Salient Features/Provisions Related to VAT and Services Tax | Commerce & Accountancy Optional Notes for UPSC PDF Download

Introduction

A value-added tax, commonly known as VAT, is a tax imposed on the increased value at each step of the production and distribution value chain for a product or service. This tax is applicable to both goods and services.

Background of VAT

• The introduction of VAT in the 1950s served as a substitute for sales tax, aiming to address issues like tax cascading and the high compliance costs associated with sales tax.
• Under the VAT system, businesses are liable to pay taxes based on the variance between their sales and purchase of goods and services. They have the option to claim tax credits for the taxes paid on inputs, preventing the taxation of the same value multiple times.
• The input tax credit approach in VAT prevents the taxation of inputs used in production, focusing on taxing only the final consumption. This efficiency makes the VAT system advantageous.
• VAT operates by taxing the value addition at each stage of the production chain, with only the final consumer bearing the tax burden. This design ensures that inputs used in production are not subject to taxation.
• Businesses, under the VAT system, can pass on the majority of the tax burden to their customers, placing the emphasis on the final consumer to bear the brunt of the taxation.
• In many countries, VAT has replaced sales tax, becoming a modern, transparent, and comprehensive tax system.
• In India, VAT was introduced by state governments in 2005 to replace sales tax. However, the Goods and Services Tax (GST) later absorbed both central and state VAT, creating a unified tax applicable throughout the country.

Objectives of VAT

• VAT is designed to improve the purchasing capacity and living standards of the less affluent by avoiding the cascading effect and inflation associated with single-point indirect tax collection methods. Unlike other tax systems, VAT minimizes the impact on prices, benefiting the poorer segments of society.
• Another key objective of VAT is to establish consistency in the state-level tax structure, considering India's federal structure that grants both states and the central government the authority to impose and collect taxes. While central taxes are uniform nationwide, state taxes, such as entertainment taxes, sales taxes, and state excise, vary across different states. The implementation of VAT aims to standardize these state-level taxes, fostering uniformity in the national market.

Cascading Effect of Tax

Tax Cascading, also known as the cascading effect of tax, occurs when a tax is applied to a commodity at each stage of its sale, leading to taxation on the tax already included in the product's value. This results in the end consumer paying taxes on the taxes paid by the previous buyers, creating a cumulative effect of taxation throughout the supply chain.

How is VAT Tax Calculated?

• VAT is computed based on the total value of goods and services transacted by a registered taxpayer within a specific tax period.
• The taxable value, used for VAT calculation, comprises the total amount invoiced to customers, excluding additional taxes like VAT, excise duty, etc.
• The fundamental formula for VAT calculation is expressed as follows: VAT = Taxable value * VAT rate.
• As an illustration, if a company generates taxable sales amounting to ₹100,000 and the applicable VAT rate is 12%, the resulting VAT payable would be ₹12,000 (₹100,000 * 12%).
• Taxpayers have the opportunity to claim an input tax credit for the VAT paid on purchases that contribute to the production of taxable outward supplies.
• The final VAT payable is determined by subtracting the input VAT credit claimed from the output VAT on sales: VAT payable = (Output VAT on sales) - (Input VAT credit claimed).
• The VAT rate applied is subject to variation among different states and is contingent upon the nature of goods and services sold by the taxpayer.

Types of VAT

• Consumption Type VAT:
  • A consumption tax is applied to expenditures on products and services.
  • In this type of VAT, capital goods acquired from other entities in the acquisition year are excluded from the tax base, with no subtraction of depreciation in subsequent years.
  • The tax base for this VAT is determined by the amount spent on consumption.
• Income Type VAT:
  • Income type VAT includes capital goods acquired in the acquisition year in the tax base but excludes depreciation in subsequent years.
  • This VAT applies to both consumption and net investment, with the tax base being the net national income.
• Gross National Product (GNP) Type VAT:
  • GNP type VAT incorporates capital goods acquired by an entity from other entities into the tax base without deduction in the acquisition year, and it does not exclude depreciation in the following years.
  • Tax is imposed on both consumption and gross investment, and the tax base for this type is the gross domestic product.

Note:

• Consumption type VAT is the most widely utilized among the three types mentioned.
• The term "VAT" commonly refers to the consumption type VAT due to its extensive usage.

Working of Value Added Tax

• VAT Collection at Every Stage:
  • VAT is imposed on the gross margin at each stage, including production, distribution, and marketing.
  • Unlike a sales tax system where the consumer pays tax at the final stage, VAT is calculated and collected at each intermediate stage.
• Example Scenario:
  • Raw material for chocolate bars is bought for ₹100, with an additional ₹4 as government-enforced chocolate tax, totaling ₹104.
  • The chocolate manufacturer sells the chocolate to a dealer for ₹150 and a VAT of ₹10, resulting in a total of ₹160.
  • The manufacturer remits ₹6 to the government, representing the total VAT at this stage, minus the earlier VAT from the raw material supplier. Notably, ₹6 equals 12% of the manufacturer's gross margin of ₹50.
• Retail Stage:
  • The retailer sells the chocolate to the customer for ₹200 plus a VAT of ₹20, totaling ₹230.
  • The retailer pays ₹10 to the government, which is the total value-added tax at ₹20, minus the preceding ₹10 VAT charged by the manufacturer.
  • The ₹10 corresponds to 20% of the retailer's gross margin on the chocolate bar.

Note: VAT is levied incrementally at each stage of the supply chain, and the tax paid is based on the value added at each stage. This method helps prevent the cascading effect seen in traditional sales tax systems.

Advantages of VAT

• Tough Against Tax Evasion: VAT's application at every stage of the goods and services transaction makes tax evasion challenging, contributing to enhanced transparency in financial transactions.
• Significant Revenue Source: When uniformly applied, VAT becomes a substantial contributor to revenue collection, playing a crucial role in strengthening tax policies and addressing fiscal policy deficits.
• Global Adoption: The VAT system is embraced by 160 out of 193 nations globally, highlighting its widespread adoption as an effective taxation mechanism.
• International Recognition: Internationally recognized, VAT fosters positive relationships with other nations in the realm of foreign trade, as it aligns with a standardized and widely accepted taxation framework.
• Thorough Transaction Monitoring: VAT ensures comprehensive scrutiny of all transactions, enhancing the effectiveness and simplicity of the tax payment process. This meticulous oversight contributes to a more efficient and streamlined taxation system.

Disadvantages of VAT

• Cascading Effect of Taxes: Under the VAT regime, the cascading effect of taxes, where taxes are applied at multiple stages of production and distribution, led to increased costs and inefficiencies in the system.
• Inability to Claim Input Tax Credit (ITC) on Services: In the VAT system, businesses were unable to claim Input Tax Credit on services, limiting their ability to offset taxes paid on inputs against their final tax liability.
• Diversity in VAT Rates and Laws: Different states had varying VAT rates and laws, creating complexity and disparities in the tax system across regions.
• Non-Adjustment of Central Sales Tax (CST) with VAT: Central Sales Tax (CST) and VAT were not interchangeable; the input of CST could not be adjusted against VAT, and vice versa, leading to inefficiencies in tax credit utilization.
• Deadweight Loss and Market Impact: VAT, like other taxes, introduced distortions in the market. An increase in prices resulted in a decrease in the number of commodities traded, leading to deadweight loss - a situation where the losses in supply and demand shifts outweigh the gains from tax revenue.
• Effectiveness of Tax and Government Spending: The effectiveness of a tax depends on whether the revenue lost by the economy is surpassed by the government's earnings. The utilization of tax revenue for constructive spending or positive externalities can mitigate the deadweight loss associated with the tax.
• Microeconomic Impact of VAT and Non-VAT: Both VAT and non-VAT systems have similar implications on the microeconomic model, influencing consumption, production, and market dynamics.
• Superiority of Consumption Taxes like VAT: Despite distortions, consumption taxes like VAT are often considered superior as they have a lesser impact on incentives to invest, save, and work compared to other forms of taxation. VAT tends to deter consumption rather than production.

How does Value Added Tax differ from Income Tax?

• Similarity to Income Tax: VAT shares a similarity with income tax as it is based on the value of a product or service at each stage of production, reflecting the incremental value added.
• Major Differences: Despite similarities, there are key differences between VAT and income tax.
• End Retailer Collection: In the VAT system, the final retailer typically collects the tax, contrasting with income tax, which is usually collected from individuals or entities based on their income.
• Flat Tax Nature: VAT is generally considered a flat tax, implying a consistent rate applied to the value of goods or services across various stages of production. In contrast, income tax often involves progressive tax rates based on income levels.
• Importer's VAT Contribution: For VAT purposes, an importer is presumed to have contributed 100% of the value of an imported product from outside the VAT zone. The importer incurs VAT on the entire value of the commodity, and this cannot be reimbursed, even if the overseas producer paid other forms of income tax.

Methods of Collection of Value-Added Tax Collection in India

• Filing Returns: Businesses registered under the GST regime are obligated to submit periodic returns, such as GSTR-1, GSTR-2, GSTR-3, and GSTR-9. These returns provide a comprehensive overview of their purchase and sales transactions, input tax credit (ITC) availed, and details of tax payments.
• Electronic Payment: To fulfill their GST obligations, businesses must electronically remit the GST applicable on their output supplies. Various electronic payment options, including NEFT, RTGS, and IMPS, are available for this purpose.
• Tax Deducted at Source (TDS): In specific cases, the recipient of a supply is tasked with deducting Tax Deducted at Source (TDS) and remitting it to the government on behalf of the supplier. This requirement is applicable to certain goods and services.
• Tax Collected at Source (TCS): E-commerce sellers play a role in collecting a predetermined percentage of Tax Collected at Source (TCS) on the supplies made through their platforms. This applies to the sale of items such as motor vehicles, coal, timber, etc.
• Personal Liability: According to GST laws, the directors or partners of a company can be held personally liable for the payment of taxes.
• Security Deposit: Businesses with an annual turnover exceeding ₹1.5 crores are obligated to furnish a cash security deposit as a safeguard against tax evasion. Non-compliance may result in the forfeiture of this deposit.

Difference between VAT and Services Tax

The difference between VAT and Services Tax can be classified in different ways, such as:

• Value-added tax (VAT) pertains to the taxation calculated on the increased value of traded goods, while services tax is the tax imposed on the rendered services.
• VAT functions as a multipoint tax, whereas services tax operates as a single-point tax.
• The application of value-added tax extends to both producers and trading products during the service, whereas services tax is exclusively applied to the services provided.
• The imposition of value-added tax is within the purview of state governments, while services tax is imposed by the central government.
• The scope of value-added tax is confined to the state, whereas services tax has a nationwide scope with specific exceptions.
• Value-added tax is enforced at different points within the state, while services tax is applicable across the entire nation, except for certain specified situations.

What is the benefit of GST over VAT? 

The primary advantage of Goods and Services Tax (GST) over Value Added Tax (VAT) lies in its ability to eliminate illegal practices through a distinctive compliance system. In addition to mitigating the cascading tax effect, GST has substantially lightened the tax burden on taxpayers. A key benefit is the removal of various indirect taxes associated with VAT. The transparency of GST reduces the overall cost of conducting business, making it advantageous for both individuals and businesses alike.

What is the Difference Between GST and VAT?

Examples of Value Added Tax

In this example with a 10% Value Added Tax (VAT) scenario, let's follow the flow of transactions within the production chain:

• Metals Dealer:
  • Sells raw materials to the electronic components manufacturer for $1 plus a 10-cent VAT.
  • Sends 10 cents of the VAT to the government.
• Electronic Components Manufacturer:
  • Purchases raw materials for $1 plus a 10-cent VAT from the metals dealer.
  • Uses the materials to produce electronic components, selling them to a cell phone manufacturer for $2 plus a 20-cent VAT.
  • Pays the government 10 cents of the VAT.
  • Keeps the other 10 cents as reimbursement for the VAT paid to the metals dealer.
• Cell Phone Manufacturer:
  • Purchases electronic components for $2 plus a 20-cent VAT from the electronic components manufacturer.
  • Produces cell phones and sells them to a retailer for $3 plus a 30-cent VAT.
  • Pays the government 10 cents of the VAT.
  • Uses the remaining 20 cents to offset the VAT paid to the electronic components manufacturer.
• Retailer:
  • Purchases cell phones for $3 plus a 30-cent VAT from the cell phone manufacturer.
  • Sells a phone to a consumer for $5 plus a 50-cent VAT.
  • Pays 20 cents to the government.
  • Retains the remainder (30 cents) as reimbursement for previously paid VAT to the cell phone manufacturer.

The total VAT collected by the government throughout the entire production chain is the sum of the VAT amounts paid at each stage:

• Metals dealer: 10 cents
• Electronic components manufacturer: 10 cents
• Cell phone manufacturer: 10 cents
• Retailer: 20 cents

Total VAT collected by the government: 50 cents.

Features of Services Tax

Service tax is a tax levied by the government on service providers on certain service transactions, but is actually borne by the customers. It is categorized under Indirect Tax and came into existence under the Finance Act, 1994.
The salient features of levy of service tax are:

• Scope: It is leviable on taxable services ‘provided’ or ‘to  be provided’ by  a service provider. The services ‘to be provided’ in future are taxed only if payment in its respect is received in advance.
  Two separate persons required  Payment to employees not covered: For  charge of service  tax, it is necessary that the service provider and service recipient should be two separate persons acting  on ‘principal to principal basis’. Services provided by an employee to his employer are not covered service tax and, therefore, salaries or allowances paid to them cannot be charged to service tax.
• Rate: It is leviable @ 12% of the value of taxable services. Education Cess @ 2% and Secondary and  Higher Education Cess @ 1 % are chargeable on the amount of service tax, thus, making the effective  rate of service tax at 12.36% of the value of taxable service.
  Update: While presenting the Budget 2015, the FM had increased the Service Tax Rate from 12.36% to 14%. This new rate of Service Tax @ 14% was applicable from 1st June 2015. Moreover from 15th Nov 2015, Swachh Bharat Cess @ 0.5% also got applicable. Budget 2016 has proposed to impose a Cess, called the Krishi Kalyan Cess, @ 0.5% on all taxable services. The new effective service tax rate in India could henceforth be 15%.
• Taxable services: Service tax is leviable only on the taxable services. Taxable services mean the  services  taxable under section 65(105) of the  Finance Act, 1994.
• Value: For the levy of the service tax, the value shall be computed in accordance with section 67 read  with Service Tax (Determination of Value) Rules, 2006.
• Free services not taxable : No service tax is leviable upon the services provided free of cost.
• Payment of service tax : The person providing the service (i.e. the service provider) has to pay  service tax in such manner and within such period as is prescribed in the Service Tax Rules, 1994. The service tax is to be paid only on the receipt of payment towards the value of taxable services.
• Procedures: Provisions have been made for registration, assessment including self assessment, rectifications, revisions, appeals and penalties on the service provider.
• CENVAT credit: The credit of service tax and excise duty across goods and services is allowable in accordance with the CENVAT Credit Rules, 2004. Accordingly, output service provider (i.e. provider of any taxable service) can avail credit not only of the service tax paid on any input service consumed for rendering any output service but also of the excise duty paid on any inputs and capital goods used for rendering output service. CENVAT credit so availed can be utilized for payment of service tax on taxable output service.
• Services provided  by  an unincorporated  association/body  to  its  members also taxable
  [Explanation to Sec. 65] : ‘Taxable  service’ includes any taxable service provided  or  to be provided by  any  unincorporated  association or  body  of persons  to a member thereof, for  cash, deferred  payment or  any  other  valuable  consideration. Hence, the services (falling under any category of taxable service) provided or to be provided by any unincorporated association/body to member thereof shall be liable to service tax.  This provision is an exception to the ‘principle of mutuality’.
• Performance of statutory activities/duties, not ’service’: An activity  performed  by a sovereign  /public authority under provisions of law does not constitute provision of taxable service  to a person and, therefore, no service tax is leviable on such entities.
• Import/Export of services: While import of services is chargeable to tax u/s 66A, the export of services has been made exempt from tax. Import/export provisions are discussed separately.