One of the most common issues in our international tax practice today is Value Added Tax (VAT). Even with all of the questions around U.S. sales tax in the wake of South Dakota v. Wayfair, at least our U.S. based clients understand the basic U.S. sales tax rules. That’s not always the case with VAT. U.S. based exporters, ranging from software developers to manufacturers, are subject to a VAT. Even those that fully understand compliance don’t often understand how simply complying and not being proactive around the VAT is costing them money and margin.
The most common issue we face with respect to VAT is the U.S. exporter incurring an unexpected VAT liability. It happens a lot and it happens because many smaller U.S. exporters don’t understand, or choose to ignore, foreign VAT rules. When it happens, and the U.S. exporter is charged with a VAT, profits can be reduced or eliminated, and the U.S. exporter can be taken out of the market by having to increase their selling price, or reduce their margins on export sales, due to unrecoverable VAT.
A basic understanding of the VAT is in order here. The VAT is an indirect tax levied on the consumption or use of goods and services. It is charged at each step of the supply chain process. The product’s end consumer bears the costs of VAT while registered businesses collect and account for VAT acting as tax collectors on behalf of the government.
Here’s a basic example of how VAT works within a Euro country with a VAT regime where all of the supply chain members are properly VAT registered and compliant:
A widget manufacturer sells to a wholesaler for €100. Under the VAT, the manufacturer collects a VAT of 5%, or €5, from the wholesaler on behalf of the government. The wholesaler pays the manufacturer a total of €105.
The wholesaler increases the selling price to €200 and sells it to a retailer. The wholesaler collects a VAT of 5%, or €10, from the retailer on behalf of the government whilst receiving a refund of the VAT paid to the manufacturer in the previous step. The retailer pays the wholesaler a total of €210.
The retailer further increases the selling price to €300 and sells it to a consumer. The retailer collects a VAT of 5%, or €15, from the consumer whilst receiving a refund of the VAT paid to the wholesaler in the previous step. The consumer pays the retailer a total amount of €315 and receives no refund of any VAT paid. Thus, the consumer bears the cost of all VAT incurred throughout the supply chain as all others have recovered what they paid.
That example is rather basic but, in practice, it can be very complex when the supply chain crosses multiple borders and VAT regimes, rates, and classifications. Product transformation through the supply chain raises additional issues. That said, it is imperative that U.S. exporters fully understand the VAT rules and their VAT responsibilities. I’ve seen too many U.S. exporters end up with unexpected VAT costs and penalties that eliminate any profits on their foreign sales especially when legal fees are added to the equation.
The most commonly raised question is how do you basically comply with the VAT? In some cases, e.g. the sale of physical goods, the law is rather settled. In the case of other emerging types of business, e.g., online software sales, the law is evolving and is based on each jurisdiction’s rules. With the exception of the European Union (EU), there really is no Uniform Commercial Code (UCC) or uniform rules on this type of activity. That makes it tough to provide general answers that a client can rely on. Only with specific facts can one arrive at specific answers.
As outlined in the example above, the global theme is that the seller is the one who bears the responsibility for paying the VAT. In practice that works in many different ways, depending on the rules of the specific jurisdiction. For a U.S. exporter, some of the most important practices and issues are:
- For physical goods, the importer of record usually incurs the VAT. If the U.S. exporter can get the foreign buyer to be the importer of record they can usually pass on VAT issues altogether.
- If the foreign buyer is a VAT registered business, they may be responsible for collecting any VAT and remitting it if they know the seller is offshore or not VAT registered. This “reverse charge” mechanism is a rule in the EU and various other jurisdictions as well. In many instances, the U.S. seller need not worry about VAT if they are aware that the foreign customer is VAT registered and they have the foreign customer’s VAT number on file. That’s great from a compliance perspective but the U.S. seller still ends up economically bearing the VAT expense that the buyer is just passing along on their behalf. Also keep in mind that most individuals don’t have a VAT registration.
- In the EU, there is a common reporting system where a non-EU company can register in one EU country, e.g., Ireland, and then run all of their EU sales through that single registration. That has merit solely for sales to EU customers where there is common reporting system.
- If the seller has a number of clients in one country with “VATable” sales, the seller should strongly consider registering there to properly collect and remit VAT. Many clients do this in places where they have sales and where VAT problems can bring serious criminal charges. They may even set up a shell company (rare) for this purpose because if there is no company than the VAT cannot be used or credited in the future by the seller due to lack of a VAT registration. Otherwise, the unrecoverable VAT paid simply becomes a sunk cost.
- A U.S. exporter may try using an intermediary. For example, the U.S. exporter can sell directly to an EU VAT registered intermediary who, in turn, sells to non-EU countries. In this case, the intermediary is the one who bears the burden for the VAT compliance in non-EU countries. Many small U.S. exporters seek out independent foreign distributors for this reason.
- Keep in mind that VAT classification is very important as different countries apply VAT at different rates to different products. For example, software for medical imaging or educational purposes may be rated differently than software for gaming. This is very similar to customs classifications. Freight forwarders often fail their clients here. A freight forwarder will make sure the VAT is paid but it is not their job, and nor do they feel it is their job, to make sure the VAT is paid at the lowest available rate. We see that a lot.
- Customs & Duties is always an issue as well even though it is out of this article’s scope. You always want to make sure that all foreign exports comply with local customs & duty rules and regulations. Even for online sales, some countries do levy import duties on, for example, imported software licenses.
These practices and issues are the ones we see most often but they are certainly not an exhaustive list or all possible outcomes. The real problem is the lack of global or regional uniformity as well as the ever evolving nature of the rules. When you couple the obvious complexities with aggressive enforcement, especially against non-resident importers, you see that it doesn’t take much for real problems to arise even for very small U.S. exporters.
VAT violations can be very nasty. Goods and inventory can be seized, a company be barred from a market and, in some countries, officers, directors, or employees can face criminal penalties including prison. I’ve been a part of criminal VAT cases and it is not for the faint of heart.
The bottom line is that the cost of upfront VAT compliance is much cheaper than defending a nasty VAT audit or trying to free impounded inventory. Don’t let VAT drag your profits down or be a barrier to profitable export sales. Contact us today to help you with your VAT and international tax questions and issues.
Frank J. Vari, JD, MTax, CPA is the practice leader of FJV Tax which is a CPA firm specializing in complex international and U.S. tax planning. FJV Tax has offices in Wellesley and Boston. The author can be reached via email at email@example.com or telephone at 617-770-7286/800-685-2324. You can learn more about FJV Tax at fjvtax.com.