Methods For VAT Taxation
How the VAT Works
How the VAT Works
A value-added tax (VAT) is a tax on the value added at each stage of Sale of Goods. A VAT can be computed under one of three methods:
1) The credit invoice method or Invoice Method (Mostly Used)
2) The subtraction method, or
3) The addition method.
1) Credit invoice method:
Stage of production: | Sales | VAT | VAT on purchases | Net VAT | |
Raw materials | Rs 100 x 10% | Rs 10 | (Rs 0) | Rs10 | |
1st processor | Rs 120 x 10% | Rs 12 | (Rs 10) | Rs 2 | |
Distributor | Rs 140 x 10% | Rs 14 | (Rs12) | Rs 2 | |
Retailer | Rs 180 x 10% | Rs 18* | (Rs 14) | Rs 4 | |
Total | Rs 18 |
* There would be no need to separately state the VAT on the invoice because the customer would not be entitled to a credit for the VAT paid.
Under the credit invoice system, a company’s recordkeeping is fairly straightforward because it will use a procedure whereby it keeps track of sales invoices showing VAT collected and purchase invoices from other businesses showing VAT paid.
2) Subtraction method:
Stage of production: | Sales | Less purchases | Calculation | VAT | |
Raw materials | Rs100 | Rs 0 | Rs 100 x 10% | Rs 10 | |
1st processor | Rs 120 | Rs 100* | Rs 20 x 10% | Rs 2 | |
Distributor | Rs 140 | Rs 120* | Rs 20 x 10% | Rs 2 | |
Retailer | Rs 180 | Rs 140* | Rs 40 x 10% | Rs 4 | |
Total | Rs 18 |
3) Addition method VAT: For this type of VAT, the tax rate is applied to the total of the taxpayer’s inputs that were not purchased from other businesses, such as employee wages, interest and owner profit (that is, the value added by the business). This should result in the same tax as with the subtraction method. For example, if the retailer total sales of Rs.18,000 less cost of materials purchased of Rs 14,000 less wages of Rs 1,500, its financial statements would show net income of Rs 2,500. Under the subtraction method, its tax base would be Rs18,000 – Rs 14,000 = Rs 4,000. Under the addition method, its tax base would also be Rs 4,000 (wages of Rs 1,500 + owner profit of Rs 2,500).