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EU: VAT - Back to basics - Essentials for importing and exporting businesses

(S) Let's zoom in on EU Value Added Tax fundamentals that every business needs to know.



Introduction

The Value Added Tax, or VAT, in the European Union is a general, broadly based consumption tax assessed on the value added to goods and services. It applies more or less to all goods and services that are bought and sold for use or consumption in the European Union.


Thus, goods which are sold for export or services which are sold to customers abroad are normally not subject to VAT.


Conversely, imports are taxed to keep the system fair for EU producers so that they can compete on equal terms on the European market with suppliers situated outside the Union.


What VAT is


Value-added tax is

  • a general tax that applies, in principle, to all commercial activities involving the production and distribution of goods and the provision of services. However, if the annual turnover of this person is less than a certain limit (the threshold), which differs according to the Member State, the person does not have to charge VAT on their sales.

  • a consumption tax because it is borne ultimately by the final consumer. It is not a charge on businesses.

  • charged as a percentage of price, which means that the actual tax burden is visible at each stage in the production and distribution chain.

  • collected fractionally, via a system of partial payments whereby taxable persons (i.e., VAT-registered businesses) deduct from the VAT they have collected the amount of tax they have paid to other taxable persons on purchases for their business activities. This mechanism ensures that the tax is neutral regardless of how many transactions are involved.

  • paid to the revenue authorities by the seller of the goods, who is the "taxable person", but it is actually paid by the buyer to the seller as part of the price. It is thus an indirect tax.

Why do all EU countries use VAT?

At the time when the European Community was created, the original six EU countries were using different forms of indirect taxation, most of which were cascade taxes. These were multi-stage taxes which were each levied on the actual value of output at each stage of the productive process, making it impossible to determine the real amount of tax actually included in the final price of a particular product. As a consequence, there was always a risk that EU countries would deliberately or accidentally subsidise their exports by overestimating the taxes refundable on exportation.


It was evident that if there was ever going to be an efficient, single market in Europe, a neutral and transparent turnover tax system was required which ensured tax neutrality and allowed the exact amount of tax to be rebated at the point of export. As explained in VAT on imports and exports, VAT allows for the certainty that exports there are completely and transparently tax-free.


How is it charged?

The VAT due on any sale is a percentage of the sale price but from this the taxable person is entitled to deduct all the tax already paid at the preceding stage. Therefore, double taxation is avoided and tax is paid only on the value added at each stage of production and distribution. In this way, as the final price of the product is equal to the sum of the values added at each preceding stage, the final VAT paid is made up of the sum of the VAT paid at each stage.


Registered VAT traders are given a number and have to show the VAT charged to customers on invoices. In this way, the customer, if he is a registered trader, knows how much he can deduct in turn and the consumer knows how much tax he has paid on the final product. In this way the correct VAT is paid in stages and to a degree the system is self-policing.


Examples


Stage 1

A mine sells iron ore to a smelter. The sale is worth €1000 and, if the VAT rate is 20%, the mine charges its customers €1200. It should pay €200 to the treasury, but as it has bought €240 worth of tools in the same accounting period, including €40 VAT, it is only required to pay €160 (€200 less €40) to the treasury. The treasury also receives the €40 and now gets €160 making €200 - which is the correct amount of VAT due on the sale of the iron ore.


  • Supply: €1000

  • VAT on supply: €200

  • VAT on purchases: €40

  • Net VAT to be paid: €160


Stage 2

The smelter has paid €200 VAT to the mine and, say, another €20 VAT on other purchases, such as furniture, stationery, etc. So when the smelter sells €2000 worth of steel it charges €2400 including €400 VAT. The smelter deducts the €220 already paid on his inputs and pays €180 to the treasury. The treasury receives this €180 from the smelter plus €160 from the mine, plus €40 paid by the supplier of tools to the mine, plus €20 paid by the furniture/stationary supplier to the smelter.


  • Supply: €2000

  • VAT on supply: €400

  • VAT on purchases: €220

  • Net VAT to be paid: €180

€180 (paid by the smelter) + €160 (paid by the mine) + €40 (paid by the supplier to the mine) + €20 (paid by the supplier to the smelter) = €400 or the correct amount of VAT on a sale worth €2000.


VAT rates

EU law only requires that the standard VAT rate must be at least 15% and the reduced rate at least 5% (only for supplies of goods and services referred to in an exhaustive list).


Actual rates applied to vary between EU countries and between certain types of products. In addition, certain EU countries have retained other rates for specific products.


The most reliable source of information on current VAT rates for a specified product in a particular EU country is that country's VAT authority. An overview of the different rates applied in all EU countries is available.


Why are there different VAT rates in the EU?

European acts in the field of taxation have to be adopted by unanimity. The current provisions on VAT rates are thus the result of different compromises agreed by all the EU Ministers of Finance.


The VAT Directive sets the framework for the VAT rates in the EU, but it gives national governments freedom to set the number and level of rates they choose, subject only to 2 basic rules:


  • Rule 1: The standard rate for all goods and services

  • Rule 2: An EU country can opt to apply one or two reduced rates but only to goods or services listed in the VAT Directive


Standard VAT rate


This is the rate that EU countries have to apply to all non-exempt goods and services (Article 96 VAT Directive).


It must be no less than 15%, but there is no maximum (Article 97 VAT Directive).


Reduced rates of VAT


EU countries have also the option to apply one or two reduced rates (Article 98(1) VAT Directive which:


  • may be applied to goods or services listed in Annex III of the VAT Directive but not to electronically supplied services (Article 98(2) VAT Directive)

  • must be no less than 5% (Article 99 VAT Directive)

  • Exceptions to the rules – "special rates" of VAT


"Special rates" refers to the multiple exceptions to the basic rules. Largely for historical reasons and under certain conditions, many EU countries (in some instances, most of them) have been allowed to depart from these rules for a transitional period, with the objective to allow for the gradual alignment of national laws with the VAT Directive, pending the definitive adoption of agreed VAT arrangements by all EU countries.


This enables them to keep "special rates" - reduced rates under 5% (including zero rates) and reduced rates for goods and services other than those listed in the directive (Articles 102-128 VAT Directive).


How do the EU countries apply VAT?

EU countries implement common rules set in VAT Directive in their national legislation. The practical application and the administrative practices of each EU country therefore vary.


Sources:

EU Commission Website


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