Introduction to VAT- Rep

8/8/2019 Introduction to VAT- Rep

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Title Page



Table of Contents

Acknowledgements.......................................................................2

Objectives of the project...............................................................3

Value Added Tax – Introduction and Issues.....................................4

Local sales tax structure...............................................................................................................7Value-added tax Structure............................................................................................................8

......................................................................................................................................................8

Advantages of VAT.....................................................................................................................9

Changes due to VAT - General Implications for Indian Industry.............................................11Model developed for Impact Analysis...........................................15

Factors determining impact on a Sector.....................................................................................17Impact of VAT implementation on the Pharmaceutical Sector........19

Assumptions...............................................................................................................................21Preliminary Analysis..................................................................................................................26

Simulation Analysis...................................................................................................................27

Changes to Excise structure.......................................................................................................29Impact of changes in indirect tax structure for pharmaceutical companies and a move to Baddi,

Himachal Pradesh......................................................................................................................31Credit Analysis Model..................................................................33

Conclusion..................................................................................37

1





Objectives of the project

The following objectives have been defined for this project by the bank as

per their requirements:

• Define the changes which have been brought about due to

implementation of VAT and their impact on Indian industry.

• Understand, in depth, the impact on various players in the

pharmaceutical industry due to implementation of VAT

• Calculate the benefits of a move to an excise and VAT free zone

(Baddi, Himachal Pradesh)

• Create a generic model to extend this analysis to other sectors, both

qualitatively and quantitatively.

3



Value Added Tax – Introduction and Issues

In the 1993-94 budget speech, the Union Finance Minister stated: "Our long

term aim should be, to move to a Value Added Tax (VAT) system - a nation

wide VAT system cannot be introduced over night. There has to be a broadagreement among the Center and the States on the design of such a

system" (Ministry of Finance 1993).

Indirect tax reforms have been an integral part of the liberalization process

since 1991. In the first phase, India has been steadily attempting to move

towards a tax structure that is simple, moderate, rational and easy to

administer and comply with. At the central level, the move has been to bring

down the tariffs – both excise and customs, reduce the number of rates,

correct anomalies, get rid of the complexities in the system and on the whole

reduce the interface with the government. Reforms at centre level were

smooth and brought in mainly through annual budget presentation in the

parliament and are applicable through out the country.

In addition to indirect taxes levied by the centre, states are empowered to

levy certain indirect taxes and sales tax forms major part of revenue foralmost all states. There was wide variation in sales tax rates of the same

commodity in different states. In many states both inputs as well as outputs

are taxed creating cascading effect. The viable solution found was to shift to

destination based VAT i.e. value added tax.

Keeping this in mind, Value Added Taxation (VAT) has been implemented in

various states in India with effect from 1st April, 2005. VAT would be

replacing a number of Local Sales Tax Acts in the states in which it has been

implemented. Also, it has been proposed to phase out CST from the current

4% (Under form C), over a time period of 2-3 years (the levy will be cut from

4% to 2% in 2006-07 and to 0% in 2007-08).

The Indian System for VAT implementation has a number of special features:

4



• VAT has not been implemented in the following states:

o Uttar Pradesh

o Rajasthan

o Madhya Pradesh

o Uttranchal

o Tamil Nadu

o Jharkhand

o Chhattisgarh

o Gujarat

This will create disparities in the applicability and uniformity of the VAT

guidelines as decided by the empowered committee of Finance

Ministers. Also, one of the major benefits of VAT, i.e. the creation of a

common nation-wide market for all goods and services would

not be possible.

• After implementation of VAT, generally, all other indirect taxes

are completely removed. However, currently CST has been retained.

Also, certain states have retained taxes such as octroi (entry tax) and

turnover tax. This may thus defeat the benefit of VAT which restricts

the cascading effect of indirect taxation in India.

• Till now, the tax credit on sales tax paid on inputs was not

completely available (a part was retained by most states). However,

with the implementation of VAT, tax credit on intra-state sales would

now be available.

• With the retention of CST for a certain time period will again create

distortions, and will impact inter-state sales.

• A number of states have ignored guidelines, and put a variety of goods

under different tax slabs. This will create distortions in the market.

• Services are also generally brought under the purview of VAT.

However, service tax has been retained in India. This may impact

companies having a mixture of goods and services in their product

portfolio.

• Tax based incentive such as exemptions and deferrals will

continue. This will thus continue to provide companies with production

units in such areas a cost advantage. Also, if companies are negatively

5



impacted under VAT, they may move to such regions to avail of the tax

benefits.

• There are a number of grey areas which still need to be clarified in

very state act. Also, another major issue will be the education of

dealers, distributors and retailers.

The Value Added Tax (VAT) is an indirect tax that closely resembles any

sales tax, but varies in the fact that it is actually included, or embedded, in

the price of goods and services at each stage of the production process. So,

VAT is a tax imposed and collected on every sale, barter, exchange or

transaction deemed sale of taxable goods, properties, lease of goods or

properties, or services in the course of trade or business as they pass along

the production and distribution chain, the tax being limited only to the value

added to such goods, properties or services by the seller or transferor.

Sales /

Inputs

Local Inter state Stock transfer Exports

Local Full input tax

credit

Full input tax

credit

Input tax credit

in excess of 4

per cent

allowed

Refund of input

tax paid

Inter state No credit No credit No credit No credit

Stock

transfer

No credit No credit No credit No credit

Note

Source: White paper on VAT

All inter state sales and purchases will attract a CST of 4 per cent , not

vatable

6



Local sales tax structure

7

Input supplier Manufacturer Dealer Retailer

Raw material = Rs 1,000

Sales tax @ 6% = Rs 60

Rs 60 collected

and paid by input

supplier

To government

Raw material cost = Rs 1,060

Value add = Rs 1,000

Sales price = Rs 2,060

Sales tax @ 10% =206

Rs 206 paid by

manufacturer


Price to dealer = Rs 2,266

Value added = Rs 500

Selling price of dealer = Rs 2,766

Resale tax @ 1 %= Rs 28

Rs 28 collected

and paid bydealer

To government

Price to retailer = Rs 2,794


Selling price of retailer = Rs 3,294

Resale tax @ 1 %= Rs 33

Selling price to customer = Rs 3,327

Rs 33 collected

and paid by retailer



Value-added tax Structure

Stages Input

supplier

Manufacturer Dealer Retailer Total tax

collection

Under present sales tax 60 206 28 33 327

Under VAT 60 140 50 50 300

Source: CRIS INFAC

8


Raw material = Rs 1,000

VAT @ 6% = Rs 60

Raw material cost = Rs 1,060

Raw material recorded = Rs 1,000

Value add = Rs 1,000

Sales price = Rs 2,000

VAT @ 10% =200

Rs 200

collected byManufacturer

Rs 200 - 60 = 140

paid by

manufacturer

To government

Rs 60

collected and paid

by input supplier

To government

Price to dealer = Rs 2,200

Recorded by dealer = Rs 2,000


Selling price of dealer = Rs 2,500

VAT @ 10 %= Rs 250

Rs 250

collected bydealer

Rs 250

collected byretailer

InputSupplier

Manufacturer Dealer Retailer

Rs 300 - 250 =

50

paid by retailer

To government

Rs 250 - 200 =

50

paid by dealerTo government

Price to retailer = Rs 2,750

Recorded by retailer = Rs 2,500


Selling price of retailer = Rs 3,000

VAT @ 10 %= Rs 300

Selling price to customer = Rs 3,300



Advantages of VAT

VAT is unanimously acknowledged to be a major reform in the indirect

taxation system for the following reasons:

1. Simplicity

Most of the industrial products are to fall under the Revenue Neutral Rate

(RNR has been proposed to be close to 12.5%) in all the states. The

surcharges, turnover tax, entry tax, octroi, etc are to be retired from the

system.

2. Self-Policing

The private enterprises will assume a more pro-active role in tax

compliance of their suppliers to ensure that they themselves obtain credit

for taxes paid on the purchases.

Thus, VAT will encourage and result in a better-administered system that

deters tax evasion. The taxpayers will also be compelled to keep proper

records of their sales and purchases.

3. Taxes Value Addition

Businesses are taxed in proportion to their value addition. This distributes

tax burden to all levels of supply chain. Under the old system the

manufacturing units shouldered a disproportionate burden of the indirect

taxes.

4. Fewer Rates

The states are to reduce the number of tax slabs to just four (1%, 4%,

12.5% and 20%).

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5. Broadens Tax Net

Since, the tax burden increases wherever the ‘VAT chain’ breaks, it is

expected that the entities will get registered under VAT to get a credit on

Input Taxes.

6. Uniform Rates

The Empowered Committee has put almost all the industrial products

under the 12.5% (RNR) category. These rates will be applied to all the

states in India. A likely consequence is greater uniformity in prices across

regions.

7. Reduced Cost of Compliance

Since the complexity is reduced, the cost of compliance is likely to go

down too. The audit of tax returns will become easier. Another positive

spillover will be reduction in the level of corruption in tax departments.

The simplicity of tax structure should make cheating by Government

officials difficult.

8. Unhindered Growth of SMEs

As the tax is only on the value addition, the major incentive for ‘vertical

integration’ i.e. to save on taxes, is lost. Thus the development of SMEs

(Small and Medium scale Enterprises) is unhindered, an essential for a

developing economy like ours.

9. Exports zero-rated

VAT (as computed in India) permits easy and effective targeting of tax

rates as a result of which the exports can be zero-rated.

10



Changes due to VAT - General Implications for Indian Industry

1. Set Off (Input Credit)

At present the set off would be available, on the input taxes, on the goods

locally purchased form registered dealers within the State only . No set off

would be available to the goods purchased in the course of imports or

inter state trade and commerce. It will be necessary to produce the tax

invoice to claim set off. The tax should have been charged in the invoice.

2. Exempted Goods

Some goods would be declared as exempted by the State Government

under the proposed VAT Act. However the present view, as per guidelines

issued by the State Government, is that no set off would be allowed on

the exempted goods. It means that the tax suffered on the raw material

for manufacture of exempted goods would not be refunded.

3. Manufacturer

The manufacturer would be required to purchase raw material after

paying full tax on the rate applicable on such material. Unlike the present

system, wherein the manufacturer can purchase the goods at a

concessional rate of tax against a declaration form, no declaration form

will be required to be issued by the manufacturer.

The input tax suffered by him would be adjusted / set-off from the sale of

the finished product. The tax adjustment of input credit of the goods

purchased within the State would be available on the sales made within

the State and also on the inter-state sales/ exports subject to the tax

payable.

11



No or limited adjustment (currently, clarity in this regard is not present)

would be available of the input credit in case of branch transfer,

consignment sale.

4. Trader

The trader is required to collect tax on the sales made by him and the tax

liability would be set off\ adjusted from the purchase\ input tax credit.

5. Issue of Invoice

Under the Value Added Tax Act, issue of invoice is mandatory. No set off \

input credit is allowed unless the original tax invoice is produced wherein

tax is clearly charged separately in the invoice.

6. Declaration Form

Use of declaration forms for purchase of goods at concessional rates of

tax or NIL rate of tax under the State Act is no longer present. There is no

requirement for declaration forms under the Value Added Tax. However,

declaration forms of CST Act still continue.

7. Accounting

The basic account books required for the purpose of VAT Act are Purchase

and Sale Register. Both the registers are the basis on which the

calculation of payment of tax is to be made.

The normal practice of entering the gross value of Purchase bill would be

changed. The assessee would be required to enter the value of goods in

the ‘Goods A\c’ and the amount of tax in the ‘Tax A\c’ separately.

8. Capital Goods

The set-off (or credit) would also be available on purchase of capital

goods under the VAT Act (to be clarified). It is understood that the set off

12



would be available within a span of 3 years from the date of usage of

capital goods in commercial production.

9. Exports

The exports are to be zero-rated. The tax paid on raw materials used in

manufacture of goods for exports would be refunded by the State

Government in adjustment. Thus, the exports would become more

competitive in the world market as there would be no tax henceforth on

raw material used for manufacture of goods for export.

10. Transitory Provisions for Raw Material and Capital Goods

The set-off of ‘tax paid’ stocks would be available. ‘Tax paid’ inventory, as

on the date of implementation would be the basis for claiming set-off

under the new VAT Act.

However, no set-off would be available for the ‘tax paid’ stock purchased

more than a year prior to the date of implementation. The tax paid on

such stocks would be reimbursed over a period of time in equal monthly

installments.

11. Registration

All importers, manufacturers, exporters and dealers having CST

registration would be required to seek mandatory registration under the

new VAT Act. All dealers having a monthly taxable turnover in excess of

Rs. 5 Lakhs are liable to register (This threshold is not the same for all the

states).

There are two types of registration. The first is VAT Dealer registration

and the second is Composition Scheme Dealer registration.

The dealers opting under composition scheme would not be able to

charge tax in the invoice and would pay lump sum fee as composition

13



amount. It is apparently for retail traders and there is a limit of turn over

for option under composition scheme.

12. Audit of Account

Every dealer having a turn over of over a set limit is required to get his

account audited by a Chartered Accountant and submit the audit report

within the stipulated time. Failure to do so would attract penalty

proceedings.

13. Penalties

Penalties have been increased manifolds in the new VAT Act. However, in

view of the widespread ignorance of the VAT laws, the government is

likely to be more liberal in the initial years of implementation.

14. Works Contract and Leasing

The dealers who import raw materials into the state would not be eligible

for the composition tax .

15. Tax Holidays

All cases of tax exemption/ concession/ holiday will be converted to

deferment. VAT liability of units enjoying deferment of present sales tax

will continue to get deferred for the unexpired period.

14



Model developed for Impact Analysis

For the purpose of impact analysis, a sector has been considered from two

perspectives:

• Firstly, the overall impact on the sector as a whole and on the final prices

chargeable to consumers is calculated. This is done through an impact

analysis using the value chain as a base.

• Secondly, the impact on every link in the value chain is analysed

separately. The impact on margins and the possibility of passing on the

increased cost to consumers (or retaining the benefit of reduced costs, in

case of positive impact) is the main focus.

A generic model is then formulated which can use publicly available

information to calculate the percentage impact on margins of the clients as

well as potential client base of the bank.

A sector can function under one of four different scenarios. The benefits

accrued to the sector as a whole due to a movement to VAT will differ as per

the scenario under which it functions. These various scenarios are outlined

below:

• Intra-state purchases and sales for entire value chain

As the entire value chain is located within the same state, this scenario

would result in the maximum benefit due to transition to VAT. This is due

to the fact that complete set-off on inputs would be available to every link

in the entire value chain. However, this scenario is highly unlikely for a

sector in general, but may be applicable only for small local players.

This scenario would be used as a base for building up the other scenarios

and carrying them forward.

15



In the earlier system of LST and resale tax the following taxes were

applicable under this scenario:

- LST on sale of all intermediate products with retention in case of

set-offs for inputs.

- Resale tax of 0.5% to 1% on resale of final products (i.e. at each

stage of distribution)

- Surcharge on LST on a number of different sectors or for specific

players.

- Excise duty as applicable

- Turnover tax

Under the new system of VAT all the above taxes would be replaced by a

single tax – VAT.

• Inter-state purchases of intermediate product and intra-state

sales of final product

Here, the intermediary suppliers are located in another state. This would

result in the application of CST on all inter-state purchase of raw materials

which would not provide set-off to the purchaser in both, the old system

as well as the new system of VAT. This would result in a lower benefit as

compared to the earlier scenario.

This scenario is also unlikely for the sector as a whole, but may be

applicable to a small regional player.

• Intra-state purchases of intermediate products and inter-state

sales of final product

Here, companies with a nation wide distribution channel generally carry

out a branch/depot transfer, which does not entail any indirect taxes.

However, LST is needed to be paid at the first point of sale in the new

state.

16



This scenario exists for a number of sectors where small suppliers cluster

around the larger manufacturers. The most obvious example would be the

automotive sector.

• Both, inter-state purchases as well as inter-state sales

This is the most likely scenario for a number of different sectors.

Under this scenario, the benefit of a move towards VAT would be highly

restricted due to the continuation of CST applicable on inter-state

transactions. If the schedule to remove CST completely over the next two

years is adhered to, it will result in major savings for such sectors.

Each of these has been analysed in detail for the pharmaceutical sector later

in the report.

Factors determining impact on a Sector

For the purpose of analysis the following points are considered to be of

utmost importance, and would form the guiding factors for the purpose of

qualitative impact analysis, as well as for the purpose of data collection for

quantitative analysis.

• Earlier LST rates and new VAT rates

- The higher the difference in rates at the sales point, the greater

the benefit in terms of reduced taxes

- Also, due the concept of retention and incomplete set-off on

inputs, the benefits may be higher than that implied by the

difference in rates.

• Location of manufacturing facility

- Plants located in states with higher sales tax to benefit due to

the reduced rate of VAT, in case of intra-state sales (cement)

17



- Multi-location manufacturing facilities would also imply higher

inter-state transactions and a reduction in benefits accrued due to

CST rates of 4% applicable.

• Input purchase pattern

- Players procuring raw materials from within the state

(automobiles) to benefit due to the full input credit.

- This may also result in clustering of small suppliers and their

movement within the same state as compared to their major

customers.

•

Sales pattern

- Players going in for stock transfer (automobiles) will have to

realign strategies to take into account the lost credit on the input

purchases.

- Inter-state purchases would also entail a major cost as compared

to intra-state purchases due to non-availability of input credit.

• Concessions on inputs

- Input costs will increase for players (consumer durables) who

currently enjoy concessional rates lower than 4 per cent, since their

inputs will now be taxed under VAT at 4 per cent.

• Exemptions

- Current sales tax exemptions will be changed to sales taxdeferrals. Players operating in notified backward areas will be

outside the VAT net.

18



Impact of VAT implementation on the Pharmaceutical Sector

Summary - Implications of VAT for manufacturers:

1. Full input credit available on intra-state purchases (withoutretentions)

2. Zero-rating of exports (Earlier, retention on inputs present)

3. Removal of CST (Benefit due to high level of inter-state

purchases and sales)

4. High impact (increase in taxes) on high-margin products with

outsourced production

5. May lead to consolidation / clustering of ancillaries and small

suppliers, reduction in outsourcing and increased vertical

integration

6. Pricing power may generally increase for pharmaceutical

companies

7. Cost to consumers may increase in case of increased taxes

payable

The unique structure and special provisions for the pharmaceutical sector

are discussed below:

• The pharmaceutical sector can be segmented on the basis of for/usage

as:

- Intermediaries

- Bulk Drugs

- Formulations

The impact on each would be studied in following sections.

19



• Many Indian pharmaceutical companies have a number of production

facilities, both in India as well as abroad. Also, their production units are

widely dispersed, thus being present in a number of states.

• Many companies have tie-ups with various international companies, and

have significant imports as well as exports. Exports may form more than50% of revenues for various companies.

• Most companies have vertically integrated value chains, thus having

presence in one or more of the above mentioned segments.

• Due to the above two factors, and the vast and dispersed Indian

pharmaceutical market, result in significant inter-state transactions, which

reduces the benefits for these companies, as they would continue to pay

CST and not be able to avail of VAT credit. However, with further evolutionof the VAT system, and phasing out of CST, the benefits accrued are likely

to increase. Also companies with significant exports would be less

impacted as exports are zero-rated and full VAT credit is available on

inputs.

• Currently, in the state of Maharashtra, due to the lobbying from the

association of pharmaceutical dealers and retailers, the structure of VAT

has been modified. Effectively, it has been modified into a single point

(rather than multiple-point) tax on the MRP of the drugs.

• Before the implementation of VAT, the sales tax structure for the

pharmaceutical sector was based on a single point tax at the first point of

sales. This provided the scope for tremendous tax savings through

licensed manufacturing (outsourcing). The following procedure was used

for the same:

- The pharmaceutical company would outsource production to a

licensed manufacturer, who would work on small margins.

- The sales tax would have to be paid at the point where the licensed

manufacturer would sell the output to the pharmaceutical company.

- The pharmaceutical company would then add its overheads and

margins and push the products down the supply chain.

20



- As the licensed manufacturer would be operating on thin margins,

the sales tax paid by him would be much less, as compared to that

which the company would have to pay.

- However, with VAT now applicable on MRP rather than sales price,

the benefit of such licensed manufacturing would now be nullified.Companies would need to look as outsourcing from a strategic

perspective, and not as a ‘tax-saving’ device. Only, companies

deriving some real benefit from outsourcing may now rely on it.

• Production from multi-state production facilities is consolidated at a

central warehouse before carrying out a branch transfer through C&F

agents. This is mainly due to the fact that the products (Tablets and

capsules) are low weight – high value in nature thus requiring delivery

in smaller quantities.

Assumptions

Certain assumptions have been made in order to simplify quantitative

analysis. The assumptions made here are as close to reality as possible.

1. Arithmetic average rate of LST = 8-10 % exists for most pharmaceuticalproducts.

For the purpose of analysis the following has been assumed:

• It is presumed that under new VAT Rules for depot transfer 4% retention

will be calculated on sale price only and not on MRP

• Chemicals were mostly taxed @ 4% plus Turnover Tax and Surcharge

• Bulk Drugs were mostly taxed @ 4% No Turnover Tax and No Surcharge

• Medicines were taxed @ 9% No Turnover Tax and no Surcharge

• No resale Tax was applicable on Chemicals, Bulk Drugs and Medicines

• Retention up to June 2004 was 3 % and from July 2% Hence local tax in

excess of 2 % was available as Set Off

21



2. The following value chain is present in the pharmaceutical sector. This

would form the basis of the analysis and determine the flow of goods:

3. CST of 4% is applicable on all inter-state transactions.

4. The margins (on which VAT is chargeable) are as follows in the

pharmaceutical sector. Values in brackets indicate amount of stock held:

• Bulk Drugs: RMC – 60-70%, Margins 10 %

• Licensed Manufacturer (specially for high margin products):

Paid a maximum of 30% of MRP, Margins – very low – 5-10%• Pharmaceutical Company (formulations): Margins – 10-20%

• C&F Agent – 1-2% (3 weeks inventory)

• Stockist – 3-4% (1-2 weeks inventory)

• Wholesaler – 8-10% (10-15 days)

• Retailer – 20% (1 week)

22

Chemicals entity manufacturer

Bulk Drugs manufacturer

Retailer

Wholesaler

Stockist

C&F Agent/Branch Transfer

Formulations

Licensed Manufacturer



5. For the purpose of analysis the following figures will be held constant

throughout:Price to consumers is assumed to be Rs. 1000 plus any taxes

including excise. This is done to show the impact of changes in tax

structures clearly on the margins of players, although this is not exactly

as per the actual scenario.6. In Maharashtra, a circular (No.VAT-2005/Act/VD-1, Copy attached) has

been issued to create a system of single point VAT collection (at the final

stage of manufacturing on MRP of that product).

7. Under the single point taxation, the VAT paid would percolate down the

system and would finally be recovered from the final consumer.

8. The single point system reduces the necessity of dealers and retailers to

keep detailed accounts for purchases and sales being made for

pharmaceutical products.

9. Sources of inputs

• Intra-state purchases (Low, 10-15%, varying)

• Inter-state purchases (Remaining, CST applicble)

• Imports (Relatively low, no sales tax payable)

10. Sales

• Intra-state (10-15% max)

• Inter-state (80-90%)

• Exports (Varying, may be very significant)

11. Need for Licensed manufacturers

• Tax – saving

• Reducing company liability such as Product liability, Labour Liability,

Factory / Government dealings

23



24

Maharashtra

Supplier B

10,000

Andra Pradesh

Supplier C

5,000

Imports

Supplier D

10,000

Maharashtra - Licensed Manufacturer A

1,000 Units

Sales Price Rs. 30 per unit

Input Costs26,900(-)LST Credit (3% Retentionon LST)60026,300(+) Profits3,700Sales to

Pharma Company X

(Same State)30,000(+) 9% LST2,700Invoice

Price32,700

9% LST900

= 10,900

4% CST200

= 5,200

8% Import Duty800

= 10,800

Sale by Maharashtra - Pharmaceutical Company X

Total Sales1,000 unitsWithin Maharashtra @ Rs 100 per

unit400 unitsOutside Maharashtra @ Rs 100 per unit600

units

To Maharashtra Distributor D1

400 UnitsSales (400 x 100)40,000(+) ResaleTax (0.5%)200Invoice 40,200Sold

to retailer @ Rs. 200 per unit

Outside State -

Transfer to Co. Depot600 units No CST, No VAT Credit

Savings due to Depot

transfer = 2400 – 1620

= Rs. 780

Outside State - Distributor D2

600 unitsSales (600 x 100)60,000(+)

CST2,400(-) LST

Credit1,620Invoice60,780Sold to

retailer @ Rs. 200 per unit

To Maharashtra Retailers

400 Units

Sales (400 x 200)80,000(+) Resale Tax

(0.5%)400Invoice 80,400Sold to finalcustomer @ MRP Rs. 300

To Outside State - Retailers

600 Units

Sales (600 x 200)1,20,000(+) LST Tax

@ 9%10,800Invoice 1,30,800Sold tofinal customer @ MRP Rs. 300

To Final Customers

400 UnitsSales (400 x 300)1,20,000(+) Resale

Tax (0.5%)600Invoice 1,20,600

To Final Customers

600 UnitsSales (600 x 300)1,80,000(+) Resale

Tax (0.5%)900Invoice 1,80,900



25

Maharashtra

Supplier B

10,000

Andra Pradesh

Supplier C

5,000

Imports

Supplier D

10,000

Maharashtra - Licensed Manufacturer A

1,000 Units

Sales Price Rs. 30 per unit

Input Costs26,400(-)VAT Credit

40026,000(+) Profits4,000Sales30,000(+)4% VAT on MRP of Rs.

30012,000Invoice42,000

4% VAT400

= 10,400

4% CST200

= 5,200

8% Import Duty800

= 10,800

Sale by Maharashtra - Pharmaceutical Company X

Total Sales1,000 unitsWithin Maharashtra @ Rs 100 per unit400 unitsOutside Maharashtra @ Rs 100 per unit600

unitsVAT paid – Rs. 12,000

To Maharashtra Distributor D1

400 UnitsSales (400 x 100)40,000(+) VAT

Paid4,800Invoice 44,800Sold to


To Maharashtra Retailers

400 UnitsSales (400 x 200)80,000(+) VAT

Paid4,800Invoice 84,800Sold to final

customer @ MRP Rs. 300

To Final Customers

400 Units

Sales (400 x 300)1,20,000(+) VATPaid4,800Invoice 1,24,800

Outside State -

Transfer to Co. Depot No clarity regardingVAT Credit

Savings due to Depot

transfer =???

Outside State - Distributor D2

600 units

Sales (600 x 100)60,000(+)

CST2,400(-) LSTCredit7,200Invoice55,200Sold to


To Outside State - Retailers

600 Units

Sales (600 x 200)1,20,000(+) VAT @

4% on MRP7,200Invoice 1,27,200Soldto final customer @ MRP Rs. 300

To Final Customers

600 Units

Sales (600 x 300)1,80,000(+) VAT

Paid7,200Invoice 1,87,200



Preliminary Analysis

The diagrams above were presented as part of a preliminary analysis and

use the following assumptions:

1. In the diagram above, it has been assumed that any changes in costs

resulting from the impact of VAT implementation would be borne by the

industry and not passed on to the consumers (in light of the competition

in the formulations markets). Thus, the purchase prices for the players

above do not change even after implementation of VAT.

2. The margins of the players in the above diagram have been decidedly

arbitrarily for ease of calculations. The impact would vary, depending on

the actual case varying for different companies.

3. Under the single point taxation, the VAT paid would percolate down the

system and would finally be recovered from the final consumer.

4. The single point system reduces the necessity of dealers and retailers to

keep detailed accounts for purchases and sales being made for

pharmaceutical products.

5. However, under the multiple-point system, such detailed accounting

would become necessary to avail VAT credit.

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Simulation Analysis

In order to understand the impact of VAT implementation on companies, the

above hypothetical figures have been used to create a simulation model, and

the analysis for the same has been included.

• Since the margins are held constant (a provision can be made to vary

them), the results may only represent companies having similar margin

structures. However, this structure is easily customizable, and the

margins can be changed to modify the system and make it suitable for

any company.

• Discrete probability distribution has been used to vary the composition of

inputs (intra-state, inter-state, imports) and sales destinations (intra-state,

inter-state, exports)

• Inputs and sales, from and to any one source can vary between 10% and

80% approximately.

• Sales tax under the previous regime has been assumed to be constant at

9% throughout all the states. In reality, it varied between 0-12% (zero for

life saving drugs)• Import duty is charged at 8%

• Differences due to some states not implementing VAT have been ignored.

Impact Analysis as per Simulation

As the simulation shows, for companies with a similar margin structure, a

slight to significant positive on margins will be present due to a move

towards VAT.

The most benefit will be derived by companies having:

• High export component as full input credit will now be available for the

same.

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• High local (intra-state) procurement of inputs as CST would not be

applicable and full input credit would be available.

• High levels of local sales resulting in major impact on the final price to

consumers if the benefit is passed on to the consumers.

The major benefit of the above simulation exercise has been the creation of

a customizable excel module which allows for changes in any of the

components and further analysis.

In fact, such analysis can be carried out at various levels:

• Sector – wise impact analysis (as demonstrated)

•

Company level analysis• Product-wise analysis

This will also assist in the development of a generic credit analysis model by

forming a part of it.

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Changes to Excise structure

The method of calculation of Excise Duty has been changed for the

pharmaceutical sector. It has been changed to one based on MRP rather than

that based on the sales price.

For this purpose, an abatement of 40% is available to cover the margins

provided and thus it aims to tax just the costs and not the margins of the

manufacturer.

This will reduce the benefits available from licensed manufacturing and may

result in a move towards consolidation of manufacturing facilities by major

players.

The excise duty is charged at 16% and an education cess of 2% is applicable

on the same, taking the effective rate of excise duty to 16.32%

Carrying out a quantitative analysis, we can come up to the following

conclusions:

• The change over to MRP based excise duty calculation will

negatively impact most companies.

• The products most impacted will be high margin products, with

extremely low manufacturing costs.

• Licensed manufacturers will be majorly impacted, as they would be

required to charge excise duty on the MRP. This may result in a

drastic margin reduction for such players.

• The exact impact can be calculated product – wise as follows:

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MRP of the Product Rs. 100 (assumed)Abatement available Rs. 40Excisable price Rs. 60Excise duty payable @ 16.32% Rs. 9.79Cost of production Rs. 30 (assumed)Excise duty paid earlier @ 16.32% Rs. 4.90

Difference in Excise Duty

payable

Rs. 9.79 - Rs. 4.90 = Rs.

4.89

As can be seen from the above calculations, the difference in excise duty

payable depends on the cost of production. This shows that a high margin

product will have a significant negative impact.

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Impact of changes in indirect tax structure for pharmaceutical companies and a move to Baddi, Himachal Pradesh

Himachal Pradesh received special incentives from the central government

due to its less developed industrial production facilities. A scheme as

outlined below was created in order to provide companies the incentive to

invest in these ‘backward’ areas.

Also, in the pharmaceutical sector, with a move towards VAT and an increase

in excise duty liability of such companies, the move may prove to be

extremely beneficial.

According to industry sources, close to 600 companies have set up shop in

less than a year of the state announcing special packages for the industry,

with investments going upwards of Rs 1,500 crores and much more being in

the pipeline.

The various incentives and sops being provided by the state include:

• 100% excise duty exemption for 10 years,

• 100% I-T exemption for 5 years, followed by 30% for the next five years,

• Sales tax deferment for 5 years and central sales tax at 1% for 10 years.

• Besides the availability of cheap power at Rs 2.5 per unit is also making a

big difference.

• Proximity to the very well developed and established northern Indian

markets, comprising Punjab, Haryana, Chandigarh, and J&K

• The near absence of red tape is also a huge incentive. The state has

appointed escort officers for medium and large projects to enable units

obtain faster clearances.

All these incentives are attracting scores of companies across sectors, which

face high sales tax and excise duty. Particularly after VAT, companies

31



making intermediates are looking for such tax havens to protect profitability

and reduce complications.

Currently, there are close to 80 pharmaceutical companies, 57 textile

companies, 37 food processing companies, 38 electronics companies, and 25

soap and cosmetics companies along with over 4,200 small scale industries

invested in Himachal Pradesh

A quantitative analysis has been carried out to find out the impact on

margins. The model used is similar to that used to carry out impact analysis

in case of move towards VAT.

The model takes into consideration only the quantifiable incentives. Thus the

total benefit will, in fact, be larger than that predicted by the model. Also, a

restriction of the model currently is that the figures have been developed

with certain margins assumed (as close to reality as possible). Companies

with different margin structures will be impacted differently.

As can be seen from the quantitative analysis, there will be a significant

positive impact on margins as compared to the old system due to a move

towards Baddi. IT will result in positive impact of close to 8-10% for a number

of players.

The benefits will be lower in case of high margin products.

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Credit Analysis Model

Assessing the credit-worthiness of clients (both, existing as well as potential)

is a major function of the Credit division of the bank. Implementation of VAT

will result in a major impact on the margins of the clients on the bank in

certain sectors.

For the purpose of understanding and assessing this impact, one of the

major objectives of the project has been to create a set of qualitative

questions which can help in providing a rough estimate of the impact. These

qualitative factors have been outlined earlier in the section defining the

factors of influence.

In this section, a model for quantitative analysis is proposed. This should

help the bank in formalizing the impact analysis and coming up with best

estimates of the impact on the company under consideration.

Based on the detailed analysis carried out for the pharmaceutical sector and

the factors listed earlier, the following generic model is proposed for the

purpose of finding out the impact on margins of any company.

For the purpose of exposition, HLL is used as an example here as it is a major

client of the bank and most of the required information is thus guaranteed to

be either available in the public domain or through the bank.

The following steps may be followed to come up with the impact on margins:

(All figures Rs. In crores unless otherwise stated)

1. Collect the following information:

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a. Annual or quarterly results of the company. These will provide most

of the information needed to carry out the analysis.

HINDUSTAN LEVER LIMITED Un-audited Financial Results for theQuarter ended 31st March, 2005

Continuing sales growth of 6.9%. FMCG sales growth of 7.1% led by HPC sales growth of 9.6%.

Audited results for the Year ended 31st December 2004

1. Net Sales 9,926.95

i) Domestic FMCG - HPC 6,882.82

ii) Domestic FMCG - Foods (including IceCream)

1,565.70

Domestic FMCG - Total ( i+ii) 8,448.52

iii) Exports 1,249.02

iv) Others 227.55

a) Continuing Business ( i+ii+iii+iv) 9,925.09

b) Discontinued business 1.86

2. Other Income 318.84

a) Operational 138.41

b) Financial 180.43

3. Total Expenditure (d+e+f+g) -8,489.58

a) Increase/(decrease) in stock in trade -54.87

b) Consumption of raw/packing materials -3,884.82

c) Purchase of goods -1,472.39

d) Cost of Goods Sold (a+b+c) -5,412.08

e) Staff Cost -574.84

f) Advertising & Promotions -835.98

g) Other expenditure -1,666.68

4. Interest -129.98

5. Gross Profit [1+2-3-4] 1,626.23

6. Depreciation / Amortisation -120.9

7. Profit before interest and taxation [1+2(a)-3-6]

1,454.88

8. Profit before taxation [5-6] 1,505.33

9. Provision for taxation - current tax -266

10. Provision for taxation - deferred tax -54.74

11. Taxation Adjustments of PreviousPeriods (net)

14.7

12. Profit after taxation, before exceptionalitems [8-9-10-11]

1,199.29

13. Exceptional Items, net of taxes -1.9314. Net Profit [12+13] 1,197.36

Paid up Equity Share Capital ( face value Re1 per share)

220.12

Reserves excluding Revaluation Reserve 1,871.92

Basic and Diluted Earnings per Share of Re1 (not annualised) - Rs. 5.44

Basic and Diluted Earnings per Share of Re1 (annualised) - Rs.

5.44

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Aggregate of Non-Promoters Holdings

- Number of Shares 1,066,394,333

- Percentage of Shareholding 48.45%

b. Get the division-wise breakup of sales. This is needed as the rates of

VAT and LST applicable will wary for the various divisions’ products.

Composition of Sales:

Source of Sales Amount Percentage

i) Domestic FMCG - Personal Care 6,882.82 69.33%

ii) Domestic FMCG - Foods1,565.70 15.77%

Domestic FMCG - Total ( i+ii) 8,448.52 85.11%

iii) Exports 1,249.02 12.58%

iv) Others 227.55 2.29%

9,925.09 99.98%

c. Get the rates of LST as applicable earlier for each of the divisions,

as well as the new VAT rates.

Product Categories for analysis and VAT Rates:

Food Products Non-food Products

Input LST Rates 0% 4%

Input VAT Rates 0% 4% with Credit

Output LST Rates avg 10% avg 15%

Output VAT Rates 4% 12.50%

d. Understand the distribution channel used by the companies along

with the margins provided to each link in the chain. In case of

intermediaries such as auto ancillaries, a major chunk of the sales

would be made directly to the bigger companies.

Distribution Channel and Margins

i. C&F Agent (Branch Transfer) 0%

ii. Wholesaler / Distributor 2%

iii. Retailer 10%

e. Find out the distribution of the production facilities of the company.

If these are fairly dispersed and the company operates on a nation-

wide basis, it may be safe to assume that most of the sales for thecompany will be through branch transfers on an inter-state basis (as

is the case with HLL). Also, the existence of outsourcing / licensed

manufacturing needs to be assessed

Production Facilities:

35



i. Around 80 manufacturing locations all over India

ii. Licensed Manufacturers

Breakup of Licensed Manufacturing

Consumption of raw/packing

materials 1472.39 100.00%i) Domestic FMCG - Personal Care 1020.88 69.33%

ii) Domestic FMCG - Foods 232.23 15.77%

iii) Exports 128.45 12.58%

f. Consumption, procurement source and division-wise breakup of

input materials consumed are required. This can again be extracted

from the annual reports of companies.

Consumption of raw/packing

materials

3,884.82

71.78% Considered to be inputs

Purchase of goods1,472.39

27.21%Considered to be purchasesfrom licensed manufacturers

Cost of Goods Sold 5,412.08 100.00%

Note: Raw materials consumed under each category is assumed to be in the

same proportion as sales composition

Breakup of Raw Materials Consumed

Consumption of raw/packingmaterials 3884.82 100.00%

i) Domestic FMCG - Personal Care 2693.53 69.33%

ii) Domestic FMCG - Foods 612.72 15.77%

iii) Exports 338.90 12.58%

g. The margins provided on outsourced products (to find out the

procurement cost) are needed.

For HLL, this has been assumed at 40%

2. Based on the above information an analysis similar to that of the

pharmaceutical sector can be carried out by substituting these values in

the excel sheet provided.

3. The percentage impact of margins is then derived from this analysis.

36



ConclusionVAT has been a major step forward for indirect tax reforms in India. I believe

that although in the short term, a number of difficulties will be faced by

corporates in India, over the next couple of years, as the entire system

stabilizes and the discrepancies discussed earlier such as CST are removed,

it will lead to major benefits for the Indian industry.

It will lead to the creation of a single nation wide market, and the anomalies

created to derive benefits due to differences in tax rates will subside. It will

lead to short term consolidation in a number of important sectors as well.

On the whole, the Indian industry should welcome this move wholeheartedly.

Documents

Introduction to VAT- Rep