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Table of Contents
Acknowledgements.......................................................................2
Objectives of the project...............................................................3
Value Added Tax – Introduction and Issues.....................................4
Local sales tax structure...............................................................................................................7
Value-added tax Structure............................................................................................................8
......................................................................................................................................................8
Advantages of VAT.....................................................................................................................9
Changes due to VAT - General Implications for Indian Industry.............................................11
Model developed for Impact Analysis...........................................15
Factors determining impact on a Sector.....................................................................................17
Impact of VAT implementation on the Pharmaceutical Sector........19
Assumptions...............................................................................................................................21
Preliminary Analysis..................................................................................................................26
Simulation Analysis...................................................................................................................27
Changes to Excise structure.......................................................................................................29
Impact of changes in indirect tax structure for pharmaceutical companies and a move to Baddi,
Himachal Pradesh......................................................................................................................31
Credit Analysis Model..................................................................33
Conclusion..................................................................................37
1
Acknowledgements
I would like to thank the following people who have constantly guided me in
this endeavor.
• Mr. Sanjeev Paul, India Head, Client Relationships, Middle Markets
• Mr. Amit Tanna, Western Region Head, Client Relationships, Middle
Markets and project guide
• Mr. Predeep Iyer, Western Region Head, Credit Analysis, Middle
Markets and project guide
• Mr. Rohit Gulati, Manager – Sales and Credit Services, Client
Relationships
• Mr. Ajit Jain, Executive Director, Ipca Labs
• Mr. Yogesh Parikh, Director – Finance, Unimark Remedies Ltd.
2
Objectives of the project
The following objectives have been defined for this project by the bank as
per their requirements:
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 broad
agreement 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.
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:
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• VAT has not been implemented in the following states:
o Uttar Pradesh o Tamil Nadu
o Rajasthan o Jharkhand
o Madhya Pradesh o Chhattisgarh
o Uttranchal 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.
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.
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Local sales tax structure
Rs 60 collected
and paid by input Rs 206 paid by
supplier
manufacturer
To government
Rs 28 collected
and paid by Rs 33 collected
dealer
and paid by retailer
To government
7
Value-added tax Structure
Rs 200
Rs 60 Rs 200 - 60 = 140
collected by
collected and paid paid by
Manufacturer
by input supplier manufacturer
To government
To government
Input
Manufacturer Dealer Retailer
Supplier
Rs 250 Rs 250
collected by collected by
dealer retailer
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Advantages of VAT
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
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.
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.
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Changes due to VAT - General Implications for Indian Industry
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
3. 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.
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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
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
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.
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
There are two types of registration. The first is VAT Dealer registration
and the second is Composition Scheme Dealer registration.
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amount. It is apparently for retail traders and there is a limit of turn over
for option under composition scheme.
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.
The dealers who import raw materials into the state would not be eligible
for the composition tax.
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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 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:
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.
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In the earlier system of LST and resale tax the following taxes were
applicable under this scenario:
Under the new system of VAT all the above taxes would be replaced by a
single tax – VAT.
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.
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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.
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.
- 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.
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- Multi-location manufacturing facilities would also imply higher
inter-state transactions and a reduction in benefits accrued due to
CST rates of 4% applicable.
• Sales pattern
• Concessions on inputs
• Exemptions
18
Impact of VAT implementation on the Pharmaceutical Sector
The unique structure and special provisions for the pharmaceutical sector
are discussed below:
- Intermediaries
- Bulk Drugs
- Formulations
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 than
50% 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 evolution
of 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:
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- 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.
Assumptions
• 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
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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:
Licensed Manufacturer
Formulations
Stockist
Wholesale
r
Retailer
10. Sales
• Tax – saving
• Reducing company liability such as Product liability, Labour Liability,
Factory / Government dealings
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Maharashtra Andra Pradesh Imports
Supplier B Supplier C Supplier D
10,000 5,000 10,000
Outside State -
To Maharashtra Distributor D1 Outside State - Distributor D2
Transfer to Co. Depot
400 Units 600 units
600 units
Sales (400 x 100)40,000(+) Resale Sales (600 x 100)60,000(+)
No CST, No VAT Credit
Tax (0.5%)200Invoice 40,200Sold CST2,400(-) LST
Savings due to Depot
to retailer @ Rs. 200 per unit Credit1,620Invoice60,780Sold to
transfer = 2400 – 1620
retailer @ Rs. 200 per unit
= Rs. 780
To Maharashtra Retailers
400 Units To Outside State - Retailers
Sales (400 x 200)80,000(+) VAT 600 Units
Paid4,800Invoice 84,800Sold to final Sales (600 x 200)1,20,000(+) VAT @
customer @ MRP Rs. 300 4% on MRP7,200Invoice 1,27,200Sold
to final customer @ MRP Rs. 300
25
Preliminary Analysis
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
• 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.
• 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.
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.
This will reduce the benefits available from licensed manufacturing and may
result in a move towards consolidation of manufacturing facilities by major
players.
29
MRP of the Product Rs. 100 (assumed)
Abatement available Rs. 40
Excisable price Rs. 60
Excise duty payable @ 16.32% Rs. 9.79
Cost of production Rs. 30 (assumed)
Excise duty paid earlier @ 16.32% Rs. 4.90
Difference in Excise Duty Rs. 9.79 - Rs. 4.90 = Rs.
payable 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
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.
The various incentives and sops being provided by the state include:
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.
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.
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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.
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.
The following steps may be followed to come up with the impact on margins:
33
a. Annual or quarterly results of the company. These will provide most
of the information needed to carry out the analysis.
34
Aggregate of Non-Promoters Holdings
- Number of Shares 1,066,394,333
- Percentage of Shareholding 48.45%
Production Facilities:
35
i. Around 80 manufacturing locations all over India
ii. Licensed Manufacturers
36
Conclusion
VAT 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.
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