"The centre will open a special account. The compensation to states will be treated as special grant-in-aid," official sources said, adding the government has already provided Rs 5,000 crore (Rs 50 billion) in the budget for this purpose.
At present, states receive a share of central taxes and grants from the budgetary allocation. The formula for these central transfers to states is determined by the finance commission.
Since compensation for revenue loss can neither treated as a share of central taxes or developmental grants provided in the budget, there was a need to create a separate account for that, sources said.
Last week, the finance ministry agreed to provide monthly adhoc compensations to states whose actual revenue growth from VAT falls short of the trend rate of growth.
The crisis over VAT: Complete coverage
The empowered committee on VAT had expressed reservation on the earlier compensation method based on auditors general's reports, which comes only after a quarter.
Accordingly, Centre relaxed the rules as the tax figures are not available with the Auditor General till the end of each quarter.
Compensations given by Centre would be reconciled after getting the quarterly reports from Auditors General. States will have to inform the finance ministry about VAT collection every month in order to get the compensation.
As per the compensation formula, states will get compensation if their actual collection from VAT is lower than the projected revenue calculated by taking the weighted average of tax collection in the best three years of the last five years.
Although there is a general thinking at the centre that there would not be much revenue loss after VAT implementation, the Empowered Committee has voiced the concerns of states and obtained the compensation package from centre.
The centre has promised to fully compensate states suffering revenue loss in first year of VAT implementation.
The compensation will be 75 per cent of the revenue loss in the second year and 50 per cent in the third year.