VAT vs. Sales Tax: Surprising Similarities You Need to Know
As businesses operate in a global market, it is essential to understand the various tax systems that can impact their operations. While the United States applies a sales and use tax system, Value Added Tax (VAT) or Goods and Services Tax (GST), as it is called in some countries, is a popular form of indirect taxation that exists in over 170 countries. Our previous article discussed the key differences between these two systems.
Despite the dominance of differences, some similarities between VAT and sales tax are worth exploring. This article will shed light on some of these common characteristics, which can help readers better grasp both VAT and sales tax systems. For those wondering why the US has not adopted a VAT system, we have an article on that topic here.
Both VAT and Sales Tax are consumption taxes, usually collected by businesses
Despite the fundamental differences in the tax collection mechanism (see our previous article), the core purpose of VAT and sales tax is the same. They are designed to generate government tax revenue based on the consumption of goods (tangible personal property) and services, hence the name: consumption taxes.
Businesses are responsible for calculating VAT and sales tax, collecting it from the buyer on behalf of the government, then remitting the tax - except for transactions in scope of the reverse charge mechanism. This process can be complex, with varying standard rates and reduced rates across VAT countries and a patchwork of state sales tax and local tax rates varying from jurisdiction to jurisdiction in the US, with more than 11,000 taxing jurisdictions for sales and use tax.
Failure to comply with these regulations can result in penalties and other legal consequences. Therefore, businesses must understand their responsibilities in collecting and remitting consumption taxes to governments.
Concepts of VAT Registration Thresholds and Sales Tax Nexus
Both VAT registration thresholds and sales tax nexus might require businesses to register for tax collection and remittance once they exceed a specific threshold. Although the thresholds and triggers differ between the two systems, they share the same goal of ensuring that businesses engaged in taxable activities are registered and collect and remit the correct taxes.
Value Added Tax
VAT registration thresholds vary across VAT countries, and the administrative formalities regarding VAT registrations can be complex. Typically, there is not just one uniform VAT threshold applicable to a country. The threshold can differ depending on the type of goods or services a business provides, and different thresholds may apply for domestically established sellers and non-resident sellers.
The threshold is generally based on the income from taxable sales, with various time frames to consider, such as a calendar year or a 12-month rolling period, or even if you expect to exceed it soon. For instance, if your business is not resident in the United Kingdom, you need to register for VAT in the UK if your taxable turnover in the UK exceeds £85,000 over the preceding 12 months or if you expect your turnover to go over £85,000 in the next 30 days.
The EU has taken steps to unify some of the VAT registration thresholds by replacing previous different distance sales of goods thresholds within the EU Member States with a new EU-wide threshold of EUR 10,000 as of July 2021.
Businesses operating across multiple countries usually face the challenge of tracking when they exceed VAT registration thresholds and complying with associated administrative VAT registration requirements.
Sales tax regulations in the United States may require businesses to collect sales tax in the state once they have established a minimum connection or link called ‘nexus’ with a particular state. Historically, having a nexus meant having physical presence, such as offices, employees, contractors, warehouses, etc., in the state.
This changed with the landmark Supreme Court decision of South Dakota v. Wayfair in 2018, which established the concept of economic nexus. This decision drastically changed nexus standards by establishing nexus based on economic activity, even without a physical presence in the state (e.g., remote sales). The Wayfair decision paved the way for all US states to adopt economic nexus rules and to require remote sellers to collect and remit sales tax to the state based solely on their economic activity within that state.
Economic nexus thresholds are usually calculated based on the dollar amount of sales to customers within the state (e.g., $100,000 in a calendar year) or based on the number of transactions made in the state (e.g., over 200 transactions in the state). Additionally, some states may have a combination of both. For example, The State of New York requires remote sellers to register if they exceed $500,000 per year in gross revenue from the state and make sales into the state in more than 100 separate transactions in the last four quarters.
Consumer Use Tax - The Reverse Charge Mechanism of Sales Tax?
Value Added Tax
In VAT, the reverse charge mechanism is a way to shift the responsibility for paying the VAT from the supplier to the customer. Typically, the supplier is responsible for charging VAT on the sale of goods or services provided in the supply chain, collecting the tax from the customer, and remitting it to the tax authorities. However, in some cases, the reverse charge mechanism comes into play, shifting the responsibility of paying the amount of VAT to the customer instead of the supplier. This mechanism “reverses” the responsibility for VAT payment, and the customer becomes responsible for collecting the VAT due on a transaction. We wrote about the reverse charge mechanism in detail here.
Consumer use tax is similar to the reverse charge mechanism in VAT. If the supplier does not charge sales tax, but the sale would typically be subject to sales tax, use tax is generally due by the purchaser, meaning that the purchaser should self-assess and remit use tax to the state.
For example, if an out-of-state seller does not have nexus with the purchaser’s state and does not charge sales tax, but the sale is otherwise taxable, consumer use tax is normally due from the purchaser. Usually, but not always, the sales and use tax rates are identical.
Use tax is intended to complement sales tax and ensure that both in-state and out-of-state purchases are subject to taxation. It provides an equal playing field for in-state and out-of-state sellers, as local sellers do not suffer a competitive disadvantage from out-of-state sellers who don’t charge sales tax.
Exemptions in VAT and Sales Tax
Sales tax and VAT share another common feature - they both have specific exemptions that apply to certain transactions, even though the scope and nature of these exemptions may differ.
Value Added Tax
In the case of VAT, governments may provide exemptions for certain transactions because of public interest (e.g., postal, medical, and educational services) or are of a specific nature (e.g., insurance and financial services). Businesses making these tax-free, exempt supplies do not charge and collect VAT; however, on the other hand, they are usually unable to recover any or most of the VAT incurred on their business purchases.
VAT also operates with zero-rated supplies for specific, typically cross-border transactions. This is also an exemption, a supply with a 0% VAT rate. They differ in terms of the ability of taxpayers to recover VAT on their purchases. If you want to learn more, this EU website is a valuable source for explaining the difference between exempt and zero-rated supplies in detail.
Similarly, sales tax exemptions may be created by US jurisdictions to carve out specific transactions that would generally be taxable. Exemptions may exist due to the nature of the parties involved, such as sales to the US federal government, state and local governments or charitable organizations, public schools, etc. Also, specific tangible personal properties may be exempted (e.g., food, clothing, medicine), and even the type of use can be the basis of an exemption (e.g., purchasing raw materials for manufacturing).
Although some exemptions are commonly found in almost every US tax jurisdiction, such as the resale exemption. It is vital not to assume that any transaction is exempt without carefully verifying the local legislation, as the exemption rules - like everything else in US sales tax - vary state by state.
Deemed supplier rules for marketplaces in VAT vs. Marketplace facilitator rules in Sales Tax
Value Added Tax
Online marketplaces like Amazon and eBay play an increasingly significant role in VAT collection. Many VAT countries are introducing new regulations that require marketplaces to collect VAT on behalf of underlying sellers transacting on the platform. This means that marketplaces are now responsible in many countries for ensuring that VAT is collected and paid on transactions that occur on their platforms. While shifting this responsibility may simplify VAT compliance for third-party sellers and increase VAT revenues for governments, it also places a significant burden on marketplaces that are trying to ensure they meet all the requirements.
For example, the EU introduced special provisions on marketplaces / electronic interfaces, making them deemed suppliers in certain circumstances. This means that even though the marketplace is not in possession of the goods supplied between the underlying seller and the final consumer, these new rules create a legal fiction whereby the marketplace is deemed to have received the goods from the underlying supplier and to have supplied the goods to the end consumer directly. As a result, the marketplace is treated for VAT purposes as if it was the actual supplier of the goods, making it liable to account for VAT on these sales.
Wayfair also opened the door for implementing marketplace facilitator rules in the US. All states with sales tax have enacted tax laws requiring marketplace facilitators to collect and remit sales tax on behalf of their third-party sellers, regardless of the seller's location. This shift in the obligation to calculate and collect sales tax – from the seller to the facilitator – is meant to fill the gap for a sizeable part of e-commerce sales that would otherwise go untaxed due to the seller's activity falling below the economic nexus thresholds. Another level of complexity here is that the definition of the marketplace facilitator varies state to state.
Overall, zooming out to see the bigger picture, the trend in tax policy is clear: both VAT and sales tax are moving towards placing more obligations on marketplaces to ensure that taxes are collected adequately on sales made through their platforms.
How can Fonoa help?
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