Basic Principle of VAT Mechanism

• Value Added Tax is a multi-stage tax collected on the value added to goods at each point of sale

• It applies at every level of production and distribution from manufacturer to retailer

• The tax is calculated as the difference between output tax and input tax on purchases

• Only the incremental value added at each stage is taxed thereby avoiding tax-on-tax

• The final VAT burden is ultimately borne by the end consumer who cannot claim credit

Role of Input and Output Tax

• Input tax is the VAT paid by a business on purchases of goods used for resale or production

• Output tax is the VAT collected by the business on its sales to customers or other dealers

• Businesses subtract input tax from output tax to arrive at the net tax payable to the government

• If input tax is more than output tax the excess can be carried forward or refunded depending on rules

• This credit mechanism ensures that businesses pay tax only on the value they add to goods

Transaction Flow in VAT System

• The manufacturer pays VAT on raw materials and collects VAT on the finished product sold to wholesaler

• The wholesaler claims input credit for VAT paid to the manufacturer and collects VAT on resale to retailer

• The retailer claims input credit for VAT paid to the wholesaler and collects VAT from the final consumer

• At each step the difference between output and input tax is remitted to the government

• This structured flow allows tax collection at each stage without increasing overall tax burden

Compliance Requirements for Dealers

• VAT-registered dealers must issue proper tax invoices mentioning VAT charged on each sale

• They must maintain detailed records of all purchases sales returns and credits claimed

• Regular VAT returns must be filed with state tax authorities within the prescribed time frame

• Dealers are required to reconcile input and output tax for each return period

• Compliance ensures eligibility for input credit and prevents penalties or disallowance

Advantages of the VAT Mechanism

• It eliminates cascading taxation and brings transparency into the supply chain

• Encourages tax compliance through the credit-based system tied to proper invoicing

• Enhances revenue generation for states without overburdening consumers or businesses

• Promotes fairness by taxing only the value addition done by each entity in the chain

• Serves as a foundation for more advanced tax systems like GST which adopt a similar model