VAT or Value Added Tax was  introduced into the Indian taxation system from 1st April 2005. This is a kind of consumption tax which get imposed on products or services at different stages of manufacturing and at final sale. This is a multi-point process of levying tax on value addition which is collected at different stages of sale with a provision for set-off for tax paid at the stage of tax paid on purchase. So VAT is a tax to be paid at every stage of  transaction of Purchase and Sale.

Don’t get confused with the above technical explanations. Let me put a simple example for your better understanding. Let’s say, when a refrigerator is manufactured  by a company the manufacturer requires various raw materials and parts. For this he has to buy the raw materials and parts from other various suppliers  When the supplier sends these raw materials and parts to the manufacturer, the manufacturer get charged a value-added tax on all of these supplies from the suppliers for producing the refrigerator. Once the refrigerator is completely built and reaches to the showroom, the consumer who purchases it must pay the value-added tax that applies to him/her.

If you look at from the point of a buyer, VAT it is the tax on the purchase price, but if you look through the point of a seller, this is the tax on the value added to a product (as per above example, value added by suppliers for making of refrigerator), material, or service received from the suplier or distributor. The manufacturer remits to the government the difference between these two amounts, and retains the rest for themselves to offset the taxes they had previously paid on the inputs.

Value Added Tax, which is a form of indirect tax paid to the government by the producer/manufacturer, and the cost is passed on to the consumer. It is the consumer who has to finally pay for VAT. The value added to any product may be calculated as the sales price minus the cost of supply and the other taxable items.

The VAT charged on the purchase of the goods from the supplier by the manufacturer is called the Input Tax and the the VAT chargeable on the sale of the goods to the customer is known as Output Tax. The goods purchase price would include an Input Tax paid at the time of purchases from the supplier. Similarly, the goods sale would also include an Output Tax collected at the time of sales to the Customer.

So, VAT would be calculated on the difference between the Output Tax collected at the Time of Sales and the Input Tax paid at the Time of Purchases. see the image below for how the does the VAT work;

In short, as it is shown in the visual above,

Value Added Tax (VAT) = Output Tax Amount – Input Tax Amount

There are mainly two methods of calculation of VAT;

  1. In the first method, tax is charged separately on the basis of the tax which is paid on purchase, and the tax that is payable on the sale (shown separately in the invoice). Therefore, the difference between the tax paid on purchase and the tax payable on sale as per the invoice is the VAT.
  2. In the second method, tax is collected and charged on the aggregate value of the tax payable on sale and purchase, by applying the rate of tax applicable to the goods. Therefore, the difference between the sale price and purchase price would be VAT. It means VAT is the tax which consumers ultimately face, which is collected at each stage.

Hope the above explanation makes you easy to understand the technicality of VAT. Do you still think it’s too complex? Share your views.

Know what is Value Added Tax (VAT) and how does it work

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