Basic Concept of VAT(MODVAT & CENVAT)/Sales TAX

Value added tax (VAT) is similar to a sales tax. It is a tax on the estimated market value added to a product or material at each stage of its manufacture or distribution, ultimately passed on to the consumer.

Generally, any tax is related to selling price of product. In modern production technology, raw material passes through various stages and processes till it reaches the ultimate stage e.g., steel ingots are made in a steel mill. These are rolled into plates by a re-rolling unit, while third manufacturer makes furniture from these plates. Thus, output of the first manufacturer becomes input for second manufacturer, who carries out further processing and supply it to third manufacturer. This process continues till a final product emerges. This product then goes to distributor/wholesaler, who sells it to retailer and then it reaches the ultimate consumer.

If a tax is based on selling price of a product, the tax burden goes on increasing as raw material and final product passes from one stage to other. For example, let us assume that tax on a product is 10% of selling price. Manufacturer ‘A’ supplies his output to ‘B’ at Rs. 100. Thus, ‘B’ gets the material at Rs. 110, inclusive of tax @ 10%. He carries out further processing and sells his output to ‘C’ at Rs. 150. While calculating his cost, ‘B’ has considered his purchase cost of materials as Rs. 110 and added Rs. 40 as his conversion charges. While selling product to C, B will charge tax again @ 10%. Thus C will get the item at Rs. 165 (150+10% tax). As stages of production and/or sales continue, each subsequent purchaser has to pay tax again and again on the material which has already suffered tax. This is called cascading effect.

Cascading effect of conventional system of taxes - A tax purely based on selling price of a product has cascading effect, which has the following disadvantages - (a) Computation of exact tax content difficult (b) Varying Tax Burden as tax burden depends on number of stages through which a product passes (c) Discourages Ancillarisation (d) Increases cost of production (e) Concessions on basis of use is not possible  (f) Exports cannot be made tax free.

VAT to avoid the cascading effect – VAT was developed to avoid cascading effect of taxes. In the aforesaid example, ‘value added’ by B is only Rs. 40 (150–110), tax on which would have been only Rs. 4, while the tax paid was Rs. 15. In VAT, the idea is that B will pay tax on only Rs 40 i.e. value added by him. Then, it makes no difference whether a product passes through 5 or 10 stages or even 100 stages, as every person will pay tax only on ‘value added’ by him to the product and not on total selling price.

Tax credit system - VAT removes these defects by tax credit system. Under this system, credit is given at each stage of tax paid at earlier stage.

Illustration of tax credit system - In the example we saw above, ‘B’ will purchase goods from ‘A’ @ Rs. 110, which is inclusive of duty of Rs. 10. Since ‘B’ is going to get credit of duty of Rs. 10, he will not consider this amount for his costing. He will charge conversion charges of Rs. 40.00 and sell his goods at Rs. 140. He will charge 10% tax and raise invoice of Rs. 154.00 to ‘C’. (140 plus tax @ 10%). In the Invoice prepared by ‘B’, the duty shown will be Rs. 14. However, ‘B’ will get credit of Rs. 10 paid on the raw material purchased by him from ‘A’. Thus, effective duty paid by ‘B’ will be only Rs. 4. ‘C’ will get the goods at Rs. 154 and not at Rs. 165 which he would have got in absence of Cenvat. Thus, in effect, ‘B’ has to pay duty only on Rs 40, which is the value added by him.

Following example will illustrate the tax credit method of Cenvat.

Note - 'B' is purchasing goods from 'A'. In second case, his purchase price is Rs 100/- as he is entitled to Cenvat credit of Rs 10/- i.e. tax paid on purchases. His invoice shows tax paid as Rs 14. However, since he has got 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.

Advantages of tax credit system - The ‘Tax Credit Method’ has following advantages - (a) Audit control is much better, which helps in controlling tax evasion. It acts as a self-policing mechanism (b) Flexibility in applying varying tax rates to different commodities (c) Useful in giving tax benefits on exports or other preferred end-uses like uses by common man etc. Most of the countries have adopted ‘tax credit’ method for implementation of VAT.

Meaning of ‘Value added’ – In the above illustration, 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 difference between selling price and the purchase price.

Advantages of VAT - Advantages of VAT are as follows : (a) Exports can be freed from domestic trade taxes (b) It provides an instrument of taxing consumption of goods and services (c) Interference in market forces is minimal (d) Aids tax enforcement by providing audit trail through different stages of production and trade. Thus, it acts as a self-policing mechanism (e) Neutrality i.e. with minimum distortion in tax structure - as there are few variations in tax rates and exemptions from taxation are very few.

The disadvantage is that paper work required increases considerably and it is not as simple as a single point sales tax.

really i got all the clarification regarding the CENVAT and VAT .

Thanks for the valuable answer.

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