Do you speak VAT? You know, Value Added Tax!
Here in the U.S., sales tax is the name of the game, but in most countries around the world, VAT (or GST, IVA, TVA, IPI, ICMS, ISS among other acronyms) is how things run.
If you work with sales tax, you understand terms such as nexus, sale for resale, and digital goods. But do you know what an input credit is? How about permanent establishment or place of supply?
If those terms are foreign to you, read on. We’ll explore some critical VAT terminology and concepts to make things clearer for indirect tax professionals. If you need to get oriented with VAT, (and most companies selling goods online do) this is a good place to start and get your bearings.
Let’s jump in and start exploring VAT terminology!
This is one of the big tax types that you’ll see in the world of VAT.
Output VAT is the charge by the supplier (seller) to the buyer on taxable supplies (sales) that is then remitted to the local tax authorities.
Most of the time, this is the VAT that sellers will charge and collect on their sales. Only registered taxpayers must collect output tax and remit it to the authorities (i.e., consumers who are not taxable persons will not collect).
To compare it to the U.S. tax structure, Output VAT is similar to sales tax or seller’s use tax, which are charged by the seller and paid by the customer. Not too dissimilar from U.S. sales tax so far…
Input VAT is what makes VAT what it is, and it’s what really differentiates VAT from sales tax.
Input VAT is the tax paid by the seller to its suppliers on purchases of goods and/or services. The seller is paying the tax to its suppliers, but it is designed not to be a cost to businesses. In most circumstances, Input VAT is recoverable (more on that in a second).
The use of the Input VAT is completely different than what you find in the U.S. sales tax structure. In the U.S., typically if you purchase items that you intend to resell prior to making any significant use of them, there is no sales tax due on your purchase. This is called a “Sale for Resale.” In the U.S., purchasers claiming a resale exemption provide a resale certificate to the seller and thus avoid paying tax on the purchase. VAT uses a different mechanism called…
Input tax credit (ITC) is a crucial term to understand when speaking about VAT. It’s the mechanism by which a seller can reclaim the Input VAT that it has paid to suppliers. In other words, it is the tax credit used to offset payment of VAT by a person other than the final consumer. And what really makes this tax structure different from the US Sales Tax is that this Input Tax Credit is allowed on virtually all purchases made by a business – not just on inventory and other items resold! So in the end, businesses incur virtually no VAT cost (unless they are the type of business that is exempt from VAT).
In short, the seller pays tax to its suppliers, charges tax on the final sale to its consumer, and uses the Input Tax Credit to reclaim the tax paid to its suppliers. The Input Tax Credit is usually taken on the VAT return. And if there is a net negative amount on the return, a cash refund is often paid by the government to the business!
Permanent establishment is essentially physical presence in a taxing jurisdiction. It is a fixed place of business that is permanent enough to give rise to VAT liability within a jurisdiction. This is one of the most common ways to create a VAT obligation.
Permanent establishment could be an office, warehouse, a branch of the company, or something similar.
In the U.S. this is simply referred to as “physical presence,” which will automatically create nexus for sellers in a taxing jurisdiction.
Place of supply is the jurisdiction where the VAT should be remitted for a given transaction. Place of supply comes up frequently with cross-border (country-to-country) transactions.
A similar concept in the U.S. tax structure is sourcing, which is how you determine which taxing jurisdiction the sales or use tax should be remitted in.
In VAT countries, Electronically Supplied Services (ESS) is the legal term for digital products (such as downloadable software, music, video games, etc.) and/or automated services delivered via the Internet. You may also hear the term E-Services used for this.
In the U.S., the term “digital goods” is commonly used to describe the same items.
Countries have been developing various ways to capture tax on the sales of Electronically Supplied Services, and the European Union (EU) has developed two different schemes, the first of which is…
The Union Scheme is a simplified scheme to report cross-border sales of electronically supplied services inside the EU. This is specifically for business parties making supplies of e-services from one EU member state to another EU member state. The other scheme is…
The Non Union scheme is a simplified scheme to report cross-border sales of electronically supplied services originating outside the EU. This is very similar to the union scheme, but it’s for businesses that are not registered in the EU and are making their supplies from outside the EU.
Yes, similar to what is happening in US after the SD v Wayfair decision, sales of electronically supplied services by businesses without a permanent establishment within a country are required to collect the VAT. In most countries this only applies on sales to unregistered consumers – B2C types of transactions.
Clear as mud, right? And this is just scratching the surface!
Looking at the terminology used for Value Added Tax makes it obvious that this is a whole different ball game compared to U.S. sales tax. Not only is the terminology different with VAT, but the way the tax system works is completely different too!
If you work for a business selling into or operating in multiple countries, there is a good chance that you have VAT obligations and need to manage this compliance as a part of your duties. If you’re not well-versed in VAT and how to stay compliant, you’re creating tremendous risk for your company.