As discussed in an earlier post, we’re creating a series of posts to cover some of the complex system accounting challenges we commonly run into. In this first blog post of the series, we’ll review the basics of VAT, especially as it compares to sales and use tax.

When U.S. companies expand internationally, they find themselves having to meet a new set of reporting and regulatory requirements. They wonder how (and if) their enterprise software solution can meet them. But before addressing these questions, it helps to understand the requirement itself.

VAT vs. Sales and Use Tax

VAT (or value added tax) is different from sales and use tax. Sales/Use tax in the United States is only charged to the final consumer of the material or service involved. Wholesalers who buy in bulk do not pay sales tax nor do the retail stores that buy from them. Retail stores at the end of the process charge sales tax to the final consumer. Thus, a 5% sales tax rate would look something like this:

Unit cost Tax Total invoice cost
Wholesaler buys from manufacturer $5.00 $0.00 $5.00
Retailer buys from wholesaler $7.50 $0.00 $7.50
Consumer buys from retailer $10.00 $.50 $10.50

VAT is different. With VAT, each entity charges VAT to the next entity at every step in the process. Thus, a 20% VAT rate would look something like this:

Unit cost Tax Total invoice cost
Wholesaler buys from manufacturer £5.00 £1.00 £6.00
Retailer buys from wholesaler £7.50 £1.50 £9.00
Consumer buys from retailer £10.00 £2.00 £12.00

As an American looking at this example, you might ask whether the retailer’s end price should be higher to compensate for all that VAT. Why is it just the difference between 5% and 20%? Did the government take a bigger piece all the way through?

No, the government isn’t getting a bigger piece. VAT taxes the value a company adds to a product as it passes through the supply chain. The total tax the consumer pays is only £2.00, not £4.50. Wholesalers, retailers and other parties in the supply chain give the government the difference between the VAT they were charged and the VAT they charged to consumers. Let’s explain:

1) When a company files a VAT return, it reports all the VAT it was charged by vendors and all the VAT it charged to customers. Then it pays the difference.

2) The company pays VAT owing to the government periodically via a VAT return.

Let’s say our retailer bought 100 widgets. Its (simplified) VAT return would look like this:

VAT paid £150.00
VAT charged £200.00
Net VAT owed £50.00

The wholesaler then files its return for the same 100 widgets:

VAT paid £100.00
VAT charged £150.00
Net VAT owed £50.00

And the manufacturer (assuming that it has dug the stuff up from the ground) files its return.

VAT paid £0.00
VAT charged £100.00
Net VAT owed £100.00

The total VAT paid is £200.00, but unlike sales tax, it’s paid in stages.

VAT may be calculated on a cash or accrual basis depending on the country and the size of the business. Lawson’s standard report handles it on an accrual basis, as we’ll discuss in our next blog post.

 

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