Is Value Added Tax a Very Complicated Sales Tax?

Timur Feinstein
February 18, 2016

Sometimes it’s good to go back to basics. Want to learn more about value added tax (VAT)? You are not alone. Since most of Europe and around the world uses a VAT system, here is a good overview about how it works and how it is similar, but different, to sales tax in the United States.

There is a bit of mystery surrounding VAT among sales and use tax professionals in the United States. Both VAT and sales tax are indirect transactional taxes and yet they are vastly different. One of key differences between sales tax in the US and VAT in the European Union countries is that sales tax in general applies only on sale to the final consumer while VAT applies on every stage of supply, including wholesale transactions. Yet, from the view of who ultimately bears the financial burden of tax, sales tax and VAT are often a different way to get to the same answer. This blog will explore the differences (and similarities) between the VAT and sales tax worlds as it applies to this important feature.

How Do Sales Tax and Sale for Resale Work?

In a sales tax system, only the final consumer pays the tax. This means that for a sale of taxable goods, a retailer collects tax from the final consumer and remits it to the tax authorities. If the retailer bought the goods from another party, let’s say a distributor, the retailer does not pay sales or use tax on its purchase, because it is purchasing goods for resale. The same is true for the distributor’s purchase from the wholesaler, and so on through the supply chain.

There is some variation as to how different states apply this principle. In some states, in order to make an exempt sale for resale, the business must receive a resale certificate or similar documentation from its purchaser. In some states, manufacturers can purchase raw materials they will use in creating goods and some states they cannot. In Hawaii, there is a wholesale rate of 0.5% that applies to resale transactions. On the US mainland, however, such purchases are exempt.

Despite these variations though, generally the ultimate financial burden of taxation falls only on the final consumer. If sales tax is administered as intended, everyone else in the chain will purchase goods exempt when the intention is to re-sell. The final consumer cannot purchase exempt for resale and, in absence of entity or use type of exemption, will pay full sales tax on its taxable purchase.

Who Gets Charged VAT and How Do Input Credits Work?

In a VAT system, every party in the supply chain pays the tax. However, every taxable person, i.e. VAT-registered business in the chain, can also generally apply a deduction of VAT paid on its purchase. For example, if a supplier purchases taxable goods for EUR 100 and later resells the goods for EUR 200, the supplier pays VAT on its purchase, collects VAT on its sale, and generally remits to the tax authorities the VAT it collected less the VAT it paid. The deduction of VAT previously paid is known an input credit.

If administered as intended, suppliers do not incur the cost of VAT because they receive an input credit for purchases. The final consumers (i.e. non-taxable persons) incur the full cost of VAT because they are not eligible to take an input credit.

VAT vs. Sales Tax: The Same Ultimate Result, But Very Different Administration

From the perspective of who ultimately bears the financial burden of tax, VAT often functions as a complicated sales tax. After all the input credits have been applied by the businesses, VAT is only truly collected from the final consumer. Thus, an input credit and an exemption for resale serve the same function: the tax is designed to be on the final consumer and not on the business. Of course, the practical application and administration of this principle is a very different story.

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Author

Timur Feinstein

Timur is the Director – Regulatory Analysis & Design at Sovos. Timur uses his eleven-plus years of experience to lead a team of tax professionals focusing on VAT determination and reporting. An attorney by trade, Timur is a member of both the Massachusetts and New York Bars. He holds a B.S. in Finance from Bentley University and a J.D. from Boston University School of Law. Timur is fluent in Russian.
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