VAT vs Sales Tax: A Practical Business Guide

VAT vs Sales Tax:

A practical business guide

On the surface, VAT and sales tax are virtually the same. They’re both indirect taxes on the sale of goods or services. However, from a business and accounting perspective, there are important distinctions that affect compliance, cash flow and profit. For businesses entering new markets, understanding the difference between sales tax and VAT is crucial.

VAT vs sales tax for consumers

For ordinary shoppers, there’s an obvious but fairly minor, difference between VAT and sales tax. VAT is an indirect tax that is generally already included in the price of an item. By contrast, the retailer charges sales tax when ringing up goods for sale.

If that were the only difference, VAT tax vs sales tax would just be a detail for shoppers to bear in mind when they go on vacation.

To understand why the distinction matters for businesses, we need to dig a little into how these taxes are structured.

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Sales tax: Who really foots the bill?

In the case of sales tax, the tax is levied at the final point of consumption, or in simpler terms, the retailer does the tax collection. Sales tax, therefore, has the benefit of simplicity. You purchase an item and pay a defined percentage on that item as local sales tax. However, the applicable tax rate can vary per location. And if you’re not the end-user of that item, the seller simply issues you a resale certificate, signaling that you have an exemption for paying the state sales tax.

However, in this scenario, the final user pays a consumption tax based on the total sales value of the item. In effect, the consumer is paying tax for the value added to the item at each stage of the value chain (in economic jargon, there is a cascade effect). This can have an inflationary effect on the price of goods.

What are examples of sales tax?

Let’s apply those concepts in practice. Suppose a business is operating in the United States. There is no US VAT system, but sales tax applies.

A company, Acme Clothing Co, manufactures trousers. In order to produce their goods, the company purchases cotton, buttons, and zips from other suppliers. None of those acquisitions is performed at the retail level. Rather, the manufacturer acquires goods it needs to manufacture items for onward sale. In this case, the company can be issued a resale certificate confirming that it is not liable for sales tax.

By contrast, now imagine a consumer who enters a retail store and purchases a pair of Acme Clothing trousers. The customer acquires the trousers for their own personal use. The customer pays sales tax on the trousers, at the tax rate set by the state in which the store is located. Importantly, the amount of tax is calculated as a percentage of the total sales value of the purchased item.

VAT: Taxing the links of the supply chain

So, how does VAT work? Value added tax overcomes the cascade effect of sales tax by levying a tax on the value added at each point of the value chain.

While VAT is designed to avoid the inflationary effect of cascade taxes, it introduces several compliance issues. For instance, by producing, distributing, importing, and selling goods and services, businesses will often be liable for VAT.

In many cases, businesses will have to charge and account for VAT in the course of regular business. In addition, under certain conditions (such as when a turnover threshold is reached) a business must register for VAT in one or more jurisdictions in which they do business. (In practice, businesses that sell in multiple countries often are obliged to register for VAT in several, or even all, of them.)

What are examples of VAT?

Now that we understand how VAT works and how it is charged across the value chain, let’s consider our trousers factory. Suppose that rather than being located in America, the business is established in a country with a VAT system.

In that case, the company cannot simply wave away its VAT obligations because the goods are being purchased for resale. Instead, the sellers of each of the items (cotton, buttons, etc.) are obliged to include value added tax in the invoice issued to the trousers factory. Those sellers must, in turn, pay that VAT to the relevant tax authority.

At the same time, when the manufacturer sells the finished items to wholesalers, the manufacturer must charge VAT on the completed goods.

The process continues throughout the supply chain until, finally, our customer strolls into a clothing store and purchases their new trousers for their personal use. At this point, VAT is charged, as with all the preceding transactions. However, there is an important distinction. Up to now, VAT invoices have been issued between VAT registered taxable persons on goods used for business persons. By contrast, the customer is an individual acquiring the trousers for personal use. The VAT paid, in that case, is therefore not reclaimable by the consumer.

Cross border VAT charges

VAT even applies to the supply of goods and services across borders. Some cross-border taxable supplies are subject to VAT reverse charges, in which case a reverse charge VAT invoice must be issued.

When bringing goods into the country from abroad, import VAT may apply. The regulations governing import VAT depend on the country to which you are importing and where the goods are located when you purchase them. For example, there is no import VAT due on import between countries within the EU. On the other hand, if you import goods into an EU Member State from outside the EU, import VAT applies. Following Brexit, import VAT applies to the trade of goods between Great Britain and the EU.

While import VAT is often overlooked, import VAT recovery can be a highly effective way to reduce the cost of trade.

The cash flow consequences of VAT

Under a VAT system, businesses across the value chain aren’t simply obligated to charge VAT. They will, naturally, also incur VAT. That is, they will generally pay VAT on the goods they purchase, even if those goods are for resale or are components of items that will be produced and sold. This is in contrast to sales tax, whereby only the final consumer actually pays the tax.

Fortunately, VAT incurred in the course of acquiring goods or services for the sake of performing business functions is reclaimable. However, that VAT is generally only recoverable within specified timelines, and the process can be fairly complex. A VAT advisory service is therefore invaluable. Specialized VAT experts help businesses effectively recover all the VAT to which they are entitled.

An integrated VAT solution

As global leaders in VAT compliance and recovery, VAT IT ensures that all the VAT boxes are ticked. From registration to the reclaim, we provide a complete VAT solution that meets all regulatory requirements while optimizing cash flow and ensuring businesses never miss an opportunity to reclaim VAT.

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