Value-added tax: What is VAT and who has to pay it?

What is VAT? A simple enough question.

The answer? Not so simple.

That’s why we’re here to help. We’ll explain the basics of VAT in uncomplicated language to grant you a clear understanding of this widely used tax system.

Value-added tax — commonly referred to as VAT — is a broad consumption tax applied to goods and services when value is added through the stages of the supply chain. Sellers generally collect the tax from consumers at the point of sale by adding it to the cost of the product. It’s similar to sales tax in the United States in that the final VAT is usually charged to the customer.

How does VAT work?

A product’s VAT is calculated and collected at each stage of the supply chain. Each seller charges the current-stage VAT to the cost of an item for the buyer — unlike with sales tax, which is typically collected only by the end seller (i.e., on the final sale). With VAT, the final seller then adds the full tax to the product's price, which the consumer pays. The seller then remits VAT to the tax authority.

For U.S. consumers, this may seem like double taxation, but it isn’t. Only each value addition is taxed, not the sale of the product itself. The seller only charges for their portion of the tax.

An example: A raw materials dealer sells its product to a factory for £101, £1 of which is VAT. The raw material dealer sends the £1 to the tax authority.

With the material, the factory produces laptop batteries, which it sells to a laptop manufacturer for £202. £2 is VAT — £1 of that reimburses the factory for VAT it paid to the raw materials dealer, the other £1 it pays to the government for its VAT.

The laptop manufacturer then sells the laptops to a computer retailer for £303, which includes a £3 VAT — £2 reimburses the manufacturer for VAT paid to the factory, and £1 goes to the tax authority.

Finally, the computer retailer sells a laptop for £404 — keeping £3 of VAT for reimbursement and sending £1 to the government.

Each additional £1 along the supply chain represents the value added at each stage.

What is the purpose of VAT?

Just like all taxes, VAT’s purpose is to raise government revenue. As a consumption tax, it does this via consumer purchases.

VAT was intended to be a more direct, less complicated system than the sales tax system in the U.S., for example. When the European Union was established, the original six countries needed a system that would streamline and standardize their various multistage, indirect taxation forms.

VAT is easier to track than the previous tax systems because it’s levied at each stage of the supply chain, and all merchants are required to maintain meticulous records of purchases, sales, and supplies.

Must my business pay VAT?

Three criteria dictate VAT collection:

  • Registration threshold
    Business activities that exceed a set monetary amount establish an obligation for companies to charge and pay VAT. Thresholds vary by country and depend in part on whether the seller is a resident or a nonresident. For example, the United Kingdom’s threshold is £85,000.

  • Permanent establishment
    A business that proves an appropriate permanence and structure for human and technical resources must register for VAT. An office building owned or rented for the company is an example of permanent establishment.

  • Specific activities
    Certain business activities constitute a VAT obligation, such as legal services. As with registration thresholds, these activities vary by country.

If you find your business qualifies for VAT filing, you must register before doing business in the country or collecting and paying VAT. There are several options in the EU for simplified VAT registrations and reporting for non-EU B2C sellers, including One-Stop Shop and Import One-Stop Shop.

Some goods and services that may be exempt from VAT:

  • Postage stamps
  • Charitable fundraising
  • Education training
  • Commercial property selling or letting
  • Insurance and financial services

Reclaiming VAT

Companies can also reclaim VAT on certain items that are used exclusively for their business operation, including:

  • Employee travel
  • Mobile service costs for business communication
  • Automobiles used for business and their fuel and maintenance
  • Portions of utilities for a home-based business

How do you file and pay VAT?

VAT returns are official tax documents used to file VAT. They detail all your organization’s transactions, applicable taxes, and calculate what you owe or what will be refunded.

Every country sets its own VAT filing deadlines, reporting frequencies, and formats, including whether you can file VAT online. Some tax authorities insist on electronic filing, some allow it as an option, and others don’t offer it at all. Some entities also permit international bank transfers, and some mandate local direct deposit or bank account transfers.

Filing VAT can be a tedious endeavor. It requires you to keep meticulous records that include receipts of all your purchases and invoices that contain VAT. You’ll also need to supply records and accounting period summaries with information such as:

  • Total sales and purchases
  • Total VAT you owe
  • Total VAT you can reclaim

Even if you break even and owe or reclaim nothing, you must file a VAT return. If you’re audited and you failed to keep appropriate records or file false returns, you could suffer substantial fines and penalties.

Does the U.S. use VAT?

Approximately 170 countries use VAT, but the U.S. isn’t one of them. The U.S. stands as the only major economy that uses a “sales and use” tax. And the only similarity between the two systems is that both impose the final tax onto the consumer.

VAT is controlled at a federal level, but the U.S. system is dictated by states — in many parts of the country, cities and certain other jurisdictions apply local and special district sales taxes on top of state sales tax. Also, the U.S. tax bears enormous variations in rates and obligations, but VAT typically has a maximum of three rates. For instance, in the UK, the standard rate is 20%, the reduced rate is 5%, and the zero rate, 0%.

Supporters and opposers of VAT fuel an active argument about whether the U.S. should adopt a similar system. Those in favor cheer its purported simplicity, efficiency, and tax loophole reduction. Those opposed fear the government’s potential to get carried away, as VAT could greatly increase government revenue and without reining in, frivolous spending. They also cite its lack of transparency for consumers and heavier burden on lower-income citizens — which is also a common complaint about sales tax.

To dig deeper into the EU and U.K. post-Brexit VAT particulars, review our guide: 5 steps for managing VAT in the EU and UK post-Brexit

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