A high level overview is provided of the EU VAT system: what is subject to VAT and the right and methods of VAT recoverability. It includes also a comparison with the US Sales and Use Taxes system.
EU VAT is a general and broad-based consumption tax on (i) the supply of goods and certain movements of goods, (ii) the supply of services as well as (iii) the importation of goods into the EU.
Currently, the EU consists of 28 Member States. The principles and structure of VAT are contained in EU law, which system to a certain extent can be compared to the Federal Tax level in the US.
However, the EU still consists of multiple countries and although VAT legislation has mostly been harmonized throughout the EU, local VAT legislation still differs substantially. Contrary to US Sales and Use Taxes, VAT is a multi-stage tax which is chargeable in every leg of the supply chain (a chart which outlines some of the major differences between sales tax and VAT).
As a general rule, a supply is subject to VAT in a country regardless of the residence of the seller. For example, Dutch VAT is due on a supply of goods in The Netherlands, even if a US company makes the supply. In its most elementary form a business will charge VAT (‘output tax’) on its sales (‘supplies’), but will be entitled to deduct the VAT (‘input tax’) that it has paid on its costs and purchases.
We note that VAT can only be deducted if the invoice meets the invoice requirements (the conditions for this are summarized in national VAT Act) and is reclaimed in the right country (e.g. Italian VAT must be reclaimed in Italy) in the correct period. If these requirements are not met there is a substantial risk of additional VAT assessments increased with penalties and/or interest as a result of e.g. a VAT audit.
The standard VAT rate ranges between 15-25% and EU countries (Hungary currently 27%!) are allowed to have 1 or 2 reduced rates, which vary per country. On cross-border supplies of goods to businesses in other EU and non-EU countries a VAT zero rate can be applied, subject to strict conditions. However, if the correct use of a zero VAT rate (i.e. supporting documentation) can not be proved, the tax administration assesses the VAT increased with penalties and interest from the supplier.
Sound VAT processes are key for own VAT risk management and meeting at the same time commercial client satisfaction (customer prefer 0% VAT rate above charging a VAT amount).
Many other countries outside the EU have similar types of VAT/GST type systems, which vary but the main characteristics are the same. In the case of cross-border transactions the “place of supply” rules determine which tax jurisdiction is allowed to levy VAT. There are separate sets of rules for goods and for services, as well as for B2B and B2C supplies. In each case, there is a basic rule to which there are exceptions to cater for particular types of transactions.
Overview of some core activities of indirect tax function
A short checklist
- What is the applicable VAT rate?
- What is the amount charged (taxable base)?
- Where does the supply take place and does the supplier need to register as a foreign entity in the country concerned?
- When does the supply take place (relevant for timing of recovery and time limits) and when does the obligation to account for VAT arise (tax point)?
- Does the company have the relevant documentation in place to support the VAT treatment applied on the supply (administrative requirements, proof of transport)?
- Can the company recover all VAT on its costs and purchases?
- What are the reporting requirements (VAT return filing, Sales/Acquisition Listings and Statistical reporting)?
Recovery of input tax
“Input Tax” is the term used to refer to the VAT that a business incurs on its purchases of goods or services and upon importation into the EU of goods. It also refers to self-assessed VAT. VAT is self-assessed on the cross-border purchase of certain services, on the acquisition of goods into one EU country from another and in a number of specific situations (e.g. in the construction industry).
Input tax credit may be claimed on a variety of business expenditure, including start-up costs and the lease or purchase of equipment, immovable property and fixed assets. Input VAT recovery is often restricted to goods and services directly used for the supplies by a business on which output tax has been charged.
Output tax is the term used for the VAT that is charged by the supplier. The supplier’s output tax is the buyer’s input tax. Input tax is normally credited (or recovered) when a business files its periodic VAT return, by setting it off against the output tax charged. Only the net difference is paid to the relevant VAT authorities. However, if a taxable person has an excess of input tax he may claim a refund of the tax, subject to certain conditions.
Irrecoverable input tax
Not all input tax may be credited (or recovered). Some VAT is by definition irrecoverable, such as the VAT on private or non-business expenditure. Each EU country also (partly) prohibits the recovery of VAT on certain types of business expenditure that also bears a private use nature.
The list differs between EU countries, but typically includes business entertainment, passenger cars, food/drinks, etc. In addition, some businesses may not recover VAT, or may not recover it in full. Typically, this will apply to very small businesses and farmers/fishermen, on whose activities a specific VAT scheme applies, and businesses making supplies that are exempt from VAT.
For these businesses VAT represents an additional cost, as these businesses are effectively treated as final consumers. This qualification as end user also applies to private individuals, public bodies and charities which are normally treated as non-businesses. Refunds may be conditional to reciprocity being granted. Input VAT/GST incurred by US companies for example is Spain is not refundable.
Attribution of input tax to taxable and exempt supplies
Supplies of goods and services, which are within the scope of VAT are taxable or exempt.
Taxable supplies are subject to VAT at a rate ranging from 0% to 25% (Hungary currently 27%), depending on the EU country and the nature of the supply. The standard rate of VAT in the EU is either 15% or higher. There are reduced rates of VAT (ranging between 5% and 15%) with some super reduced rates in some countries.
Exempt supplies are not subject to VAT at any rate. Exempt activities include most financial and insurance transactions, the provision of health and welfare services and education.
Only taxable supplies give rise to the right to recover VAT. Businesses that only make taxable supplies can recover VAT in full (subject to the restrictions mentioned above).
Businesses that only make exempt supplies cannot recover any VAT. Many businesses make both taxable and exempt supplies. Where a business makes significant exempt supplies it can only recover a fraction of the VAT that it incurs on business costs and overheads i.e. it may recover the VAT to the extent that it relates to the taxable supplies that it makes. In these circumstances the business is referred to as being “partly exempt” for VAT purposes.
Many VAT authorities require a partly exempt business to attribute its input tax as far as possible to the exempt and taxable supplies that it makes.
Input tax directly attributable to exempt supplies is irrecoverable. Input tax directly attributable to the taxable supplies is recoverable in full. General overhead costs are apportioned between the taxable and exempt supplies. A common (and in some countries the only) method of apportionment is to use a pro-rata based on the value of taxable supplies expressed as a proportion of the total supplies.
Other formulae may be permitted
Similar rules apply to non-business organizations, such as charities and governmental bodies, which also have business activities.
Input VAT must normally be directly apportioned between business (further apportioned between taxable and exempt supplies) and non-business activities and recovered accordingly.
Again, VAT paid on general overheads or directly related to non-business activities will represent a cost to these organizations.
Written by Richard Cornelisse
I started my career as a manager at Arthur Andersen and then became a partner in EY where I led the indirect tax performance team for Netherlands and Belgium. Currently I am a senior managing director of Phenix Consulting.
I have over 20 years’ experience advising clients on international VAT issues. I am specialized in the tax aspects of financial transformations, shared service centre migration, and post merger integration work. I am also somewhat of a mentor, giving back to the profession. If you are interested in conversation and discussion, please feel free to contact me.