This paper seeks to demonstrate how a conceptual framework of value addition can aid in identifying risky assessees, selecting them for detailed scrutiny and investigation to combat evasion of VAT/GST.

The model framework presented below is founded upon the direct additive method of computing value addition.

In the direct additive method, value addition is computed from the aggregate expenses less expense on tax paid inputs plus the operating profits, and tax rate is applied on such value addition for assessing VAT/GST.

An estimate of VAT/GST payable as per this framework gives a good benchmark for estimation of tax compliance under the indirect subtractive method in which input tax credits are subtracted from the tax payable on the gross value of goods or services supplied.

Since tax payers have little incentives to understate their business expenses and their operating profits in a capital market environment, this framework also provides an effective tool for audit control on their self assessed returns.

In a single tax rate regime as in Cenvat, VAT/GST payable during the financial year as assessed by indirect subtractive method = gross tax payable on output input tax credit utilised txVf txVI = t(Vf - VI )= txVA, where t is the tax rate, Vf is the aggregate value of output sold during the year, VI is the aggregate value of inputs in respect of which tax credit has been utilised during the year, and VA(=Vf Vi) is the aggregate value addition or tax base during the year.

The same tax base (VA) can be computed through direct additive method from profit and loss account after making suitable adjustments as shown below:

Value addition for the purpose of levy of VAT/GST in a financial year, VA = Sum of all expenditures in the profit and loss account + operating profit booked in the account value of taxable inputs in respect of which credit was availed and utilised during the year value of exempted finished goods sold /services provided value of export goods/services in respect of which no tax is paid net stock of goods in inventory other income during the year.

Using the given framework, we see how value addition and Cenvat payable can be computed and how compliance rate, which is the percentage measure of Cenvat actually paid over what is payable according to the above model framework, can be estimated.

Take for instance Cenvat compliance rate for Bhilai Steel Plant in 2001-02 (All figures in Rs crore):

VA= 4,366 (aggregate expense) + 297 (profit) - 613 (cost of inputs) - 143 (value of export goods plus exempted goods) = 3,907
Cenvat payable= 3907x0.16= Rs 625.12
Cenvat actually paid = 625
Compliance rate=100x625/625.12= 100%
Now consider Cenvat compliance rate for a steel factory near Delhi in 2007-08 (Rs crore)
VA= 441.72 (aggregate expense) + 14.50 (profit) - 355.30 (cost of inputs) - 26.54 (value of non-duty export goods plus exempted goods)- 9.2 (inventory)- 3.3 (other income)= 62
Cenvat (including education cess of 3%) payable @ 16.48% = 62x0.1648 = 10.22
Adjustment for goods cleared in March 2008@14.42%= 20.20x0.0248= 0.5
Cenvat payable in 2007-2008= 9.72
Adjustment for net Cenvat credit lying in balance= 0.33
Adjustment for Cenvat credit capital goods utilised = 1.23
Adjustment for input service tax credit utilised = 1.35
Net Cenvat payable= 9.72-0.33-1.23-1.35 = Rs 6.8
Cenvat actually paid = 0.215
Compliance rate = 100x 0.215/6.8=3.16%; Tax gap = 6.585

A sensitivity analysis is required to be done to see if the compliance rate is underestimated and tax gap overestimated. Only possible scenario of overestimation is the case where manufacturing expenses include expenses on taxable inputs other than capital goods and input services.

In this case that scenario is absent. On the contrary, some of the raw materials included in the cost of raw materials, Rs 355.30 crore, are not subjected to Cenvat and therefore the tax gap is underestimated to that extent.

What emerges from the above analyses is that it is necessary and desirable to develop a risk management system (RMS) for GST with the compliance rate/tax gap as the crucial risk assessment parameter. The RMS will enable tax administrations to accept without audit and investigation returns for companies like BSP whose compliance rate is high.

Audit control and enforcement machinery may thus entirely focus on companies such as the one shown above with low compliance rate and huge tax gaps the RMS select as risky. Such a RMS would make both state and central GST administration efficient and effective without making them obtrusive.

The policy implications regarding design and administration of GST/VAT also emerge from the framework:

(a) Single rate tax regime is better from the points of view of efficient administration and effective enforcement;
(b) The broader the tax base and lesser the exemption, the better the tax design from the perspective of efficiency, equity, neutrality, and effective enforcement;
(c) Exemptions complicate assessment, leave scope for transfer pricing, and make the tax structure less e-governance friendly;
(d) Developing audit, enforcement, and the risk assessment is likely to lead to higher level of compliance of the indirect subtractive form of GST; and
(e) If an automated assessment and audit modules are developed on the suggested lines, increase in the number of tax payers due to lower threshold level of exemption will not pose any problem for central GST administration.