How VAT works | What is VAT | VAT Explained with Example

How Does VAT System Works?


With the final approval and signing of GCC united VAT Agreement by the all the member countries, the taxation system VAT is all set to be implemented in GCC Member States. It is expected to be implemented by 2018 and the formulation of laws and regulations in each of the member countries are some of the major immediate steps involved in the implementation of VAT.

While these countries are preparing for implementation VAT, what does it implies to the businesses, for whom the subject Indirect Taxation is new although it exists in certain business specific scenario. No doubt, in several ways the business will be impacted. The reason being, indirect tax 'VAT' being an transaction based tax, which requires you to ensure that every transaction recorded are VAT complaint. To ensure compliance, it is imperative for businesses to understand what is VAT? How does VAT system work? Let us discuss.

What is VAT?

Value Added Tax (VAT) is the tax levied at every level of value addition done to the product across the supply chain. It is levied at every point of sale from manufacturer till it is sold to an end consumer. This achieved by allowing tax paid on purchase known 'Input Tax Credit' or also known as 'input VAT' to be adjusted with the VAT collected on sales knows as 'Output VAT'. Ultimately, the entire tax is paid by the consumer.

How does VAT system work?

VAT is a consumption based tax with the provision to allow Input tax credit -Tax paid on purchases to be utilized or set-off against the VAT liability Tax collected on Sale. If there is any balance liability after adjustment, the same needs to be paid to the government.

Let us understand with an example

Name Type Purchase Sales VAT
Cost VAT 10% Total Selling Price VAT 10% Total Input VAT Output VAT VAT Payable
Output VAT - Input VAT
A-One Supplies Raw Material Supplier -- -- -- 1,000 100 1,100 100 100
Best Bicycles Ltd Manufacturer 1,000 100 1,100 1500 150 1650 100 150 50
Top Distributor Ltd Distributor 1500 150 1,650 2200 220 2420 150 220 70
Favourite Bicycles Store Retailer 2200 220 2,420 2500 250 2750 220 250 30

In the above example,

  • 1. Best Bicycles Ltd, bicycle manufacturer pays VAT 100 @ 10% on purchase of raw materials which are required to manufacturer a bicycle. After manufacturing, he sells the bicycles to Top Distributors Ltd at 1,500 plus of 150. In arriving the VAT payable to the government, Best Bicycles Ltd need to adjust the input of 100 with output VAT 150 and the balance 50 will be the payable.
  • 2. Top Distributor LTD sells the bicycles at 2,200 + VAT 220 to Favourite Bicycles Store who is a retailer. Since he has already paid VAT of 150 to Best Bicycles Ltd, he will allowed adjust Input put of 150 with output VAT 220 and the balance 70 will be payable to the government. If you observe, the VAT of 70 which he is paying is exactly 10 % on value addition of 700.
  • 3. Favorite Bicycles Store is retail store, he sells the bicycle to Mr. Imran who is end consumer for 2,500 with VAT 250. Similar to the above, Favorite Bicycle store adjusts the Input VAT of 220 with output tax 2500 and pays balance 30 to the Government.

Now, if you closely observe, the total tax paid by all parties (A-One Supplies 100 + Best Bicycles Ltd 50 + Top Distributor Ltd 70 + Favourite Bicycles Store 30) is 250 which is exactly the same amount of VAT paid by the Mr Imran on purchasing the bicycle. Therefore, the businesses engaged in supply chain will pass on the burden of tax to next stage and ultimately, VAT is paid by the end consumer.



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