If you have made purchases outside the U.S.A., you may have completed a form for the refund of value-added tax (VAT). What exactly is value-added tax and how might it affect your small business?
First, consider two main reasons that VAT might impact your small business: (a) It is possible that the US will implement value-added taxation that would affect your business, and (b) You might find your business buying or selling goods in one of the many countries that do have a VAT system.
What is value-added tax (VAT)?
When goods or merchandise are manufactured, a tax is added to the value of the product at each stage of production — and it is called value-added tax (VAT). These taxes must be paid when the product is sold to the next business in the chain of production (the dollar amount is similar to sales tax).
Ultimately, the customer will be required to pay the total VAT at the time of sales or purchase. It’s collected by vendors who are VAT-registered. This tax is the value of the product minus any of the costs of the product on which tax has already been paid.
A simplified example of VAT in action…
Let’s say you have a small baking business, and your unique cakes are sold by a local shop. Here is how the VAT system would work. We’ll assume that the tax rate is 10%.
Farmer. You buy your baking supplies from a local farmer, and the total you pay per cake is $2.00. The VAT ($0.20) is added to that, so you give the farmer a total of $2.20. The farmer will send the $0.20 to the government.
Baker. You bake the cakes and charge the local shop owner $5.00 per cake. That means the shop owner has to give you a total of $5.50 ($5.00 for the cake and 10% VAT of $0.50). Since the farmer already paid the first $0.20 to the government, you only pay $0.30 to the government.
Shop owner. The shop owner sells your cakes for $10 each. When the VAT is added on, the shop owner ends up collecting $11.00 per cake from the customer. The VAT is $1.00, but since $0.50 of that was already paid by you and the farmer, the shop owner only sends $0.50 to the government.
Each of the business owners complete government paperwork. Cheating is discouraged because of the chain of related payments and credits.
Benefits of VAT
Up until now, a VAT has not been imposed on US goods and services. However, there have been strong supporters of the VAT that has been so successful for other nations. Other publications predict VAT is inevitable. In fact, in 2014, valued-added tax was (again) proposed for tax reform. As explained in Forbes, a VAT could simplify US taxation and decrease taxes for individuals and businesses — without hurting the government’s budget. In fact, some states already employ taxes very similar to VAT.
VAT has been widely used by most European countries, and more than 160 countries around the world follow this system. A VAT raises revenue for the government in sales. VAT may also be called a goods and service tax by the government.
In many cases, VAT is actually recommended over a sales tax as it prevents tax evasion to a large extent. When the Small Business Association (SBA) commissioned a 2013 study about sales tax for the Internet and small business exemptions, VAT was included in the report.
If you want to perform business transactions in other countries, you must first find out whether the prospective country follows the VAT system—as it would indicate that the country has a solid economic system.
The VAT rates tend to vary from country to country. Some may charge no more than about 10 percent, while others might charge up to 20 percent or more.
Sales tax and VAT
Sales tax and VAT are types of consumption taxes where people are taxed on how much they buy, but they do differ in a few ways.
Sales tax is the amount that one has to pay for the whole cost of a product or a service, while VAT is the amount that one has to pay on the exchange of the product only when its value increases.
While VAT is collected at various stages within the business chain, sales tax is collected only once at the time of purchase of the product. Also some countries use only the VAT system and have opted out of the sales taxation structure.
In countries with a VAT system, businesses have to register through the government in order to collect VAT. These businesses can be a single person or a large corporation. However, the regulations regarding who has to register do vary from country to country. If tax reform in the US includes VAT, the system may not be the same as in other countries.
Those individuals and businesses that do register must charge VAT on all goods or services that they sell or provide. There are some exceptions to this, but again, those exceptions vary from country to country. These individuals and businesses can also often take a deduction for any VAT they paid on goods or services they acquired.
A taxable person
VAT can be considered a general tax as it can be applied to all types of businesses that manufacture products or provide services. So a taxable person can be an individual or even a company that charges VAT on the sales of products or services. However, when the annual profit is less than a certain amount, then there is no need to add VAT during sales.
Also, as a U.S. resident, you may be exempt from paying a VAT in a foreign country. Use IRS Form 6166 – Certification of U.S. Tax Residency to obtain the exemption. Please note that the exemption only satisfies the requirements that pertain to your U.S. federal income tax status. A foreign country may have additional requirements.
Recovery of the VAT
There might be a chain of manufacturers and traders who have handled various stages of the production and sales of different products. Those manufacturers can charge VAT taxes on their invoices when they sell the products to other people or businesses in the chain. As such, they are allowed to deduct the VAT they have paid on retailer charges. All the sellers collect the VAT, which they then pay to the government and thus contribute to the economic growth of the country. However, the consumer will not be allowed to recover the amount of the VAT tax because it’s included in the price of the final purchase of a product.
When a big change like VAT is being considered, it is good to have up-to-date records so you can evaluate the impact of the new taxes on your business. Have you checked out Patriot Software? Our online accounting software is guaranteed accurate and easy to learn.