The New VAT ACT
In the FY2019/20 budget speech, Honorable Minister of Finance has announced the introduction of a new VAT Law effective from 1 July 2019. The Value Added Tax and Supplementary Duty Act 2012 was enacted in December 2012 after three years of preparations for completing the draft with inputs from international and national experts and extensive consultations with the business community. At the time of enactment of the law it was understood that effective implementation of the new law will require three years of preparations in terms of automation of the VAT administration and restructuring of the VAT administration along functional line. Accordingly, as per the original plan, the VAT Act 2012 was supposed to be implemented on 1 July 2016 (at the beginning of FY2016-17 budget). In the event, due to delays in automation and resistance from the business community, a new VAT Law has been introduced after seven years. However, the new VAT law is a compromise outcome entailing fundamental and sometimes arbitrary changes to the original VAT Act 2012.
The purpose of this paper is to: identify the major changes made to the VAT Act 2012; analyze the implications of the changes for the operations of the VAT administration; assess the implications of the changes in terms of tax incidence and the consequent price impact on the consumers; impact on the level of protection offered to domestic producers through Supplementary Duty (SD) applied at the import stage; and infer about the impact on industrial structure and for the Small and Medium Enterprise (SME) sector.
Major changes made to the VAT Act 2012
The budget speech of the Honorable Finance Minister and the accompanying Finance Bill mentioned a number of major changes to the VAT Act 2012 as part of government’s understanding or political compromise with the business community represented by the Federation of Bangladesh Chamber of Commerce and Industries (FBCCI). The changes were made to ensure smooth implementation of the new VAT Act.
The most important change was with respect to introduction of multiple VAT rates. Under the new VAT Act 2012 (as Amended in 2019), the government will move away from a uniform 15% VAT rate envisaged in the VAT and Supplementary Duty Act 2012 and instead introduced many VAT rates: 15% at the import stage; 10% at domestic manufacturing stage; 7.5% at wholesale stage; 5% at retail stage; and several other lower effective rates—ad valorem and specific as stated in Schedule 3–on selected products primarily to limit price pressures arising from the changes made under the new system. One saving grace is that, domestic manufacturer, wholesalers and retailers may still opt for the original 15% VAT rate with full input tax credit, if they consider that advantageous from their business point of view.
The second most important change was elimination of input tax credit, which is at the heart of any VAT system, when VAT paid by suppliers are at rates different from 15%.
The second most important change was elimination of input tax credit, which is at the heart of any VAT system, when VAT paid by suppliers are at rates different from 15%. Domestic manufacturers and other suppliers paying VAT at rates different from the 15% rate will not be able to take input tax credit. The decision to eliminate the input tax credit provision for supplies at rates different from 15% is understandable because if input tax credit is allowed, in many instances there will be refund of taxes to the manufacturers and other suppliers entailing substantial revenue loss for the government. The input tax credit will generally exceed the VAT on the output at every stage of production and sales as long as downstream VAT rates are lower than 15%. For example, take the case of a domestic manufacturer who adds 20% value at the manufacturing stage on inputs imported from abroad (valued at BDT 100) and sells the product to a wholesaler at BDT 120 after including the value addition of BDT 20 for nation-wide distribution. The manufacturer paid Tk. 15 as VAT at the import stage, and after completion of the manufacturing process his total VAT will be (10% of Tk. 120) BDT 12. If the manufacturer is allowed to take full input tax credit, he will deduct BDT 15 from his BDT 12 output tax, and claim BDT 3 as net refund from the VAT authorities. The same situation will be repeated at the wholesale and retain levels. Thus a fully operational input credit system is not possible under the multi-rate and multi-stage VAT rates system as designed and implemented in Bangladesh.
Reliance on advance collection of VAT at the import stage has further increased under the new VAT law by requiring all importers to pay advanced VAT at 5% rate.
Reliance on advance collection of VAT at the import stage has further increased under the new VAT law by requiring all importers to pay advanced VAT at 5% rate. This withholding rate is too high which implicitly assumes that the importers would be adding at least 33.3% value addition when they sale the imported products or processes further through the manufacturing process. There is no way that a commercial importer will be adding 33.3% value addition by selling the imported items in the domestic market. There is no way that commercial importers would be able to adjust this advance VAT by selling the products in the domestic market, and accordingly they will simply increase prices by this amount and pass on this tax to buyers and create cascading of taxes. Even for most manufacturers it will be difficult to adjust this advance tax against their output tax because their manufacturing/processing stage value addition may fall well short of the 33.3% level.
The principle of not using supplementary duty for protection purpose was once again violated as it was the case under the VAT and Supplementary Duty Act of 1991. The original 2012 VAT Act intended to reduce dependence on supplementary duty and also lower the level of domestic protection by reducing the long list of items subject to supplementary duty and applying the SD rates equally on both domestic and imported goods and services. In the event, the new VAT Act maintained the discriminatory nature of SD by applying it primarily on imports. As a result, instead of reducing the degree of protection offered through SDs, the level of protection further increased in FY2020 budget.
In most respect the new VAT Law deviates fundamentally from the VAT Act of 2012 and is very similar to the VAT Act of 1991.
In most respect the new VAT Law deviates fundamentally from the VAT Act of 2012 and is very similar to the VAT Act of 1991. First, the number of items subject to rates other than 15% under the new law are listed in Schedule 3 of the VAT Act which is part of the FY2019-20 Finance Bill. The list is very similar to the list of products subject to truncated base or tariff value based system under the VAT Act of 1991. Second, similar to the 1991 law, the new VAT law does not allow input tax credit for those firms which are producing/supplying items listed in Schedule 3 of the new VAT Act. Third, with the loss of input credit chain, the documentary connection or paper trail will be lost for the truncated suppliers which will reduce tax compliance. Fourth, the loss/truncation of input credit chain will affect other VAT registered persons or sellers of goods and services who buys these products because they would not be able to take credit for whatever amount of VAT they paid even if the VAT registered persons are paying VAT at the rate of 15 percent. Finally, the original version of VAT Act 2012 did not have any requirement for price declaration by VAT registered suppliers/sellers because this provision was considered to be unnecessary and contrary to the way businesses are operated in any country. However, the new VAT law has inserted a new provision (under Section 72.5) which requires all registered firms to submit input-output coefficients in specified manner to their respective VAT offices. This new provision is completely unnecessary and fundamentally deviates from the accounts based operation of the VAT system.
Administrative changes envisaged at the time of VAT 2012
The originally envisaged 3-year lag in implementing the 2012 VAT Law was to (i) introduce a fully automated VAT administration without any or very little manual intervention; (ii) restructure the VAT administration along functional lines from the current geographical based system in which one VAT official is responsible for the jurisdiction—VAT commissioners for the commission rates, Deputy Commissioners for Divisional Offices, and Assistant Commissioners for Circle Offices (the lowest level of VAT office)– looks after all relevant issues associated with VAT administration in that VAT jurisdiction; and (iii) introduction of Electronic Cash Registers at all important retail outlets to monitor turnover at retail level VAT outlets. In order to put in place an automated VAT system, the National Board of Revenue (NBR) initiated a comprehensively designed VAT on line project with financial and technical support from the World Bank. The VAT online project aimed at ease of doing business through fully automated registration system, fully automated on-line VAT return submission, and fully automated VAT payments through VAT registered person’s bank account.
At the NBR front, the project also aimed at: (i) automated return processing along with flagging of any identified inconsistencies; (ii) sending amended tax returns (if needed) or sending automatic non-filers notices to those who have failed to submit their VAT returns on time; (iii) automated tax file or case management including automated personal tax records and e-mail and SMS communications with taxpayers without personal (face to face) interactions; (iv) selection of tax returns for audit purpose based on criteria based online system; and (v) management of audit program and audit reports using off-site and on-site visits.
Current state of automation of the VAT administration
Progress with VAT automation process has gone through periods of ups and downs, depending on the signals from the political authorities. The project gained a lot of traction during 2015-17 till the 2-year postponement right before the formal introduction with the FY2018 budget. Although preparations were not completed some of the important modules like VAT Taxpayer Registration and VAT on Line Return Submission were completed with field testing. Other modules like setting up the online payment system and on-line taxpayer ledger were almost ready. The phone/mobile phone help desk to assist taxpayers with different aspects of the VAT system was also set up under the VAT on-line project. These help centers were operated by private sector entities under contract with the project.
As the implementation became uncertain and the implementation period extended by 2 years but no systematic enhancement of resources was made available, most of the national and international consultants engaged under the project had to move on to their other activities and the project essentially started to drift. The persons responsible for the project on the NBR side also retired or transferred to other positions as part of regular rotation, leaving the project virtually on a drifting state and not much progress could be made until the recent introduction of the VAT Act 2012 with the FY2020 budget.
Implications of the modified/amended VAT Act 2012
What is understood according to the VAT law details provided is that only taxpayers paying 15 percent VAT rate are eligible for input tax credit while taxpayers paying VAT at various other rates will not be eligible for input tax credit. This situation will put taxpayers subject to different rates and VAT registered persons buying inputs from these taxpayers in a difficult position. The input tax credit system is a mechanism which is at the heart of a proper VAT system so that under this system, total tax incidence cannot exceed 15%, if 15% is the maximum VAT rate. Now under the new structure, all importers would need to pay 15% on their imports, but manufacturers can opt for 10% or 15% VAT rate. If the manufacturers opt for 10% VAT rate, then their tax incidence may go up to 25% if they used imported raw materials subject to 15% VAT on import stage. On the other hand, if a manufacturer uses 15% VAT rate then he is eligible for input tax credit tax and the total tax incidence will not exceed 15 percent. On the contrary, if manufacturers do not use input tax credit and the products are sold to wholesalers and retailers in subsequent stages, than total incidence of VAT due to tax on tax (cascading effect) can go up to a maximum of 37.5%, comprising: import stage 15% + manufacturing stage 10% + wholesale stage 7.5% + retail stage 5% = 37.5%. This tax incidence should be compared with a maximum of 15% VAT incidence in a properly designed VAT system.
Many countries have multiple VAT rates but that generally ranges between 3-5 rates and are applied at different rates on different products and services taking into account socio-economic and health related issues. But Bangladesh is now the only country in the world where different VAT rates will be applied to same products at different stages of processing/sales. To illustrate this more clearly, for example the product is television. If the VAT rate on the product is 20%, in all other countries applying VAT, the same VAT rate of 20% will apply at the import stage, at the manufacturing stage, at wholesale and at retail levels. But as designed in Bangladesh, the same TV could be subject to 15% VAT at the import stage, 10% VAT at the domestic stage, 7.5% tax at wholesale stage, and 5% tax at the retail stage–there will be multiple rates based on stages of sales an unique characteristic of the newly introduced Bangladesh VAT system. In other countries, if product is at say 15% VAT rate then that rate remains uniform at all stages. We will therefore be inheriting a VAT system where there will be different rates at different stages of production/sales, along with different rates for different classification of products/product groups. For instance, all manufacturing will be charged at 10% even if the product falls under a lower tax bracket.
The complications in tax administration that may arise due to this political compromise are as follows:
- Uniform tax rate is administratively very efficient and reduces scope for rate changing and loopholes for tax shifting by taxpayers. This also makes consumers more aware of the prevailing tax rates and the prices of products accordingly. Therefore, multiple rates will make the tax system much more complication and hence difficult to administer and create more room for tax evasion and shifting by tax payers, which will eventually result in loss of revenue.
- Loss of input tax credit up to the retail level will essentially mean that it will be impossible to determine how much will be the tax component and price and consequently tax incidence on consumers. Different combinations of import, production and sales would lead to different tax incidences and price impacts for the same product. It will no longer be the same for the same product.
- The most important reason for input tax credit is to make the indirect tax system independent of industrial or production structure. Manufacturers can sub-contract components to other firms without any additional incidence of taxes on production cost. Under the new VAT system, if Bangladeshi manufacturers sub-contract components of the production process to other firms such sub-contracting will be considered a new manufacturing activity/process causing additional 10% tax on the subcontracted component which cannot be adjusted by the parent firm against its output tax. In the process, horizontal structure of production–with large factories and companies sub-contracting part of the production processes to smaller ones–will become non-viable and production process will become increasingly vertical going against the global norm.
We know in countries like Germany, Mercedes-Benz sub-contracts most component of the automobile production process to small and medium enterprises (SME), which creates an ecosystem of production, help create more new entrepreneurs and large number of jobs in the SME sector, thereby contributing to thriving economy as a whole. This situation is same for all other major automobile manufacturers (like Toyota, Nissan or Hyundai) or electronics manufacturers across the globe, and this practice is only possible since these countries have developed and implemented a fully functioning proper VAT system that does not hamper with the production structure (which is a choice to be made freely by the business enterprises and not in response to the tax structure) or in other words, the production structure should remain VAT neutral for the VAT system to be efficient. One of the prime reasons for more than 160 countries to adopt properly functioning VAT by replacing the old-fashioned excise tax system is to avoid cascading of taxes and put in place a tax system that is neutral to industrial organization and promote horizontal business integration/expansion.
As a result of our new VAT law, our factories/companies will integrate all the production processes under one roof/premise through a process termed as “vertical integration” and the biggest loser of this will be the SME sector. This will impact the RMG sector as well, because large RMG enterprises often outsource a part of their production to smaller factories that cannot compete and export orders directly from the international sourcing companies. This will effectively put SMEs in a serious disadvantageous position. Most countries around the world have adopted the VAT system because of the tax neutrality of the production system; this inherent benefit will be completely lost under the new VAT system.
The new VAT system will also be disadvantageous for the firms who will be operating under the 15% VAT rate as originally in operation since 1991. Any purchases made from VAT registered firms who are paying at rates different from the 15% rate, will not be able to get input tax credit even if the purchaser is paying VAT at 15% rate. Thus even 15% VAT payers would also not be immune from the tax-on-tax (cascading) effect. Since most retailers and wholesalers are likely to opt for the lower VAT rates, the scale of the problem may become significant.
The multiple VAT rates will also create problem with transparency in accounts. Most VAT registered persons who are engaged in wholesale and retail trade would opt for lower VAT rates and forego input tax credit in order to avoid transparent books of accounts. For the most part value addition at the retail level is about 10% to 20% at best, which means with proper VAT at 15 with full input tax credit the tax incidence at that level will be 1.5% to 3%. But these entities are interested to pay 5% or more and opt out of the standard VAT system just to avoid standard books of accounts. These businesses are aware of the fact that proper VAT is in their interest because its tax incidence will be low and VAT will be entirely passed on to the final consumers. But, they are more afraid of dealing with income tax liability resulting from transparency in books of account than paying VAT at higher rates. The net result is that, the buoyancy in direct taxes that many countries have obtained through the introduction of VAT and improved accounting will not be applicable for the NBR in Bangladesh.
Will the state of automation and administrative restructuring bring any benefits to the taxpayers?
Although the VAT Law 2012 envisaged a completely automated taxpayer friendly system of tax administration and registration and payment systems in reality NBR is very far from that. This automated system is not ready as yet and only VAT registration process has been automated and online return submission process has been tested with large taxpayers. It is also regrettable that even the VAT online registration process has been manualized to a great extent by the NBR. As designed, persons can apply for VAT registration on line but the online process is only limited to submission of online registration form. The form then goes from the central server to the field offices for field verification which takes time and very often following up with the field officers by the applicant. This manual intervention is completely unwarranted and undermines the automation process by delaying the whole process and establishing direct contacts with the VAT field offices and officers. Since this so-called automated registration process is not free from human intervention, this still leaves room for delays, corruption and speed money. There are plans for automation at submission of returns and payments of taxes, we have not yet seen how this process will work, but apprehensive that the NBR in all likelihood would try to make the process manually controlled and require physical presence of taxpayers at tax offices. All other modules like development of taxpayer’s ledger with all relevant financial information related to taxpayers, automated processing of returns and payments, and audit module are being developed. The automated system is still in the testing stage and knowing the nature of NBR, it runs the risk of becoming manualized with human interventions at every stage.
The other key element of improving VAT revenue collection was the introduction of Electronic Fiscal Devises (EFD) at every VAT outlet and its effective monitoring with a view to increase compliance with the new VAT system. The idea is good, but if we review the past performance of NBR with Electronic Cash Register (ECR) system we should be skeptical about the EFD introduction as well. ECRs were supposed to be introduces at least 10-15 years ago. It was mandated by law for many types of VAT registered enterprises, but there was no follow up and no compliance. A few years back the former Minister of Finance announced that ECR machines will be imported by the government and distributed to the registered outlets. In the event, years passed but the tendering process for ECRs could not be completed. I the mean time ECRs have been replaced by EFD world-wide, but NBR could not complete its tendering process. Since FY17 the government has decided to introduce EFDs in place of ECRs because of their enhanced functionality, but as of now no single EFD is operational in Bangladesh. Furthermore, NBR has not made any preparations for monitoring the EFDs at the central monitoring unit.
The restructuring of the NBR administration, from geographical to functional line, which is a standard practice in any modern tax administration, has already been discarded by the NBR due to opposition from the field level.
The restructuring of the NBR administration, from geographical to functional line, which is a standard practice in any modern tax administration, has already been discarded by the NBR due to opposition from the field level. A plan was prepared to align VAT administration along functional lines with strengthened capacity building at the NBR level, but it never got accepted for implementation, perhaps because of strong opposition from within the NBR. There was an expectation that once the VAT administration is reorganized along functional lines, this will serve as the model for other NBR wings (Direct tax and Customs) to be reorganized along similar lines. Given the disappointment with the reorganization of VAT administration, it is very clear that administrative restructuring of the NBR along functional lines is not going to take place in the foreseeable future.
The new VAT Law has all the characteristics of VAT Act of 1991 which it replaced, and also made it more complicated in terms of withholding of Advanced Tax at 5% rate at the import stage and by combining multiple tax rates on different products with multi-stage VAT. In essence the new VAT law has all the characteristics of the 1991 VAT Act and additional distortions. It is not only “old wine in a new bottle” but in all likelihood should be more appropriately characterized as “more contaminated wine in a new bottle”. In this sense, Bangladesh is moving backward rather than forward, whereby we are reverting back to the old excise system instead of a proper VAT system, which was the objective of the VAT Act of 2012, as it was enacted in December 2012. Consultations with business community is important, and some trade-offs at the margin are also acceptable, which was already done before the parliamentary approval of the 2012 VAT Act. However, the major changes that have been made to the already parliament-approved original VAT Act of 2012 just before its implementation in 2019 have fundamentally changed the character of the 2012 VAT Act by trading away the basic principles of VAT for having something which is basically excise duty. Bangladesh does not have a VAT system anymore, what we have should be renamed as Excise-cum-VAT Act of 2019 not the VAT Act of 2012 and what we have is a very complicated mixed system not to be found anywhere in the world!
We are not sure how much adverse impact this new VAT law will have on the consumers, on revenue collection, and on the SME sector. Only time will tell. However, it can be foretold that the NBR and the government should be prepared for another round of VAT reform and related tax administration reform in not too distant future if they really want to put the VAT system back on track.