How does VAT operate

Value Added Tax is a tax which generates revenue for the Government in an effective manner through out the value add process from raw material to finished product.  So for the businesses and consumers we do need to understand a few basic principles of VAT.

All businesses (apart from exempted ones) do act as tax collectors for the Government, hence, need to maintain a standard set of records and transparency in all their dealings to avoid regulatory strictures or penalties.  The following example is being presented on a generic level to give a basic understanding of VAT for non-tax professionals and businessmen.

Farmer sell wood to a furniture manufacturer for X amount.  The farmer collects VAT at applicable rates as part of the sales proceeds and deposits the same with the Authorities within the stipulated period.  Let us call this first VAT charged as A.

The Manufacturing firm takes around 5 months to use the wood to build furniture say 100 chairs.  The Manufacturer can take credit for the VAT paid to the farmer i.e. A as soon as he has received the goods and paid the invoice provided details of the farmer's VAT registration number, etc as stipulated are available in the invoice for the Manufacturer to claim the credit.  (I will not go into the concept of carry forward for now)  As and when the Manufacturer sells the chairs to his dealers or customers for a price which includes the cost of the product plus his profit margin, he needs to add and collect the VAT from his dealers or customers and deposit it with the Authorities.  Let us call the VAT charged by the Manufacturer as B.

So in the first month the manufacturer gets a credit of A in the reporting to the authorities (monthly/quarterly reporting are mandated in most geographies) and every month where there has been a sale a VAT liability to the authorities is reflected in the report.  In all cases the liabilities and credit will be settled within a fixed period of time as detailed in the Tax guidelines.

The key take away from the above is the need to have clear accounting records to be able to deliver on the tax collector responsibility adequately and maintain the reputation of our businesses.

Posted in: VAT

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