A quick VAT Primer

This is a very quick overview of the terminology and workings of VAT in the EU. It isn’t intended to be exhaustive, but it should cover the basics and help you to understand the more detailed material supplied by EU member states’ VAT administrations.

This guide was written on the 1st of January 2015 and should be accurate for that date. Nevertheless, the author accepts no responsibility for any errors container herein; if in doubt, check with a qualified accountant or your own tax authority.

What is VAT?

Value Added Tax, or VAT, looks from the perspective of a consumer to be the same as a Sales Tax — that is, a tax based on the price of the item they have purchased.

The main difference between the two is that a true Sales Tax is only applied at the point of sale to a consumer. VAT, on the other hand, is applied for every intermediate transaction involved. For instance, imagine company A makes a widget, which it sells to a wholesaler, B, who then sells it on to a retailer, C, from where it is finally sold to a consumer, D. Let’s also say tha the rate of Sales Tax or VAT we’re considering is 10%. Here’s what happens in both cases:

Sales Tax

  1. Company A sells widget for £10 to Wholesaler B.
  2. Wholesaler B sells widget for £15 to Retailer C.
  3. Retailer C sells widget to Consumer D for £20, plus £2 sales tax.
  4. Retailer C now pays the £2 to the government (typically — sometimes Consumer D might need to pay it instead).

VAT

  1. Company A sells widget for £10 plus £1 VAT to Wholesaler B. On its tax return, Company A lists the £1 as “output” tax, and Wholesaler B lists the £1 as “input” tax.

  2. Wholesaler B sells widget for £15 plus £1.50 VAT to Retailer C. On its tax return, Wholesaler B lists the £1.50 as “output” tax, and Retailer C lists the £1.50 as “input” tax.

  3. Retailer C sells widget to Consumer D for £20, plus £2 VAT. On its tax return, Retailer C lists the £2 as “output” tax.

  4. Each of the companies now pays the difference between their output and input tax to the government, so Company A pays £1, Wholesaler B pays £0.50, and Retailer C pays a further £0.50.

    The total received by the government is still £2, but it has been collected piecemeal from all of the suppliers in the chain.

Implications of VAT

The first implication of the above is that all businesses are going to have to file tax returns for VAT purposes, because they need to account for the “input” tax (tax that has already been paid) and “output” tax (tax they have collected on a sale).

The second implication is that government is going to have to regulate invoices and credit notes, because those are going to be the primary source of information on how much VAT is payable, and they must be usable as proof of tax paid by businesses claiming input tax as well as showing clearly the amount of output tax that has been collected at each step.

Additionally, supply chains are rarely as simple as the above; typically, Company A would have multiple inputs to its widget, and would want to claim the input tax on each of those.

One further complication is that, as with Sales Tax, it is desirable that some things be exempt from VAT. In a pure Sales Tax, that’s easy — you just don’t charge VAT to the consumer when they purchase an item. With VAT, you wouldn’t want the government to end up out of pocket because of input tax claims against something that was exempt, so typically businesses are prohibited from claiming input tax for any item that was used to produce an exempt item for sale. If an item they purchase is partly used for the production of VAT-exempt items, and partly for items subject to VAT, they may have to work out what proportion applies and can only reclaim that proportion of the input tax.

If that sounds complicated, that’s because it is.

So why would anyone choose a VAT over a Sales Tax? The idea is that it is harder to avoid paying VAT. In a Sales Tax system, Consumer D could pretend to be a business and purchase from Retailer C without paying the Sales Tax. But in the VAT system, VAT is always charged, so Consumer D can’t avoid paying it.

Self-billing and the Reverse Charge

In the EU VAT system, there are actually two instances where VAT is not charged. The first is if you operate a “self-billing” arrangement with a customer or supplier; let’s imagine that Company A and Wholesaler B have an agreement to operate self-billing. Company A now does not need to worry about VAT; it sells its widget directly to Wholesaler B for £10, marking the invoice clearly to indicate that the self-billing arrangement applies.

Wholesaler B then accounts for VAT as if it has sold the item to itself. So, it lists £1 as “output” tax and also £1 as “input” tax. When it sells the widget to Retailer C, with whom it does not operate self-billing, it lists the £1.50 of “output” tax as before, so Wholesaler B will now pay £1.50 to the government. Notice that the final amount paid to the government is still the same £2.

The second place is actually a variant of self-billing, and applies where a business purchases a service (more on this in a moment) from an overseas supplier. In that specific case, the EU “reverse charge” mechanism applies; the supplier need not worry about VAT, though if they are also in the EU they may need to indicate on the invoice that the reverse charge applies. The purchaser then accounts for VAT as if it had sold the service to itself. The upshot of this rule is that services supplied to business customers are taxed at the rate in the customer’s country, not in the supplier’s country as might otherwise be the case.

Goods and Services

We’ve skirted around this a bit so far, but EU VAT law distinguishes between goods (broadly speaking, physical items) and services (pretty much everything else, including digital “goods” like software, music and films).

The rules for goods, services and e-services are very different and so the first thing to consider when you are going to sell something in the EU is whether what you are selling is a good, a service, or an e-service.

(An e-service, in case you are wondering, is a service that is provided electronically with minimal human intervention. Downloadable software is one such example. The rules on what is or is not an e-service can be quite tricky so if you need clarification you may need to consult your tax authority.)

When must I charge VAT and at what rate?

Case 1: You are in the same EU member state as your customer

In this case, the rules that apply are those of that member state.

Case 2: You are in a different EU member state to that of your customer

  • If you are selling a good, then provided your sales have not exceeded the distance selling threshold for your customer’s member state, you can charge VAT according to your country’s rules. Otherwise, you must register in the customer’s member state and apply that member state’s rules to the sale.
  • If you are selling a service or an e-service and the customer is a business, you charge no VAT but indicate to the customer that they should apply the reverse charge mechanism.
  • If you are selling a service to a consumer, you charge VAT according to your country’s rules.
  • If you are selling an e-service to a consumer, you can either register in the customer’s member state and apply the relevant rules, or you can register for the Mini One Stop Shop in your member state. In both cases you will charge VAT at the rate applicable in the customer’s member state.

Case 3: You are outside the EU and your customer is in an EU member state

  • If you are selling a good, VAT is your customer’s responsibility and should be dealt with, along with import duty, by the shipping company.
  • If you are selling a service, VAT is your customer’s responsibility and they are supposed to operate the reverse charge.
  • If you are selling an e-service to a business, VAT is your customer’s responsibility and they are supposed to operate the reverse charge.
  • If you are selling an e-service to a consumer, you need to register for the Mini One Stop Shop in any EU member state (you can pick whichever you please), and charge VAT at the rate applicable in the customer’s member state.

Case 4: The customer is outside the EU

In this case, the sale is outside of the scope of EU VAT. Note that this is different from being exempt, in that you are allowed to reclaim any input tax associated with the sale.