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

If you plan to do business outside of the United States, you’ll need to figure out value-added tax (VAT) sooner or later. It’s the most common consumption tax in the world.

This post will help you understand this widely used tax system by answering the following questions:

What is VAT?

Value-added tax (VAT) is a broad consumption tax assessed on the value added to goods and services as they move through the supply chain. This includes labor and compensation charges, interest payments, and profits as well as materials.

As with other consumption taxes, including goods and services tax (GST) or retail sales taxes, consumers pay value-added tax. VAT is not a charge on businesses — though sellers are responsible for collecting and remitting it. 

How does VAT work?

VAT is typically collected at each stage of the production chain and distribution of goods or the provision of services.

For U.S. consumers, this may seem like double taxation, but it isn’t. In fact, it’s designed to be a neutral tax. Each seller or supplier applies VAT only to the value added at that stage. Moreover, most businesses can take a credit or deduction for the VAT they pay (input VAT) to offset the VAT they collect and remit (output VAT).

“As the final price of the product is equal to the sum of the values added at each preceding stage,” explains the European Commission Taxation and Customs Union, “the final VAT paid is made up of the sum of the VAT paid at each stage.” With the final sale, the retail consumer pays VAT on the full purchase price and bears the burden of the tax because they can’t deduct input VAT.

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

The factory uses the materials to produce laptop batteries, which it sells to a laptop manufacturer for €202. €2 is VAT. The factory deducts €1 for the VAT on the raw materials and remits the other €1 to the government.

The laptop manufacturer then sells the laptops to a computer retailer for €303, which includes €3 VAT. The manufacturer deducts €2 input VAT and sends €1 to the tax authority.

Finally, the computer retailer sells a laptop to a consumer for €404, including €4 VAT. The retailer deducts the €3 tax paid to the manufacturer and sends €1 to the government.

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

What’s the purpose of VAT?

Just like other indirect taxes and income tax, VAT’s purpose is to raise government revenue.

The VAT system was designed to be more direct and less complicated than sales taxes or gross turnover taxes. VAT is easier to track than some tax systems because it’s levied at each stage, and all merchants are required to maintain meticulous records of purchases, sales, and supplies. It’s also administered by the federal government rather than numerous state and local governments.

That said, value-added tax has historically been relatively easy to avoid. The European Union has long suffered from an extremely high VAT Gap: the difference between the amount of value-added tax revenue expected and the amount actually collected and remitted.

While unintentional shortfalls like bankruptcies and miscalculations certainly play a part in this, the European Commission estimates “one quarter of the missing revenues can be attributed directly to VAT fraud linked to intra-EU trade.”

Requiring electronic invoicing (e-invoicing) and real-time reporting for cross-border transactions could help reduce VAT fraud by up to €11 billion a year, while also lowering administrative and compliance costs. Thus, e-invoicing and real-time reporting mandates are becoming more common.

Does my business need to register for VAT?

VAT requirements vary by country, but usually you need to register to collect and remit VAT in countries where you:

  • Have a permanent establishment; 
  • Meet the value-added tax registration threshold; or 
  • Engage in certain activities.

Permanent establishment
You typically need to register for VAT if you have a permanent establishment in a country with a VAT regime. This includes a fixed place of business or the fixed place of business of someone acting on your behalf. Having employees in the country could also create a VAT obligation.

Registration threshold
In many countries, nonresident businesses are required to register for VAT if their business activities exceed a set monetary amount. You must register for VAT in the United Kingdom if your VAT taxable turnover is more than £85,000, though you may voluntarily register for VAT at any time.

VAT thresholds vary by country and are subject to change.

Specific activities
Certain activities, such as hosting a convention in the country, may establish a VAT obligation for a nonresident business.

If your business qualifies for VAT filing, you must register for VAT before doing business in the country or collecting and paying VAT.

The European Union offers simplified VAT registrations and reporting options: the One-Stop Shop (OSS) and the Import One-Stop Shop (IOSS). Learn how Avalara can simplify EU VAT compliance for your business.

VAT rates

VAT rates are set by each country just as sales tax rates in the United States are set by state and local governments.

However, members of the European Union must abide by several basic VAT rules:

  • Countries must have a standard VAT rate and may have up to two reduced rates 
  • The standard VAT rate cannot be less than 15%
  • The reduced VAT rate(s) cannot be less than 5% 

There are three VAT rates in Germany as of July 2023: a 19% standard rate for most transactions; a 7% reduced rate on specified products and services, including certain food products; and a zero rate for international and intracommunity transport.

The EU also permits three kinds of special rates:

  • Super-reduced rates of less than 5%
  • A zero rate 
  • A parking rate, or intermediary rate, that’s less than the standard rate but no lower than 12% 

Automating the collection and remittance of VAT helps ensure you apply the proper rate to each transaction.

 

Can you be exempt from VAT?

EU countries must exempt supplies of certain goods or services and can choose to exempt certain other supplies. Common exemptions include education, healthcare, and financial services.

An exemption is not the same as a zero rate. When a transaction zero-rated, the consumer doesn’t pay VAT, but the seller (or supplier) has a right to deduct value-added tax paid on related purchases. When a transaction is exempt from VAT, the seller or supplier cannot claim a deduction for input VAT paid; there what’s known as a “hidden” VAT.

Reclaiming VAT

You may be able to receive a VAT refund for tax paid on qualifying expenses. Companies can generally recover or reclaim VAT on certain items used exclusively for their business operation, including:

  • Car rental
  • Employee travel
  • Mobile service costs for business communication

Every country sets its own rules regarding what and how nonresident businesses can reclaim VAT from abroad. Learn more about how to reclaim VAT in the EU.

How do you file and pay VAT?

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

Different countries have different VAT filing deadlines, reporting frequencies, and formats. Some tax authorities insist on electronic filing, others accommodate but don’t require it (though if it’s allowed, it’s generally preferred). Tax authorities throughout the EU must allow you to submit your return online. As for payment, some entities permit international bank transfers, while some mandate local direct deposit or bank account transfers.

Filing VAT can be tedious. 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
  • The VAT you can reclaim

You may need to file a VAT return even if you have no VAT to report: The EU VAT Directive says returns must be made at least once a year, and many EU countries require monthly or quarterly returns.

Failure to keep appropriate records could lead to substantial fines and penalties, as could filing late or false returns. The U.K. changed the way penalties and interest apply to late VAT payments and returns effective January 1, 2023.

Is there VAT in the U.S.?

Approximately 170 countries use VAT or the similar GST, but the U.S. isn’t one of them. The U.S. is the only major economy to use a retail sales and use tax.

Unlike VAT, which is controlled at the federal level, U.S. sales tax is dictated by state and local governments. All but five states levy a state sales tax, and 38 states allow local sales taxes, creating more than 13,000 sales and use tax jurisdictions. The U.S. sales tax system is incredibly complex.

Tax experts and politicians periodically weigh the pros and cons of creating a U.S. value-added tax. In 2018, for instance, the Congressional Budget Office determined a 5% VAT could help reduce the deficit by raising revenues “without discouraging saving and investment by taxpayers.” However, it would be costly for the government to set up and administer and could place a heavy tax burden on lower-income citizens — a common complaint about sales tax.

Avalara can help you manage international tax compliance. Contact us to learn more. 

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