after 1977 when European Union made adopting VAT regime as condition precedent to 
joining European Union. Vat Rate in Europe varies between 19% to 25%. 
China introduced Vat in 1984 and fu l fledged Vat was implemented in China in 1994. The rate is about 17%. 
In Japan, there is 'consumption tax' of 5% [4% national levy and 1% regional levy]. 
About 130 countries have introduced Vat. USA has not introduced Vat since in USA, income tax is major 
revenue at Central level and there is retail tax at State level. 
 
Concept of VAT was developed to avoid cascading effect of taxes. VAT was found to be a very good and 
transparent tax co lection system, which reduces tax evasion, ensures better tax compliance and increases tax 
revenue. 
Modvat (modified value added tax) was introduced in India in 1986 (Modvat was re-named as Cenvat w.e.f. 
1-4-2000) at Central level. The system was termed as Modvat, as it was restricted upto manufacturing stage 
and credit of only excise duty paid on manufacturing products (and corresponding CVD paid on imported 
goods) was available. 
System of VAT was introduced in service tax w.e.f. 16-8-2002. 
 
Credit of excise duty and service tax was made inter-changeable w.e.f. 10-9-2004. Thus, partial integration of 
goods and service tax has been achieved at Union level. 
Cenvat was not extended to sales tax, as sales tax is under jurisdiction of State Governments. 
However, State Governments have introduced sales tax VAT after 2005. 
9.2 Basic Concept of VAT 
 
Genera ly, any tax is related to se ling price of product or value of services. In modern production technology, 
raw material passes through various stages and processes ti l it reaches the ultimate stage. Output of the first 
manufacturer becomes input for second manufacturer, who carries out further processing and supply it to third 
manufacturer.   This   process   continues   ti l   a   final   product   emerges.   This   product   then   goes   to 
distributor/wholesaler, who se ls it to retailer and then it reaches the ultimate consumer. 
For example, steel ingots are made in a steel mi l by 'A'. These are ro led into plates by a re-ro ling unit 'B', 
while third manufacturer say 'C' makes furniture from these plates. He sales it to 'D' who is final consumer. Of 
CA DHRUV AGRAWAL – National Chairman Taxation Committee-All India Confederation of Small & Micro Industries Association  
 
 
tax on a product is 10% of se ling price, the transaction would go as fo lows. 
 
Details                                                                                    A                     B                    C                     D 
 
Purchase                                                                                   -                 110                 165                 220 
 
Value Added                                                                       100                   40                   35                   30 
 
Sub-Total                                                                            100                 150                 200                 250 
 
Add tax 10%                                                                         10                   15                   20                   25 
 
Total                                                                                    110                 165                 220                 275 
The value added by B is only Rs 40 while he is paying tax on Rs 100 on which A has already paid the tax. He 
is also paying tax on Rs 10 which is actua ly tax paid by A. Similarly, C is paying tax on material on which A 
and B have already paid the tax. Thus, tax is paid again and again on the material which has already suffered 
tax. There is also tax on tax. 
Similar situation arises when one service provider uses another service as his input service. 
 
This is ca led cascading effect or 'snow ba ling effect' of taxes. 'Snow ba li ng' means suppose a sma l ice ba l 
starts ro ling from top of Himalaya, it accumulates ice as it ro ls down and become very big piece by the time it 
reaches bottom of hi l. 
This has the fo lowing disadvantages— 
 
(a)   Computation of exact tax content di fficult 
(b)   Varying Tax Burden as tax burden depends on number of stages through which a product passes. If 
same product passes through 5 stages, tax burden will be less. If same product passes through 10 
stages, tax burden will be more. 
(c)   Discourages  Anci larisation  and  growth  of  sma l scale  industries,  since  manufacturer  tends  to 
manufacture himself instead of buying the parts from outside. This increases cost of production. 
(d)   Concessions on basis of end use is not possible. For example, Government wants to exempt product 
of D as it is for flood relief or for common man's consumption. Now, even if Government gives tax 
exemption to D, the product or service does not become tax free as relief of taxes earlier paid by A, 
B and C cannot be given. 
(e)   India is member of World Trade Organisation (WTO). As per WTO, there should be free and fair 
competition. Hence, no country can give export incentives, but exported product or service can be 
made tax free. In aforesaid example, if D is exporting his product or his service, such exports cannot 
be made tax free, since Government does not know how much tax was paid earlier and cannot give 
relief. Thus, exports cannot be made tax free. 
9.2-1 VAT to avoid the cascading effect 
 
VAT was developed to avoid cascading effect of taxes. The basic principle is that at every stage, tax should 
be paid only on value added at that stage and not on entire sale price. 
'Value added' is the di fference between sale price and cost of material and other inputs on which tax has been 
paid. 
In the aforesaid example, 'value added' by B is only Rs 40 (150–110), In VAT, the idea is that B will pay tax 
on only Rs 40 i.e. value added by him. 
Then, it would make no di fference whether a product passes through 5 or 10 stages or even 100 stages, as at 
CA DHRUV AGRAWAL – National Chairman Taxation Committee-All India Confederation of Small & Micro Industries Association  
 
 
every stage, tax will be paid only on 'value added' by him to the product and not on total se ling price. 
 
9.2-2 Meaning of 'Value added' 
 
In the  above  i lustration,  the  'value'  of inputs  is Rs  110,  while  'value'  of output  is  Rs  150.  Thus,  the 
manufacturer has made 'value addition' of Rs 40 to the product. 
Simply put, 'value added' is the gross di fference between se ling price and the purchase price in case of traded 
goods, and gross di fference between se ling price of final product and purchase price of inputs, in case of 
manufactured goods. 
9.2-3 Input Tax credit system to implement concept of VAT 
 
VAT (Value Added Tax) removes the cascading effect of taxes by 'input tax credit' system. Under this system, 
input tax credit is given at each stage of tax paid at earlier stage. For example, B will get input tax credit of tax 
paid by A, C will get credit of tax paid by B and so on. Thus, aforesaid example will be re-worked as follows 
in Vat. 
 
Details                                                                                    A                     B                    C                     D 
 
Purchase                                                                                   -                 100                 140                 175 
 
Value Added                                                                       100                   40                   35                   30 
 
Sub-Total                                                                            100                 140                 175                 205 
 
Add tax 10%                                                                         10                   14              17.50              20.50 
 
Total                                                                                    110                 154            192.50            225.50 
Note - 'B' is purchasing goods from 'A'. His purchase price is Rs 100 as he is entitled to input tax credit of Rs 
10 i.e. tax paid on purchases. His invoice shows tax paid as Rs 14. However, since he has got input tax credit 
of Rs 10, effectively he is paying only Rs 4 as tax, which is 10% of Rs 40, i.e. 10% of 'value added' by him. 
Similarly, you will find that C is actua ly paying tax of Rs 3.50 (17.50 - 14) which is 10% of Rs 35 and D is 
actua ly paying tax of Rs 3 on his 'value added' of Rs 30. 
If you see the invoice of D, it shows tax of Rs 20.50, which is the total tax on that Government paid as fo lows 
- Rs 10 by A, Rs 4 by B, Rs 3.50 by C and Rs 3 by D. 
 
Thus, if D is granted exemption of Rs 20.50, the product can be made tax free, which was not possible earlier. 
Exemption to D from total tax can be granted by any of the fo lowing ways— 
(a)   A low him not to charge Vat on his sale and to take input tax credit of his inputs and utilize it for 
payment of taxes on his other sales (thus, indirect refund of input taxes) 
(b)   A low him to charge Vat (sales tax) on his sales and grant him rebate of that tax on his sales 
(c)   A low him not to charge Vat on his sale and grant him rebate of taxes paid by him on his inputs [If 
majority of his final products or output services are exempt from tax] 
'D' can opt for any one of the benefits which suits him. 
 
9.3 Vat is consumption based tax 
 
You will find that actua ly tax is co lected by Government only at final stage i.e. consumption stage. Ti l then, 
the credit is passed on to next buyer. Thus, effectively Government does not get any tax revenue. 
In the aforesaid example, if 'D' does not make any further sale, he cannot pass on the input tax credit to any 
subsequent buyer or customer. Hence, that tax goes entirely to Government. 
Hence, Vat is termed as 'consumption based tax'. 
Page 4


CA DHRUV AGRAWAL – National Chairman Taxation Committee-All India Confederation of Small & Micro Industries Association  
 
 
 
 
 
 
 
 
 
 
 
 
CHAPTER 9 - VAT Concept  and i ts appli cati on i n GST 
 
 
 
 
 
 
 
 
 
9.1 Background of Vat 
 
Vat in core concept in GST. 
CHAPTER 9 
 
VAT Concept and its application in GST 
 
Concept of Vat (Value Added Tax) was first proposed in 1918 by German Industrialist Dr. Wilhelm von 
Siemens. 
 
France was the first country to introduce VAT on 10th April 1954. European countries introduced Vat on 
goods and services, after 1977 when European Union made adopting VAT regime as condition precedent to 
joining European Union. Vat Rate in Europe varies between 19% to 25%. 
China introduced Vat in 1984 and fu l fledged Vat was implemented in China in 1994. The rate is about 17%. 
In Japan, there is 'consumption tax' of 5% [4% national levy and 1% regional levy]. 
About 130 countries have introduced Vat. USA has not introduced Vat since in USA, income tax is major 
revenue at Central level and there is retail tax at State level. 
 
Concept of VAT was developed to avoid cascading effect of taxes. VAT was found to be a very good and 
transparent tax co lection system, which reduces tax evasion, ensures better tax compliance and increases tax 
revenue. 
Modvat (modified value added tax) was introduced in India in 1986 (Modvat was re-named as Cenvat w.e.f. 
1-4-2000) at Central level. The system was termed as Modvat, as it was restricted upto manufacturing stage 
and credit of only excise duty paid on manufacturing products (and corresponding CVD paid on imported 
goods) was available. 
System of VAT was introduced in service tax w.e.f. 16-8-2002. 
 
Credit of excise duty and service tax was made inter-changeable w.e.f. 10-9-2004. Thus, partial integration of 
goods and service tax has been achieved at Union level. 
Cenvat was not extended to sales tax, as sales tax is under jurisdiction of State Governments. 
However, State Governments have introduced sales tax VAT after 2005. 
9.2 Basic Concept of VAT 
 
Genera ly, any tax is related to se ling price of product or value of services. In modern production technology, 
raw material passes through various stages and processes ti l it reaches the ultimate stage. Output of the first 
manufacturer becomes input for second manufacturer, who carries out further processing and supply it to third 
manufacturer.   This   process   continues   ti l   a   final   product   emerges.   This   product   then   goes   to 
distributor/wholesaler, who se ls it to retailer and then it reaches the ultimate consumer. 
For example, steel ingots are made in a steel mi l by 'A'. These are ro led into plates by a re-ro ling unit 'B', 
while third manufacturer say 'C' makes furniture from these plates. He sales it to 'D' who is final consumer. Of 
CA DHRUV AGRAWAL – National Chairman Taxation Committee-All India Confederation of Small & Micro Industries Association  
 
 
tax on a product is 10% of se ling price, the transaction would go as fo lows. 
 
Details                                                                                    A                     B                    C                     D 
 
Purchase                                                                                   -                 110                 165                 220 
 
Value Added                                                                       100                   40                   35                   30 
 
Sub-Total                                                                            100                 150                 200                 250 
 
Add tax 10%                                                                         10                   15                   20                   25 
 
Total                                                                                    110                 165                 220                 275 
The value added by B is only Rs 40 while he is paying tax on Rs 100 on which A has already paid the tax. He 
is also paying tax on Rs 10 which is actua ly tax paid by A. Similarly, C is paying tax on material on which A 
and B have already paid the tax. Thus, tax is paid again and again on the material which has already suffered 
tax. There is also tax on tax. 
Similar situation arises when one service provider uses another service as his input service. 
 
This is ca led cascading effect or 'snow ba ling effect' of taxes. 'Snow ba li ng' means suppose a sma l ice ba l 
starts ro ling from top of Himalaya, it accumulates ice as it ro ls down and become very big piece by the time it 
reaches bottom of hi l. 
This has the fo lowing disadvantages— 
 
(a)   Computation of exact tax content di fficult 
(b)   Varying Tax Burden as tax burden depends on number of stages through which a product passes. If 
same product passes through 5 stages, tax burden will be less. If same product passes through 10 
stages, tax burden will be more. 
(c)   Discourages  Anci larisation  and  growth  of  sma l scale  industries,  since  manufacturer  tends  to 
manufacture himself instead of buying the parts from outside. This increases cost of production. 
(d)   Concessions on basis of end use is not possible. For example, Government wants to exempt product 
of D as it is for flood relief or for common man's consumption. Now, even if Government gives tax 
exemption to D, the product or service does not become tax free as relief of taxes earlier paid by A, 
B and C cannot be given. 
(e)   India is member of World Trade Organisation (WTO). As per WTO, there should be free and fair 
competition. Hence, no country can give export incentives, but exported product or service can be 
made tax free. In aforesaid example, if D is exporting his product or his service, such exports cannot 
be made tax free, since Government does not know how much tax was paid earlier and cannot give 
relief. Thus, exports cannot be made tax free. 
9.2-1 VAT to avoid the cascading effect 
 
VAT was developed to avoid cascading effect of taxes. The basic principle is that at every stage, tax should 
be paid only on value added at that stage and not on entire sale price. 
'Value added' is the di fference between sale price and cost of material and other inputs on which tax has been 
paid. 
In the aforesaid example, 'value added' by B is only Rs 40 (150–110), In VAT, the idea is that B will pay tax 
on only Rs 40 i.e. value added by him. 
Then, it would make no di fference whether a product passes through 5 or 10 stages or even 100 stages, as at 
CA DHRUV AGRAWAL – National Chairman Taxation Committee-All India Confederation of Small & Micro Industries Association  
 
 
every stage, tax will be paid only on 'value added' by him to the product and not on total se ling price. 
 
9.2-2 Meaning of 'Value added' 
 
In the  above  i lustration,  the  'value'  of inputs  is Rs  110,  while  'value'  of output  is  Rs  150.  Thus,  the 
manufacturer has made 'value addition' of Rs 40 to the product. 
Simply put, 'value added' is the gross di fference between se ling price and the purchase price in case of traded 
goods, and gross di fference between se ling price of final product and purchase price of inputs, in case of 
manufactured goods. 
9.2-3 Input Tax credit system to implement concept of VAT 
 
VAT (Value Added Tax) removes the cascading effect of taxes by 'input tax credit' system. Under this system, 
input tax credit is given at each stage of tax paid at earlier stage. For example, B will get input tax credit of tax 
paid by A, C will get credit of tax paid by B and so on. Thus, aforesaid example will be re-worked as follows 
in Vat. 
 
Details                                                                                    A                     B                    C                     D 
 
Purchase                                                                                   -                 100                 140                 175 
 
Value Added                                                                       100                   40                   35                   30 
 
Sub-Total                                                                            100                 140                 175                 205 
 
Add tax 10%                                                                         10                   14              17.50              20.50 
 
Total                                                                                    110                 154            192.50            225.50 
Note - 'B' is purchasing goods from 'A'. His purchase price is Rs 100 as he is entitled to input tax credit of Rs 
10 i.e. tax paid on purchases. His invoice shows tax paid as Rs 14. However, since he has got input tax credit 
of Rs 10, effectively he is paying only Rs 4 as tax, which is 10% of Rs 40, i.e. 10% of 'value added' by him. 
Similarly, you will find that C is actua ly paying tax of Rs 3.50 (17.50 - 14) which is 10% of Rs 35 and D is 
actua ly paying tax of Rs 3 on his 'value added' of Rs 30. 
If you see the invoice of D, it shows tax of Rs 20.50, which is the total tax on that Government paid as fo lows 
- Rs 10 by A, Rs 4 by B, Rs 3.50 by C and Rs 3 by D. 
 
Thus, if D is granted exemption of Rs 20.50, the product can be made tax free, which was not possible earlier. 
Exemption to D from total tax can be granted by any of the fo lowing ways— 
(a)   A low him not to charge Vat on his sale and to take input tax credit of his inputs and utilize it for 
payment of taxes on his other sales (thus, indirect refund of input taxes) 
(b)   A low him to charge Vat (sales tax) on his sales and grant him rebate of that tax on his sales 
(c)   A low him not to charge Vat on his sale and grant him rebate of taxes paid by him on his inputs [If 
majority of his final products or output services are exempt from tax] 
'D' can opt for any one of the benefits which suits him. 
 
9.3 Vat is consumption based tax 
 
You will find that actua ly tax is co lected by Government only at final stage i.e. consumption stage. Ti l then, 
the credit is passed on to next buyer. Thus, effectively Government does not get any tax revenue. 
In the aforesaid example, if 'D' does not make any further sale, he cannot pass on the input tax credit to any 
subsequent buyer or customer. Hence, that tax goes entirely to Government. 
Hence, Vat is termed as 'consumption based tax'. 
CA DHRUV AGRAWAL – National Chairman Taxation Committee-All India Confederation of Small & Micro Industries Association  
 
 
In case of inter-state transactions, if goods are manufactured in 'X' State, sent to 'Y' State and sold in 'Y' 
State, the tax revenue will be co lected only by 'Y' State and no revenue will accrue to 'X' State Government. 
This does not make di fference in respect of Central Taxes like excise duty and service tax (later it will be 
CGST and IGST) as wherever tax is paid, revenue goes to Central Government. However, this makes huge 
di fference in respect of State Vat and SGST 
9.3-1 Nature of Vat/GST 
 
International   VAT/GST   guidelines   issued   by  OECD   (Organisation   for  Economic   Cooperation   and 
Development) state as follows [quoted with approval in Coca Cola India v. CCE (2009) 22 STT 130 (Bom 
HC DB) and ABB Ltd. v. CCE (2009) 21 STT 77 = 15 STR 23 (CESTAT 3 member bench)] 
'Value  added  tax systems  are  designed  to  tax final consumption  and  as such,  in most cases,  it is only 
consumers who should actua ly bear the tax burden. Indeed, the tax is levied, ultimately, on consumption and 
not on intermediate  transactions  between firms,  as tax charged  on these  purchases  is,  in principle,  fully  
deductible.  This feature  gives  the tax its main characteristic  of neutrality in the value  chain and  towards 
international chain. - - Value added taxes are taxes on consumption, paid, ultimately by final consumers- - In 
principle, business should not bear the burden of tax since there are mechanisms in place that a low for a 
refund of the tax levied on intermediate transactions between firms'. 
9.3-2 Advantages of VAT/GST 
 
It can be seen that a l earlier disadvantages have gone in Vat system. Advantages of VAT are as follows : 
 
(a)   End use based exemptions or concessions can be given as tax as shown in invoice is the total tax 
borne by that commodity. Concessions can be given to goods used by poor people. Government 
has flexibility in applying varying tax rates to di fferent commodities. 
(b)   Exports can be freed from domestic taxes, which is permissible under WTO. 
(c)   Vat provides an instrument of taxing consumption of goods and services. 
(d)   Interference in market forces is minimum. 
(e)   Aids tax enforcement by providing audit trail through di fferent stages of production and trade. 
(f)  Vat acts as a self-policing mechanism. For example, B will get credit only if A issues invoice showing 
tax. Hence, B insists on tax invoice from A. Thus, B acts as police for A, C acts as police for B and 
so on. This increases tax compliance. It also indirectly increases income tax revenue. 
(g)   Tax evasion is reduced. Even if tax is evaded at one stage, the transaction gets caught in next stage 
of production or distribution and then Government gets its revenue. 
(h)   Simplicity with minimum distortion in tax structure - as there are few variations in tax rates and 
exemptions from taxation are very few. 
(i)   Transparent - The invoice shows total tax borne by that commodity. There are no hidden taxes. 
(j)   Certainty in taxation due to simple tax structure and minimum variations. 
9.3-3 Disadvantages of Vat 
 
Though Vat system has many advantages, the system is not free of pitfa ls and di fficulties. 
 
(a)   Heavy compliance cost - detailed accounting and paper work is required as is not as simple as a 
single point sales tax. 
(b)   Hindrance in inter-state movement of goods - Each State wants to keep record of goods coming in 
and going out of State, for which check posts are required. This delays movement and increases 
corruption. Rea ly, a l the goods will be tax paid during inter-statement of goods as IGST will have to 
Page 5


CA DHRUV AGRAWAL – National Chairman Taxation Committee-All India Confederation of Small & Micro Industries Association  
 
 
 
 
 
 
 
 
 
 
 
 
CHAPTER 9 - VAT Concept  and i ts appli cati on i n GST 
 
 
 
 
 
 
 
 
 
9.1 Background of Vat 
 
Vat in core concept in GST. 
CHAPTER 9 
 
VAT Concept and its application in GST 
 
Concept of Vat (Value Added Tax) was first proposed in 1918 by German Industrialist Dr. Wilhelm von 
Siemens. 
 
France was the first country to introduce VAT on 10th April 1954. European countries introduced Vat on 
goods and services, after 1977 when European Union made adopting VAT regime as condition precedent to 
joining European Union. Vat Rate in Europe varies between 19% to 25%. 
China introduced Vat in 1984 and fu l fledged Vat was implemented in China in 1994. The rate is about 17%. 
In Japan, there is 'consumption tax' of 5% [4% national levy and 1% regional levy]. 
About 130 countries have introduced Vat. USA has not introduced Vat since in USA, income tax is major 
revenue at Central level and there is retail tax at State level. 
 
Concept of VAT was developed to avoid cascading effect of taxes. VAT was found to be a very good and 
transparent tax co lection system, which reduces tax evasion, ensures better tax compliance and increases tax 
revenue. 
Modvat (modified value added tax) was introduced in India in 1986 (Modvat was re-named as Cenvat w.e.f. 
1-4-2000) at Central level. The system was termed as Modvat, as it was restricted upto manufacturing stage 
and credit of only excise duty paid on manufacturing products (and corresponding CVD paid on imported 
goods) was available. 
System of VAT was introduced in service tax w.e.f. 16-8-2002. 
 
Credit of excise duty and service tax was made inter-changeable w.e.f. 10-9-2004. Thus, partial integration of 
goods and service tax has been achieved at Union level. 
Cenvat was not extended to sales tax, as sales tax is under jurisdiction of State Governments. 
However, State Governments have introduced sales tax VAT after 2005. 
9.2 Basic Concept of VAT 
 
Genera ly, any tax is related to se ling price of product or value of services. In modern production technology, 
raw material passes through various stages and processes ti l it reaches the ultimate stage. Output of the first 
manufacturer becomes input for second manufacturer, who carries out further processing and supply it to third 
manufacturer.   This   process   continues   ti l   a   final   product   emerges.   This   product   then   goes   to 
distributor/wholesaler, who se ls it to retailer and then it reaches the ultimate consumer. 
For example, steel ingots are made in a steel mi l by 'A'. These are ro led into plates by a re-ro ling unit 'B', 
while third manufacturer say 'C' makes furniture from these plates. He sales it to 'D' who is final consumer. Of 
CA DHRUV AGRAWAL – National Chairman Taxation Committee-All India Confederation of Small & Micro Industries Association  
 
 
tax on a product is 10% of se ling price, the transaction would go as fo lows. 
 
Details                                                                                    A                     B                    C                     D 
 
Purchase                                                                                   -                 110                 165                 220 
 
Value Added                                                                       100                   40                   35                   30 
 
Sub-Total                                                                            100                 150                 200                 250 
 
Add tax 10%                                                                         10                   15                   20                   25 
 
Total                                                                                    110                 165                 220                 275 
The value added by B is only Rs 40 while he is paying tax on Rs 100 on which A has already paid the tax. He 
is also paying tax on Rs 10 which is actua ly tax paid by A. Similarly, C is paying tax on material on which A 
and B have already paid the tax. Thus, tax is paid again and again on the material which has already suffered 
tax. There is also tax on tax. 
Similar situation arises when one service provider uses another service as his input service. 
 
This is ca led cascading effect or 'snow ba ling effect' of taxes. 'Snow ba li ng' means suppose a sma l ice ba l 
starts ro ling from top of Himalaya, it accumulates ice as it ro ls down and become very big piece by the time it 
reaches bottom of hi l. 
This has the fo lowing disadvantages— 
 
(a)   Computation of exact tax content di fficult 
(b)   Varying Tax Burden as tax burden depends on number of stages through which a product passes. If 
same product passes through 5 stages, tax burden will be less. If same product passes through 10 
stages, tax burden will be more. 
(c)   Discourages  Anci larisation  and  growth  of  sma l scale  industries,  since  manufacturer  tends  to 
manufacture himself instead of buying the parts from outside. This increases cost of production. 
(d)   Concessions on basis of end use is not possible. For example, Government wants to exempt product 
of D as it is for flood relief or for common man's consumption. Now, even if Government gives tax 
exemption to D, the product or service does not become tax free as relief of taxes earlier paid by A, 
B and C cannot be given. 
(e)   India is member of World Trade Organisation (WTO). As per WTO, there should be free and fair 
competition. Hence, no country can give export incentives, but exported product or service can be 
made tax free. In aforesaid example, if D is exporting his product or his service, such exports cannot 
be made tax free, since Government does not know how much tax was paid earlier and cannot give 
relief. Thus, exports cannot be made tax free. 
9.2-1 VAT to avoid the cascading effect 
 
VAT was developed to avoid cascading effect of taxes. The basic principle is that at every stage, tax should 
be paid only on value added at that stage and not on entire sale price. 
'Value added' is the di fference between sale price and cost of material and other inputs on which tax has been 
paid. 
In the aforesaid example, 'value added' by B is only Rs 40 (150–110), In VAT, the idea is that B will pay tax 
on only Rs 40 i.e. value added by him. 
Then, it would make no di fference whether a product passes through 5 or 10 stages or even 100 stages, as at 
CA DHRUV AGRAWAL – National Chairman Taxation Committee-All India Confederation of Small & Micro Industries Association  
 
 
every stage, tax will be paid only on 'value added' by him to the product and not on total se ling price. 
 
9.2-2 Meaning of 'Value added' 
 
In the  above  i lustration,  the  'value'  of inputs  is Rs  110,  while  'value'  of output  is  Rs  150.  Thus,  the 
manufacturer has made 'value addition' of Rs 40 to the product. 
Simply put, 'value added' is the gross di fference between se ling price and the purchase price in case of traded 
goods, and gross di fference between se ling price of final product and purchase price of inputs, in case of 
manufactured goods. 
9.2-3 Input Tax credit system to implement concept of VAT 
 
VAT (Value Added Tax) removes the cascading effect of taxes by 'input tax credit' system. Under this system, 
input tax credit is given at each stage of tax paid at earlier stage. For example, B will get input tax credit of tax 
paid by A, C will get credit of tax paid by B and so on. Thus, aforesaid example will be re-worked as follows 
in Vat. 
 
Details                                                                                    A                     B                    C                     D 
 
Purchase                                                                                   -                 100                 140                 175 
 
Value Added                                                                       100                   40                   35                   30 
 
Sub-Total                                                                            100                 140                 175                 205 
 
Add tax 10%                                                                         10                   14              17.50              20.50 
 
Total                                                                                    110                 154            192.50            225.50 
Note - 'B' is purchasing goods from 'A'. His purchase price is Rs 100 as he is entitled to input tax credit of Rs 
10 i.e. tax paid on purchases. His invoice shows tax paid as Rs 14. However, since he has got input tax credit 
of Rs 10, effectively he is paying only Rs 4 as tax, which is 10% of Rs 40, i.e. 10% of 'value added' by him. 
Similarly, you will find that C is actua ly paying tax of Rs 3.50 (17.50 - 14) which is 10% of Rs 35 and D is 
actua ly paying tax of Rs 3 on his 'value added' of Rs 30. 
If you see the invoice of D, it shows tax of Rs 20.50, which is the total tax on that Government paid as fo lows 
- Rs 10 by A, Rs 4 by B, Rs 3.50 by C and Rs 3 by D. 
 
Thus, if D is granted exemption of Rs 20.50, the product can be made tax free, which was not possible earlier. 
Exemption to D from total tax can be granted by any of the fo lowing ways— 
(a)   A low him not to charge Vat on his sale and to take input tax credit of his inputs and utilize it for 
payment of taxes on his other sales (thus, indirect refund of input taxes) 
(b)   A low him to charge Vat (sales tax) on his sales and grant him rebate of that tax on his sales 
(c)   A low him not to charge Vat on his sale and grant him rebate of taxes paid by him on his inputs [If 
majority of his final products or output services are exempt from tax] 
'D' can opt for any one of the benefits which suits him. 
 
9.3 Vat is consumption based tax 
 
You will find that actua ly tax is co lected by Government only at final stage i.e. consumption stage. Ti l then, 
the credit is passed on to next buyer. Thus, effectively Government does not get any tax revenue. 
In the aforesaid example, if 'D' does not make any further sale, he cannot pass on the input tax credit to any 
subsequent buyer or customer. Hence, that tax goes entirely to Government. 
Hence, Vat is termed as 'consumption based tax'. 
CA DHRUV AGRAWAL – National Chairman Taxation Committee-All India Confederation of Small & Micro Industries Association  
 
 
In case of inter-state transactions, if goods are manufactured in 'X' State, sent to 'Y' State and sold in 'Y' 
State, the tax revenue will be co lected only by 'Y' State and no revenue will accrue to 'X' State Government. 
This does not make di fference in respect of Central Taxes like excise duty and service tax (later it will be 
CGST and IGST) as wherever tax is paid, revenue goes to Central Government. However, this makes huge 
di fference in respect of State Vat and SGST 
9.3-1 Nature of Vat/GST 
 
International   VAT/GST   guidelines   issued   by  OECD   (Organisation   for  Economic   Cooperation   and 
Development) state as follows [quoted with approval in Coca Cola India v. CCE (2009) 22 STT 130 (Bom 
HC DB) and ABB Ltd. v. CCE (2009) 21 STT 77 = 15 STR 23 (CESTAT 3 member bench)] 
'Value  added  tax systems  are  designed  to  tax final consumption  and  as such,  in most cases,  it is only 
consumers who should actua ly bear the tax burden. Indeed, the tax is levied, ultimately, on consumption and 
not on intermediate  transactions  between firms,  as tax charged  on these  purchases  is,  in principle,  fully  
deductible.  This feature  gives  the tax its main characteristic  of neutrality in the value  chain and  towards 
international chain. - - Value added taxes are taxes on consumption, paid, ultimately by final consumers- - In 
principle, business should not bear the burden of tax since there are mechanisms in place that a low for a 
refund of the tax levied on intermediate transactions between firms'. 
9.3-2 Advantages of VAT/GST 
 
It can be seen that a l earlier disadvantages have gone in Vat system. Advantages of VAT are as follows : 
 
(a)   End use based exemptions or concessions can be given as tax as shown in invoice is the total tax 
borne by that commodity. Concessions can be given to goods used by poor people. Government 
has flexibility in applying varying tax rates to di fferent commodities. 
(b)   Exports can be freed from domestic taxes, which is permissible under WTO. 
(c)   Vat provides an instrument of taxing consumption of goods and services. 
(d)   Interference in market forces is minimum. 
(e)   Aids tax enforcement by providing audit trail through di fferent stages of production and trade. 
(f)  Vat acts as a self-policing mechanism. For example, B will get credit only if A issues invoice showing 
tax. Hence, B insists on tax invoice from A. Thus, B acts as police for A, C acts as police for B and 
so on. This increases tax compliance. It also indirectly increases income tax revenue. 
(g)   Tax evasion is reduced. Even if tax is evaded at one stage, the transaction gets caught in next stage 
of production or distribution and then Government gets its revenue. 
(h)   Simplicity with minimum distortion in tax structure - as there are few variations in tax rates and 
exemptions from taxation are very few. 
(i)   Transparent - The invoice shows total tax borne by that commodity. There are no hidden taxes. 
(j)   Certainty in taxation due to simple tax structure and minimum variations. 
9.3-3 Disadvantages of Vat 
 
Though Vat system has many advantages, the system is not free of pitfa ls and di fficulties. 
 
(a)   Heavy compliance cost - detailed accounting and paper work is required as is not as simple as a 
single point sales tax. 
(b)   Hindrance in inter-state movement of goods - Each State wants to keep record of goods coming in 
and going out of State, for which check posts are required. This delays movement and increases 
corruption. Rea ly, a l the goods will be tax paid during inter-statement of goods as IGST will have to 
CA DHRUV AGRAWAL – National Chairman Taxation Committee-All India Confederation of Small & Micro Industries Association  
 
 
be paid on a l such goods. There is no need for physical barriers for movement of goods from one 
State to other. The inter-state check posts can be abolished, if there is strong political will to do so. 
(c)  State where goods are produced do not get any tax revenue as a l revenue goes to State where 
goods are consumed as Vat works on destination principle. For example, major quantity of wheat 
produced in Punjab goes outside the State. Similar situation exists in case of minerals in Jharkhand, 
software  in Karnataka  or manufactured  products  in industria ly advanced  States.  Of course  the 
States get indirect benefits like growth of employment, improved economy etc. but no direct benefit 
of Vat/sales tax. 
(d)   Tax evasion through bogus i nvoices. Since input tax credit is on the basis of invoice, the invoice is 
like currency note to the se ler. Printing invoice is much easier than printing currency notes. Under 
GST, the input tax credit will be on basis of electronic  returns.  Hence,  chances  of evasion on 
account of bogus i nvoices is much less. 
9.3-4 'Missing Trader' or 'hawala' in GST 
 
'Missing Trader' is a trader who makes a sale or provides service, co lects tax and then disappears.  The 
customer avails input tax credit of such taxes (which are not actua ly paid by the se ling dealer). This is 'hawala 
trade'. 
Another  type of fraud  is termed  as 'carousel fraud'.  'Carousel'  means 'merry-go-around'  or' roundabout' 
(Concise Oxford Dictionary). This is 'missing trader fraud' of sophisticated type. It is much more involved and 
di fficult to trace. 
One dealer 'A' se ls goods to 'B' and charges Vat. 'B' avails credit of tax shown by 'A' in his Invoice. 'B' se ls 
the goods to 'C' and charges Vat. 'B' has to pay only di fferential amount as tax. 'C' avails credit of tax shown 
by 'B' in his Invoice. 'C' se ls goods to 'D' by charging Vat. Since 'C' has availed credit of Vat paid by 'B', he 
has to pay only di fferential amount, which is sma l. 'D' exports the goods and claims refund of input tax i.e. 
entire tax shown by 'C' in his Invoice. 
This is a legitimate transaction. The missing link is that 'A' actua ly does not deposit tax to Government. 'A' 
either  has his own Vat registration  number  or he hijacks  other's  Vat number.  He co lects  tax and  then 
disappears. Thus, 'D' gets ref und of tax which is actua ly not paid by 'A'. By the time Government traces the 
transaction to 'A', he i.e. 'A' has disappeared. 
The same goods are used again and again for 'imports' and 'exports'. That is why the fraud is termed as 
'carousel' fraud. The high value goods like microchips and mobile phones are genera ly used for such deals. 
 
UK is said to be main victim of such fraud. It is reported that UK has lost 12.6 Billion Euro in such frauds. It 
is said that fraudsters prefer UK since it has weak and time consuming legal system! 
9.3-5 Case of innocent dealer 
 
Suppose in above example, 'D' is i nnocent. He is not aware that 'A' has not paid the tax. He has actua ly 
purchased and exported the goods. In such case, can Government disa low refund to 'D'? 
If 'D' is innocent, he cannot be penalised by default of 'A'. 
 
One  such case  has been decided  by Court of Justice  of European Comm unities.  It is highest  Court of 
European Union.  In Optigen  Ltd v. Commissioners  of Customs and  Excise 2006  EUECJ  C-354/03 
(decided on 12-1-2006), it has been held that Government cannot refuse refund in such cases. 
9.3-6 Invoice matching in GST 
 
In Mahalakshmi Cotton Ginning Pressing  and Oil Industries v. State of Maharashtra (2012) 35 STT 
589 = 21 Latest Case528 = 51 VST 1 (Bom HC DB), the Maharashtra Vat Act provided that set off (input