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This paper presents a new control algorithm for a shunt active power filter to compensate harmonics and reactive power required by nonlinear loads. If the utility voltage is distorted, active power filter (APF) allows similar level of distortion in the compensated source current. Therefore, the resultant source currents have the same waveform as that of the supply voltage, thereby attributing the responsibility of utility and customer at the point of common coupling (PCC). Due to similar shape of the source voltage and currents, reactive power is compensated completely. The proposed scheme provides an additional feature of compensation of either only harmonics, or both harmonics and reactive power simultaneously, based on the desired capacity of the APF. Various simulation results are presented with ideal and distorted mains voltage and compared with other algorithms. Proposed algorithm is implemented as a prototype to verify the simulation results.