When most people think about “taxes” it’s likely that their thoughts first turn to “direct taxes.” However, in today’s economy, “indirect taxes” are becoming increasingly important in funding state and local governments. Indirect tax is also becoming increasingly complex, especially for businesses charged with meeting their indirect tax compliance obligations globally. In this article, we will discuss the differences between direct and indirect taxes, why indirect tax is growing in importance, and the fundamentals of indirect tax compliance.
Direct versus indirect tax
Indirect taxes are those that are not “directly” imposed on individuals and businesses but rather are applied at the time a good or service is transferred in some way, shape or form. For example, income taxes (corporate or personal), property taxes and estate taxes are all examples of “direct” taxes. They share the common characteristic of being levied directly against an individual or business as wealth is earned or held. They are paid directly by the holder of the wealth and the obligation to pay these taxes is generally not legally passed on to another party.
Indirect taxes are different. They apply within the stream of commerce as goods are manufactured, distributed, transferred and sold at or, in the case of services, as they are provided. Common types of indirect taxes include the following:
Retail Sales Taxes: Sales taxes exist in 45 US states, the District of Columbia, the Commonwealth of Puerto Rico, as well as in thousands of localities. It’s less common globally.
Sales tax is generally applied at the point of final sale in the stream of commerce, with intermediary transactions often non-taxable under the “resale” exemption. In most states, sales tax applies to all sales of tangible personal property unless specifically exempted under the law. Conversely, it only applies to specifically enumerated services. However, states like South Dakota, New Mexico, Hawaii, and West Virginia buck the trend and broadly tax both tangible property and services.
Value Added Tax: VAT, along with its close cousin Goods and Services Tax (GST) exists in much of the rest of the world. In most places, VAT is administered at the country level rather than the state and local level. Canada is unique in that have a country level GST that sometimes sits aside Provincial sales taxes.
Like sales tax, VAT is applied as goods and services are transferred in the stream of commerce. Unlike sales tax, VAT/GST is charged at every step of the supply chain. In the end, though, the final consumer bears the full VAT burden as intermediary buyers can reclaim any VAT paid against VAT collected when the item is further sold.
Excise Taxes: Jurisdictions often charge special levies on certain luxury items or other goods that are perceived as imposing social costs. Common examples include excises on alcohol, tobacco and fuel.
While not precisely an excise tax, in recent years we have seen a proliferation of point-of-sale fees on items such as paint, mattresses, lumber, tires, batteries, electronics and other products that harm the environment when not disposed of properly. The fee is, largely, intended to create funds that ensure the ecological disposal of these items at the end of their useful lives.
Duties/Customs: Taxes are often levied as items cross national borders either by the importing country (tariffs) or by the exporting country (duties) for economic and political reasons beyond the scope of this article.
Why indirect taxes are important
The rest of the world has always known that indirect taxes serve as a substantial and reliable source of government funding, perhaps that is why VAT/GST rates globally are often higher than sales tax rates in the US. For example, the average VAT rate within the member states of the EU is 21.6%, the highest rate being Hungary at 27% and the lowest being Luxembourg at 17%. By comparison, according to the Tax Foundation, the average state and local sales tax rate in the US is 6.6%.
According to the International Monetary Fund, as of 2022, VAT represents more than 30% of the total tax take for most countries. These days, US sales tax doesn’t lag too far behind, representing, on average, 29.52% of state tax revenue in 2022. That number undoubtedly has increased over the last few years as states have reaped the benefits of the S.D v. Wayfair Supreme Court decision, enabling them to impose sales tax collection and remittance obligations on sellers located wholly out-of-state. In fact, some would suggest that the ability to tax remote sellers, coupled with substantial federal subsidies prevented a full-scale state budgetary collapse in the early days of the COVID-19 pandemic.
Recognizing the growing importance and stability of sales tax, a wide swath of states has, in recent years, opted to reduce their income and property tax rates in favor of expansions to the sales tax. Perhaps this is best embodied by Kentucky HB 8 which, as of January 1, 2023, provided for a gradual reduction of the personal income tax while simultaneously expanding the sales tax to include a number of personal and professional services.
The challenges of indirect tax compliance
Tax compliance is getting more complex. Rates, rules and requirements change all the time and are changing at a faster and faster pace. In 2023 alone there were 715 standard sales tax rate changes (compared to 534 in 2022) and 634 adjustments to the forms upon which sales tax is remitted and reported. There was also no shortage of last-minute changes, giving taxpayers precious little time to change their systems to maintain their compliance. A great example is Michigan. There, the legislature and governor passed a bill changing the tax treatment of delivery charges that took effect the minute after it was signed.
While we are seeing a solid handful of states, like Georgia, expand their sales tax base by making certain digital products taxable, we are seeing even more states enact targeted sales tax exemptions for personal essentials such as feminine hygiene products, diapers and grocery food. Keeping up, especially when indirect tax compliance is not your primary business, is far from easy.
As governments expand their reliance on indirect tax, it’s natural to expect that they will increase their efforts in ensuring sellers remain complaint. While perfection is not possible, regulators will continue to strive to collect as much of the tax that is legally owed as humanly possible. In the US, this manifests in a greater number of sales tax audits. In the rest of the world, the future of compliance is far more digital.
Rather than rely on companies sending periodic VAT returns and conducting occasional taxpayer audits, many global tax administrations are inserting themselves directly into the stream of commerce, requiring information about what is being bought and sold in real or near-real time, and in its most challenging manifestation, requiring buyers and sellers to request and receive approval from the government prior to shipment.
This trend first manifested in South America but quickly spread to Europe. In its least disruptive manifestation, the UK’s “Making Tax Digital” (MTD) requires taxpayers to keep digital transactional records in a standard format and file periodic VAT returns using MTD-compatible software. MTD is not entirely dissimilar to SAF-T (Standard Audit File for Tax) which represents an international standard for the electronic reporting of accounting data from taxpayers to tax administration. SAF-T requirements exist in many European countries but are quickly being displaced by real-time or near-real-time Continuous Transaction Controls or CTC’s.
The bedrock principle behind CTC’s is the notion that “the truth is in the transaction” and greater visibility into transactions enables broader tax compliance. Spain’s SII requirement is a notable example. Under the rules, taxpayers must supply electronic invoicing records within 4 calendar days of the transaction taking place. Hungary has a similar requirement, except that the transactional details must be provided in real time. Italy takes things one step further, becoming the first EU country to require data to be transmitted and “cleared” by the Government prior to shipment.
Concluding Thoughts
As indirect taxes grow as an important source of government funding, governments will continue to adapt, evolve and sometimes even innovate in designing policies and procedures intended to ensure robust compliance and enforcement. Businesses need to stand ready to meet the indirect tax compliance challenges as they exist today and will exist tomorrow. To learn more about the state of indirect tax, check out our 5 key takeaway blog.
Take Action
Are you ready to get a handle on indirect tax compliance? Reach out to our experts to get started on your journey to always-on compliance.
