Value-Added Tax | Income | Consumers | Retailers | Manufacturers | Raw material producers
While taxes are an inevitable part of life, have we ever wondered how the Value Added Tax or VAT system works — that has been implemented in Nepal for the past 25 years?
VAT applies to all of us, both as consumers and as businesses. Understanding the nuances of VAT, including its ins and outs, is important whether we spend our income on consumption (from cereals to mobile phones) or business that makes purchases or sales of goods and services.
And with the government running out of cash in recent times and consequently imposing VAT on onions and potatoes this budget, the details of VAT, how it is collected and affects every one of us has become more important to understand.
First and foremost, the government raises revenue (raajaswa) through tax and non-tax means to meet its annual plans and program expenditure — the budget or say to meet resources for financing a sustained growth of public investment, although it doesn’t solely depend on revenues but also on external and internal debts and grants.
Taxes can be direct or indirect.
Direct taxes are paid directly by individuals/entities to the imposing authority — for instance income tax, property tax, land tax, and vehicle tax.
VAT is an indirect form of tax, levied upon goods and services before they reach the end consumer who ultimately bears that tax as a part of the price of the goods or services they purchased. Custom (bhansaar) and excise duty (anta shulka) are other examples of indirect taxes.
For clarity, non-tax revenue includes royalties (for instance from mountaineering, electricity, forestry, mining and quarrying, and water and other natural resources), fees from national parks, and fines and penalties.
What is VAT? How does it operate?
An indirect form of tax, VAT is a tax levied on goods and services at every stage of the supply chain where value is added — designed to be a multi-stage tax system as the tax is collected by all sellers in each stage of the supply chain.
Businesses charge an additional 13% VAT on their sale invoice, but that doesn’t mean they bear the tax. Suppliers, manufacturers, distributors, and retailers all collect VAT on taxable sales but the VAT amount levied on a good or service is borne by its end consumer. However, it is still misconstrued that merchants are responsible for paying the VAT which has led to negligence at the consumers' end in demanding VAT bills.
For business enterprises who act as different sellers in each stage of the supply chain, the difference between the VAT collected on sales (output VAT) and the VAT paid on purchases (input VAT) determines whether the business owes money to or is eligible for a refund from the government.
For instance, in a year, if the tax amount collected on sales is more than the tax amount paid on purchases, the business owes the difference to the government while it is eligible for a refund if otherwise.
Reasons for introducing VAT in Nepal
The introduction of the VAT system through the Value Added Tax Act 1996, replaced four taxes — Sales Tax, Contract Tax, Hotel Tax, and Entertainment Tax — levied on most businesses in 1996.
The objective was to modernise and increase the efficiency of the county’s tax system and enhance revenue mobilisation. The new tax system however could not be fully implemented until fiscal year 1998/99 due to political instability and resistance from the business community.
The preamble of the Act suggests that VAT was majorly commenced as a means of expanding the tax base and generating stable revenue for the government, reducing the risks of tax evasion.
The preamble reads, “Whereas, it is expedient to make the process of revenue collection effective by levying the Value-Added Tax on all kinds of transactions including the sale, distribution, transfer, import or export of goods and services and recovering the tax through a systematised process for increasing the mobilisation of revenue needed for the economic development of the country.”
The standard VAT rate in Nepal is 13% since 2005, which was earlier set at 10%.
Businesses must register for VAT with the Inland Revenue Department (IRD) as defined by different criteria under the Act.
In the fiscal year 1999/2000, the formative year of the VAT implementation, the number of businesses registered under the VAT system had already crossed 17,000. As of mid-2022, the number of taxpayers registered for VAT had reached 314,076 which was 214,109 by mid-July 2019, says the Economic Survey 2022.
The VAT system applies to goods and services consumed domestically and imported into the country. Exported goods are exempted from VAT based on destination principles of international taxation — meaning that suppliers are allowed a refund of input VAT.
One of the rationales behind applying VAT to imports is to keep a level playing field for domestic producers so that they can compete on equal terms with foreign-based suppliers.
Overall, VAT seemed to be a tax system that would reduce tax compliances and administrative loads of enterprises, but such was not the major case.
VAT’s contribution to national revenue
There is no doubt that the VAT system has boosted tax collection.
Since its implementation, VAT revenue has significantly increased — from Rs 8.35 billion in FY 1997/98 to Rs 314.3 billion in FY 2021/22 — by almost 38 times.
Its share of contribution to total government revenue has however shown a declining trend if the records between the fiscal year 2017/18 and 2021/22 are considered, which can be partly attributed to the post-pandemic effect.
In its early years, VAT contributed 32.19% of total tax revenue which is still hovering around the same range while the VAT-to-GDP ratio is between 5.5-6.6.
One glaring fact about most of the gains/revenue in VAT is that it is highly import-based hovering around the extent of 60-65%, which also points out weak internal VAT revenue mobilisation.
Why should the existing VAT system be under scrutiny?
There have been significant changes in the global economy, such as the rise of free markets, globalisation, technological advancements, and changing business models, and our economy cannot remain untouched.
Although VAT has been in implementation for 26 years now, the VAT performance in revenue mobilisation isn’t impressive. Also, while the taxation systems around the world are being reviewed and restructured to stay true to changing economic needs, the Value Added Tax Act 1996 has not seen any remarkable amendments although the act is amended around 25 times.
The burden on the poor
A major criticism is the enforcement of a single VAT rate for all products and services. Since the VAT rate levied on luxury products remains the same as basic and usual goods, the indirect tax burdens the lower-income consumers who spend the majority of their income on consumption. Case in hand, the government this year slapped a 13% VAT on essential goods (imported) such as onions, potatoes, garlic, and beans through the Financial Bill 2023 which removed 170 goods from the tax-free list of the act. Another example is VAT on sanitary pads which makes the regular use of pads for girls dearer.
The single VAT rate, which does not distinguish between basic and luxury goods, also distorts national revenue. For example, when consumers are spending a significant amount on luxury products and when VAT rates are standard, the government is unable to capitalise on people's buying habits.
Economies such as South Asia have adopted a multi-tiered tax structure with varying tax rates for different categories of goods and services to comply with the needs of their consumers.
For instance, India introduced a Goods and Services Tax (GST) in 2017, which replaced multiple indirect taxes levied by the central and state governments. The GST rates in India are divided into five slabs: 0%, 5%, 12%, 18%, and 28%. The VAT system in Sri Lanka until 8 June 2022 appiled a standard rate of 8%. Following its worst-ever economic crisis, it was revised to 12% and then to 15%.
VAT bill fraud
VAT bill frauds involve individuals frequently producing and issuing fake VAT bills to evade taxes which is tantamount to stealing from the treasury and pocket taxes that are paid by the public.
For instance, when a phony Rs 100 purchase VAT bill is submitted, it results in a loss of 25% income tax and 13% VAT, and a total tax avoidance of 38%.
Similarly, when you make a purchase at a retail store or a pub that won’t issue a VAT bill, they’d pocket the tax paid by you.
Investigations and numerous incidents have demonstrated that small to large corporate enterprises are engaged in VAT avoidance.
On July 16, 2017, the Commission for the Investigation of Abuse of Authority (CIAA) filed cases against three members of the Tax Settlement Commission (TSC) at the Special Court on the charge of embezzling Rs 10.02 billion in what is the biggest corruption case in Nepal’s history.
The TSC was formed in 2015 with a mandate to collect outstanding tax dues, mainly from sick industries in a bid to revive them, but even companies faring well and making sound profits enjoyed tax exemptions.
Companies like Ncell and Tribeni Distillery, for example, which were capable of paying taxes, were exempted from paying billions of rupees under the scheme.
Enterprises that collected VAT paid by the general public were also exempted. As many as 20 companies that were involved in fake VAT bill scandals in the past were also given tax exemptions.
When a team from the Internal Revenue Department raided a Bhatbhateni departmental store on January 19, 2011, it was discovered that the store had increased expenses based on fictitious VAT bills to evade taxes.
The same year the Internal Revenue Department established an inquiry committee to look into VAT bill fraud. The committee, led by Lakshman Aryal, then the department’s deputy director general, came to the preliminary conclusion that there had been an evasion of 3.25 billion rupees tax amount.
In 2012-13, big VAT-registered firms were found producing fake transaction bills in the name of fake firms, instead of filing VAT returns based on taxes paid by consumers of goods and services.
Later on, the inquiry established that 518 business organisations had produced fraudulent VAT bills in order to dodge paying 3.7 billion rupees in VAT, 3.33 billion rupees in income tax, and 205 million rupees in excise duty.
In March 2019, the Department of Revenue Investigation filed a case against 24 individuals associated with 24 firms on charges of evading taxes amounting to Rs. 1.75 billion through the production and issuance of fake VAT bills. Similarly, a large number of such VAT evasion cases are still ongoing in court.
These fraud incidents of enormous sizes that make news every now and then raise questions about the integrity of the business community, and both integrity and capabilities of tax administrators.
VAT system in need of reforms
The government must pay close attention to the VAT system as the collection of VAT amounts affects how the social security schemes are funded and can be a key factor in the country’s transition from a least developed to a developing country.
Any businesses or organisations with zero transactions for 12 months will face withdrawal and cancellation of their VAT registration certificate, according to the existing provisions. Almost one-third — around 31% — of taxpayers filed for zero returns in FY 2021/22, says the IRD, which must be scrutinised and held accountable if necessary.
Firms filing for debit returns (firms’ VAT liability/payables to the government) comprised almost 23% while 45.7% were credit returns (VAT receivables from the government), which is another worrisome stats considering the vast discrepancy.
The issue of VAT bill fraud underscores the need for authorities to take timely measures and implement effective laws.
For this, the VAT invoicing mechanism where business operators refrain from voluntary issuing of invoices unless buyers seek one needs regular monitoring and strong punitive measures combined with informational campaigns to educate the public on the concept and importance of demanding VAT bills.
Business managers must be aware of tax evasion within their company as they can be held liable for such actions. Also, taxpayers should, with professional assistance, understand how much they owe in taxes to prevent any unintentional tax evasion.
The Inland Revenue Department (IRD) which facilitates the collection of VAT must also modernise as an institution and ensure its Chartered Accountants and auditors handling tax-related tasks for different organisations are adequately resourced to prevent corruption and ensure efficiency and effectiveness in the taxation system.
As the tax regime usually attracts powerful nexus between administrators and interest groups, which is not an exception in rich countries either but more dangerous for poor economies, structural institutional reform of the IRD is highly desirable to check the powerful role of tax administrators and their bargaining power to resist reforms that bury loopholes.
For businesses, tax compliance is costly due to burdensome processes with registration, filing, need for accounting, and payment, particularly for MSMEs.
Embracing and promoting digitalisation is one way to go about modernising the taxation system and administration, making the VAT regime business-friendly and resilient to fraud and corruption.
Owing to many factors, a considerable size of the economic transactions is still outside the tax net. The existing VAT system lags behind in complying with changing economic needs and ensuring fairness and efficiency. Categorising goods into basic, mid-range, and luxury items with corresponding tax rates could be the beginning of reform.
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