VAT Tax - Gimme the Facts!

Steve D'Amato, CPA, Tax Senior Manager   email
June 2011

Value-added tax (VAT) exists in over 120 countries worldwide with rates ranging from 5 percent in Japan to 25 percent in Sweden, but the United States is one of the nations without a VAT system.  As business becomes more global, an increasing amount of American companies are encountering and paying VAT.  So, you are probably asking, "What exactly is VAT?"

Although more complicated, VAT is similar to sales tax in that it is a consumption tax--a tax on purchases rather than on income.  To a buyer, VAT is a tax on the purchase price of products or services.  To the seller, it is a tax on the "value added" to the product or service.  The tax is assessed to the business at each stage of the manufacturing and distribution process and is typically passed on to the buyer as a price increase.  The "value added" is the sales price minus the cost of the materials and other taxes charged.  At the end of the day, the end user in a VAT system (as in a sales tax system) ultimately incurs and pays the tax.   

There are two major differences between VAT and sales tax.  One difference is the way the tax is collected and remitted to the government.  Sales tax is generally collected and remitted to the government only once, when an item is purchased by the end user.  Conversely, in a VAT system, the tax is collected and remitted to the government each time the product is purchased in the supply chain; a credit is also available for taxes previously paid.

The other major difference is the incentive for the end user to avoid paying the tax.  Under the sales tax system the seller must determine whether or not the buyer is in fact the end user.  The seller has an obligation to collect the tax from the buyer.  If the seller does not collect the sales tax, but should have, the government agency will look to collect from the seller the sales tax that is owed.  (The seller could then request reimbursement of this sales tax from the buyer, although this can be difficult if not problematic.)  There also may be situations when the seller unnecessarily collects sales tax and unintentionally over-collects sales tax.  VAT protects against this situation, because a VAT is assessed at every point of the distribution process.  Since the seller is required to pay VAT amounts added to the product at previous points in the supply chain, it provides an economic incentive to collect the VAT from the buyer.  The VAT system also eliminates the need for the seller to determine if the buyer is the end user.  (For more information regarding VAT, please click here to view an excerpt from the federal Committee on Ways and Means report, "Description and Analysis of Proposals to Replace the Federal Income Tax.")

The VAT can increase tax revenue for governments.  Supporters of the VAT claim it has improved the economies of countries all over the world, including Europe and Asia, and they believe it could do the same for the U.S.  They even feel the VAT could offer a new way to fund Social Security and government-controlled health care as well as reduce the deficit.  Others believe that it would not work in the U.S. as this new tax would slow economic growth.  It is also uncertain, if a VAT were to be enacted in the U.S., what would happen with the current income tax.  Would it remain, or would it be repealed? 

If you have questions or would like to learn more about VAT, please contact your Kolb+Co. adviser or Steve D'Amato.