In the production process output of a manufacturer may become the input of another manufacturer. Thus, when tax is based on selling price of a product, burden of tax will go on increasing as tax on subsequent stages are levied on tax on earlier stages. This is known as cascading effect. For example, let us assume that the tax rate of a product is 10 % of the selling price. Manufacturer X sells goods to Y for Rs. 110 (inclusive of tax of Rs. 10 i.e. 10 % of selling price of Rs. 100). Y uses such as input and incurs conversion cost of Rs 90. If Y sells such goods to Z, the value of such goods will be Rs. 220 (Rs. 200+ 10% of Rs 200). Tax is levied by Y on Rs. 200 which includes tax of Rs. 10 levied by X. Thus, tax is levied on tax also. In fact, value added by Y is Rs. 90 (Rs 200-Rs 110). So, tax should be Rs. 9 (i.e. 10% of value added). In this way, tax liability goes on increasing on every transfer.
To remove the above defect, MODVAT (MODIFIED Value added) Credit scheme was introduced in 1986. Later on, this scheme was renamed as CENVAT (Central value added) Credit scheme which came into force from April, 1, 2000.
CENVAT Credit Scheme:
If a manufacturer pays excise duty for purchases of materials used by him as input in the process of manufacture, he will get credit of such duty paid from the duty payable on sale value of his output so that the duty payable shall be on the ‘value added’. Such scheme is known as CENVAT Credit scheme.
Let us assume that the rate of excise duty is 10 %. Let A raises invoice of Rs. 220 for goods sold to B which includes excise duty of Rs. 20. B uses the same inputs and incurs conversion cost of Rs. 80. B sells such goods to C and raises invoices of Rs. 308. While calculating cost of input a Rs. 200 (and and Rs. 220 as he is allowed a credit of duty paid amounting Rs. 20 under CENVAT Credit Scheme) and the conversion cost of Rs. 280 @ 10 %. Excise duty is charged on Rs. 280 @ 10% and B raises invoice of Rs. 308(i.e. Rs. 280 + 10 % of RS. 280) to C. thus. The effective duty payable by B is Rs 8 (Rs 28- RS 20) which implies that the duty is levied on ‘value added’ by B (i.e. 10% of Rs .80).
Persons entitled to CENVAT Credit: According to rule 3(1) of the CENVAT Credit Rules, a manufacturer or producer of final products shall be entitled to CENVAT Credit of specified duties paid on input or capital goods received in the factory.
Products for which CENVAT credit is available: CENVAT Credit is available to all ‘final products’ and capital goods received in the factory. According to rule 3 (e) of the CENVAT Credit Rule, ‘final products’ means excisable goods manufactured from input except matches. Rile 2 (g) of the CENVAT Credit Rule defines the term ‘input’. High Speed Diesel Oil (HSD), Light Diesel Oil (LDO) and Motor Spirit (Petrol) are not ‘input’ and hence not eligible for CENVAT Credit.
Thus, from the above explanation one can have a general view of CENVAT Credit scheme.