VAT Explained: A Comprehensive Guide to Value Added Tax for Suppliers of Goods & Services
Value Added Tax vs Goods and Services Tax
Value Added Tax (VAT) and Goods & Services Tax (GST) are both consumption taxes applied at various stages of production and distribution. These taxes are calculated based on the extra value a business adds at each step, which is the difference between its purchases of taxable goods and services from other businesses (inputs) and its taxable sales (outputs).
Although the consumer ultimately bears the cost of such a consumption tax, the responsibility for collecting and remitting the tax to the authorities lies with the suppliers of goods and services.
Methods for Calculating VAT
There are various methods for suppliers of goods and services to calculate VAT, including: (1) the credit-invoice method, (2) the subtraction method, and (3) the addition method.
(1) Credit-Invoice Method:
The credit-invoice method, adopted by most countries with a VAT system, requires sellers to charge VAT on all sales. The seller calculates VAT by subtracting the VAT they have already paid on business purchases (i.e. input VAT) from the VAT collected on their sales (i.e. output VAT). Output VAT is calculated by applying the VAT rate to the seller’s sales price of goods or services. The difference between output VAT and input VAT is the amount the firm remits to the tax authorities.
Final consumers, unlike businesses, cannot claim VAT credits for purchases. These credits, known as input VAT deductions, are only available to businesses. This system ensures that VAT is only applied once, at the final point of sale, preventing the tax from being charged multiple times along the supply chain and making sure the full VAT burden is passed to the final consumer.
The VAT paid at each stage of production or distribution is based on the value added by the firm at that specific stage. In theory, the total VAT paid throughout the supply chain should equal the VAT charged to the final consumer (i.e. the sales price of the good or service to the final consumer multiplied by the VAT rate).
To claim a VAT credit, taxpayers must retain purchase invoices from their sellers that contain the name of the taxpayer and the amount of VAT collected by the sellers. At the end of a reporting period, taxpayers calculate their VAT liability by subtracting the total VAT amount stated on their purchase invoices from the total VAT amount on their sales invoices. The credit-invoice method enhances VAT enforcement by allowing tax auditors to cross-check records between firms, as the VAT on one firm's sales invoice should match the VAT on another firm's purchase invoice.
(2) Subtraction Method
The subtraction method calculates VAT by applying the VAT rate to the firm's net value added, which is determined by subtracting the firm’ inputs (i.e. purchases of taxable goods and services from other businesses) from its outputs (i.e. taxable sales). This method is also called a business transfer tax.
Unlike the credit-invoice method, which relies on sales and purchase invoices, the subtraction method may use a firm's financial or income tax records, as it focuses on the difference between sales and purchases to determine VAT liability.
(3) Addition Method
The addition method calculates VAT by applying the VAT rate to the firm's value added, which is determined by adding together its inputs that are not purchased from other taxpayers (i.e. untaxed inputs such as wages, interest, and profits).
Like the subtraction method, the addition method may measure value added by using income tax or financial accounting records rather than sales and purchase invoices. However, the addition method focuses on the items of production that the subtraction method ignores, making it a mirror image of the subtraction method. These two methods are considered alternative but essentially equivalent ways to calculate VAT.
Treatment of Capital Purchases
The tax treatment of capital purchases, such as plant and equipment, can vary under VAT systems. There are several ways VAT on capital inputs might be handled:
- Expensing Capital Purchases: In some cases, VAT on capital purchases is treated like any other input, meaning that firms can deduct the VAT paid on these purchases immediately. This approach effectively excludes capital goods from the VAT tax base, similar to how expensing works under an income tax system.
- Amortizing VAT on Capital Purchases: Alternatively, firms may be required to amortize the VAT paid on capital goods over the expected life of the asset. This means the VAT is credited against the firm’s VAT liability gradually, instead of being fully deducted in the year of purchase.
- No Deduction for Capital Purchases: In certain situations, firms may not be allowed to deduct VAT paid on capital purchases at all, which would increase the overall tax burden on these investments.
The credit-invoice method supports immediate expensing by allowing firms to take a credit for VAT paid on capital goods in the year they are purchased. The subtraction method, on the other hand, offers more flexibility by allowing capital costs to be either expensed immediately or amortized over time.
VAT Relief
A VAT system may exclude certain goods, services, or taxpayers from VAT for economic, social, political, or administrative reasons. This relief is typically provided through zero-rating or exemptions.
Zero-Rating
When a taxpayer or product is zero-rated, the sale is treated as a taxable transaction, but the VAT rate is 0%. Although no VAT is collected or remitted on sales, taxpayers must still register with tax authorities under the VAT system. Importantly, zero-rated taxpayers can claim a credit (in the form of a VAT refund) for the VAT they paid on the inputs used to produce that product. Sellers of a zero-rated product do not collect VAT on their sales of the product but can still claim a credit (including a VAT refund) for the VAT they paid on their inputs.
Exemption
Exempt taxpayers do not register with tax authorities and thus are not part of the VAT system. They do not collect VAT on their sales and cannot claim a VAT credit for their input purchases, unlike zero-rated taxpayers. If a business sells both exempt and non-exempt products, it must separate its VAT liabilities accordingly by allocating its VAT payments between the two kinds of sales.
Further Considerations
Under the credit-invoice method, purchasers of exempt products generally cannot claim a VAT credit for VAT paid on inputs. This breaks the chain between inputs and outputs along the production and distribution process and can lead to VAT cascading, where VAT is charged multiple times throughout the supply chain potentially resulting in the total VAT exceeding the retail sales price for the end consumer, when multiplied by the VAT rate.
Commentators generally prefer zero-rating over exemptions to prevent this issue. However, exemptions can simplify administrative tasks for small businesses, as they do not require registration requirements. To the extent exemptions are used, the subtraction method is often preferred over the credit-invoice method to avoid VAT cascading.
Border Adjustments for Exports and Imports
Most countries with a VAT system apply “border adjustments” by zero-rating exports and taxing imports. This approach ensures that both domestically produced and imported goods are taxed equally within a country, maintaining a level playing field in the global market.
- Exports: Under the border adjustments, exports are zero-rated, meaning exporters do not collect or remit VAT on goods and services sold to foreign buyers. Although no VAT is charged on exports, exporters can still claim refundable credits for the VAT they paid on inputs used to produce these goods or services.
- Imports: In contrast, importers must collect and remit VAT on the full price of imported goods and services when they bring them into the country. This is because VAT was not applied to the inputs for these products.
VAT Global Implementation
Currently, over 170 countries have VAT, including all OECD member countries except the United States. Standard VAT rates vary among countries, ranging from 4.5% in Andorra to 27% in Hungary for 2024.
The European Union (EU) has made ongoing efforts to harmonize the VAT systems across the EU Member States, primarily through EU Directives. However, full harmonization has yet to be achieved. Significant variations remain in areas such as tax rates, relief for certain goods, services or taxpayers, and special rules for imports and exports among EU countries.
Potential US Adoption of VAT
In the United States, state and local governments already levy a retail sales tax on goods and services within their jurisdictions. There are no constitutional barriers preventing the US federal government from imposing a federal VAT. A model for this coexistence can be seen in Canada, where the federal government imposes a VAT while some provinces maintain their own retail sales taxes (e.g. British Columbia, Manitoba, and Saskatchewan). This suggests that introducing a federal VAT in the US would not pose major coordination challenges for state governments or businesses.
Resources
For a brief primer on the indirect tax system in the United States see A Guide to Understanding Indirect and Direct Taxes
Further information is available at: