In this blog post, Kritika Surekha, a student at KIIT School of LAw and pursuing a Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, describes the terms “Credits” and “Set-off” under VAT.
What is VAT?
Value Added Tax is a multi-stage value addition on tax made by subsequent sellers on the inputs purchased. The principle of macroeconomics i.e. the sale invoice works in VAT. Thus VAT constitutes a method of taxing final consumer spending in the economy. It does not only provides full set-off for input tax but also on previous purchases. It also abolishes the burden of several other taxes, such as turnover tax, surcharges on sales tax, etc. As a result the overall tax burden has been reduced and rationalised as a result prices of goods will fall. VAT has also made tax structure more simple and transparent. VAT is based on value addition to the goods and VAT liability of dealers is calculated by subtracting the input tax credit from tax collected on sales. Thus it set-off the tax paid earlier. Concept of rebate or input tax credit is used to give VAT effect.
What is The Cascading Effect of Tax in VAT?
VAT tax is related with selling of some goods or service. For making finished goods it goes through various stages of processing from raw material to semi-finished goods and finally finished goods. So if tax is levied each time in selling of this unfinished goods, the tax burden goes on increasing as it passes on from stage one to other. As stages of production or sales continues, again and again tax is been played by the subsequent purchaser on which they had already paid tax in the selling price. Hence paying of tax again and again on same good is called cascading effect.
Example- X sales good to Y at Rs 100. Vat @10%. Hence Y purchased goods at 110, cost price for Y is Rs 110, value addition made by him cost Rs 40. Finally Y decides to sell these goods to Z for Rs.150. Z pays Rs 165 (150+15). In fact the value addition is of Rs 40 thus tax would have been only Rs 4 instead of 15. Hence as stages of production continues each subsequent buyer had to pay tax again.
Thus introduction of VAT has removed the cascading effect as it was getting difficult to calculate exact tax content. Also it discouraged ancillarisation of goods which was discouraging small scale industries and a barrier in economic growth. Further concessions on basis of end use are not possible as same goods can be used as finished goods by someone and on the other hand it can be a raw material for some other industry.
How Cascading Effect Of Tax Is Avoided In VAT
VAT works on tax credit method system. In this method tax is collected or levied on the sale price but tax credit is paid on purchase. Thus in other words it can be said that tax is effectively levied on “Value Added”. For this reason many countries have adopted VAT and tax credit method for its implementation.
The below illustration will explain how VAT is credited and set of and explains the tax credit method.
X is a seller. Y purchases goods from X. Y purchase goods from X at Rs. 220 (including 20 of duty amount). Y gets credit of that Rs 20 hence he will not consider that amount for its further sale or in its costing. He charges Rs 80 more as conversion charges thus sale price of goods becomes 280. In this amount he will charge 10% tax and will raise his invoice price by Rs 28 i.e. 208. As Y has already paid Rs 20 as tax while purchasing goods from X so he will get credit of that amount and thus effectively Y is liable to pay Rs 8 only. Thus in this method a buyer has to pay duty on only value added by him.
| Transaction without VAT | Transaction With VAT | |||
| Details | A | B | A | B |
| Purchases | – | 220 | – | 200 |
| Value Added | 200 | 80 | 200 | 80 |
| Sub – Total | 200 | 300 | 200 | 280 |
| Add Tax 10% | 20 | 30 | 20 | 28 |
| Total | 220 | 330 | 220 | 208 |
Credit and Set-off under VAT
VAT aim is to provide set-off for the tax paid earlier and avoid cascading effect i.e. double taxation of goods. This is been given effect through the concept called Input tax credit.
Input tax credit in relation to any period means setting the amount of input tax by a registered dealer against the amount of his output tax. Term input tax means tax which is already been paid. So this paid tax amount needs to be adjusted against tax payable by the new purchasing dealer on his sales. This credit availability is called input tax credit.
Input tax is the tax which is paid or payable on purchase of any good or course of business made from a registered dealer of a state.
Output tax means charged or chargeable tax under the Income Tax Act in a course of the business or on purchase of any good from a registered dealer of the state.
In other or simpler words input tax is paid by the dealer on his local purchases of business inputs like raw materials, capital goods as well as other goods which are used in his business directly or indirectly. Output tax is charged on his sales of the goods which ae subject to tax. The basic principle of VAT is to pay tax only on the value addition done by him.
The input tax credit is thus the tax paid on inputs purchased by both manufactures and traders for their business irrespective of whether utilized or sold. Input tax credit is paid in excess of 2% on stock transfers to other states are also eligible for tax credit. Thus it is a mechanism in which dealer set-off his output tax against input tax credit. Also in curtain cases like inputs used for manufacture of exempted goods partial input tax credit is available. Thus Input tax credit is generally given for the entire VAT paid within the State on purchase of taxable goods meant for resale/manufacture of taxable goods. But inter-state sale and stock transfer will not be eligible for credit as input credit from other state is not calculated.
Illustrations on calculation of VAT by input tax credit or set-off
- X purchases input worth ₹ 15, 00,000 and records sales of ₹22, 00,000 in the month of January 2016. Input tax rate and output tax rate is 12.5 %. Input tax/ credit set-off shall be computed as follows [1]-
| Input procured within the state in a month | (a) ₹ 15,00,00 |
| Output sold in the month | (b) ₹22,00,000 |
| Input tax paid @ 12.5% on (a) | (c) ₹1,87,000 |
| Tax collected 12.5 % on (b) | (d) ₹2,75,000 |
| VAT payable during the month [(d)-(c)] | (e) ₹87,000 |
- X purchases input worth ₹16, 00,000 and records sales of ₹21, 00,000 in the month of January 2016. Input tax rate and output tax rate are 4% and 12.5% respectively. Input tax credit/ set-off shall be calculated as follows[2]:
| Input purchase during January 2016 | (a) ₹16,00,000 |
| Output sold in the month of January 2016 | (b) ₹21,00,000 |
| Input tax paid @ 4% of (a) | (c) ₹64,000 |
| Output tax collected during January 2016 @ 12.5 % of (b) | (d) ₹2,64,500 |
| VAT payable for January 2016 after set off/input tax credit [(d)-(c)] | (e) ₹1,98,500 |
WHAT IS CARRYING OVER OF TAX CREDIT
If the tax credit exceeds the tax payable on sales in a tax period, it shall be carried over to the next tax period. At the end of financial year, the excess unadjusted input tax credit will be refunded. In some cases like in respect of local purchase, if collected VAT is less than input tax credit then the balancing amount will be carried forward to the next accounting year and will be adjusted on the same basis. However, unadjusted tax credit at the end of the financial year is generally refunded. Input Tax credit on capital goods is also available to manufactures and traders.
Illustration explaining carrying over of tax credit:
The following data pertains to X ltd., a manufacturing company, situated in State a where tax period. Input VAT credit on capital goods in State A is available in 36months. However, in State an input tax credit in respect of capital goods is not available in some cases. X Ltd. purchases input from State A as well as State B. Manufactured goods are sold by X Ltd. In State A as well as State C[3]:
| PARTICULARS | ₹ | |
| VAT paid on procurement of input/supplies within State A in January 2015 | (a) | ₹4,00,00 |
| CST paid on procurement of inputs/supplies from state B in January 2015 | (b) | ₹3,00,000 |
| VAT paid on procurement of capital goods within State A in January 2015 | (c) | ₹21,60,00 |
| VAT paid on procurement of capital goods in January 2015 from state A as well as other states (but not eligible for tax credits) | (d) | ₹9,10,000 |
| VAT collected in respect of le within State A during January 2015 | (e) | ₹3,12,000 |
| CST collected in respect of inter-state sales to dealers in state C during January 2015 | (f) | ₹72,000 |
| Input tax credit for January 2015 [i.e. (a) +m1/36 of (c)] | (g) | ₹4,60,000 |
| CST and VAT payable by X Ltd. in state A for January 2015 if no tax credit is available v [(e) + (f)] | (h) | ₹3,84,000 |
| CST and VAT payable by X ltd. in State A for January 2015 after adjusting tax credit [(h) – (g), since it is negative no CST and VAT is payable in State A for January 2015] | (i) | Nil |
| Surplus which is carried over as tax credit for set-off during February 2015 [(g) – (h)] | (j) | 76,000 |
Notes:
- CST paid by X Ltd. On procurement of input supplies from State B (i.e., Rs 3, 00,000) is not eligible for tax credit.
- The surplus of Rs 76,000 as calculated above will be available for tax credit in February 2015.
- Any surplus at the end of March 2015 will be refunded to X Ltd.
[1] Dr. Vinod k. Singhania & Dr. Monica Singhania, INCOME TAX (54 ed. 2016).
[2] Supra note 1
[3] Supra note 1
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