VAT vs Sales Tax: Where the Difference Hides
Sales and use tax and Value Added Tax (VAT), or Goods and Services Tax (GST), as it’s called in some countries, are two common types of consumption taxes that governments worldwide use. In the United States, sales tax is the primary form of taxation on consumer goods, while VAT is more common in over 170 other countries all around the globe.
While both VAT and sales tax are consumption taxes, they have some fundamental differences that bring different implications for businesses and consumers. This article will explore the key differences between these two, while we will look closely at the similarities in our next article. If you are curious, you can read more about why the US has not implemented a VAT system.
Different tax collection mechanisms
Value Added Tax
VAT is a multi-stage, indirect tax that is charged at every stage of the production process and distribution. The businesses involved in each stage referred to as "taxpayers" in VAT terms (meaning they have a VAT registration and a VAT number), are responsible for collecting and remitting the amount of VAT to the tax authority equal to the value added on goods and services supplied in the chain.
Taxpayers can claim back VAT paid on their purchases, except for the final consumers at the end of the chain, who ultimately bear the tax's cost. This system ensures that VAT is a fair tax that eventually falls on the final consumers, making it economically neutral for businesses, while creating a stable source of revenue for governments throughout the entire supply chain.
Sales tax is a single-stage consumption tax imposed on the sale of tangible personal property and services at the final point of sale to the end consumer. Sales tax is generally charged once at the retail level; this is why it's sometimes referred to as retail sales tax.
Unlike VAT, businesses have no tax credit mechanism to claim back the sales tax they pay on their purchases. Instead, sales tax operates with exemptions.
Most states require some certificate or equivalent documentation as proof of exemption. For example, a resale certificate is a document that allows a business to make tax-exempt purchases based on the assumption that the products will be later resold and the end consumer will pay the sales tax. For this, the purchaser business must provide a resale certificate to the seller so the seller can make sure that they can sell the product tax-free when making their own sales to the business purchaser. Another example is manufacturing exemption. In most states, for example, raw materials that become parts of the finished products are exempted, so manufacturers can purchase them without paying sales tax.
The lack of exemption can make the business the end consumer, meaning that the sales tax burden falls on the business and cannot be credited, as there is no mechanism to do that. Therefore, taxes on intermediate stages in the supply chain on businesses may result in a cascade effect where the tax is added to each stage of the supply chain leading up to a final sale to consumers. Some studies estimate that around 40% of the total sales tax revenue comes from taxes levied on business-to-business sales.
Navigating between the different terms and scopes in VAT and Sales Tax
Value Added Tax
VAT operates with two basic terms: sale of goods and services. Supply of goods refers to transferring tangible property, while the definition of supply of services is pretty easy: it’s typically defined as anything other that doesn’t fall under the supply of goods.
The approach taken by VAT to determine what should be taxed is fairly straightforward. If the necessary conditions are met, all goods and services are subject to VAT unless they are otherwise exempted for some reason (e.g., medical services are usually exempted for public interest).
In contrast, the US sales tax distinguishes between tangible personal property (TPP) and services. Generally, TPP in sales tax is similar to “goods” in VAT. By definition, it is usually viewed as personal property that can be seen, touched, or measured in some way and is perceptible to the senses.
While the distinction between goods and services is quite evident in VAT, it can be challenging in the US to classify some transactions as either TPP or services. Since sales tax is mainly imposed on tangible personal property, states often define TPP in the broadest possible terms. The complexity of this is further increased because - as with everything else in sales tax - it varies state by state. For example, an office desk would be considered goods in VAT and TPP for all states in sales tax; we can be pretty sure about that. But let’s see the tax treatment of the digital download of a song. In the world of VAT, this qualifies as a supply of services (electronically supplied services in EU terms). However, since downloaded music can be listened to - it is perceptible to the senses - some US states may consider this a transfer of TPP, not services. This may result in significant implications on the tax treatment: think about that many states tax TPP, but not certain services.
As for the scope of taxation, state tax laws generally follow a common approach: they levy sales tax on all retail sales of tangible personal property unless explicitly exempted and do not tax services unless expressly stated as taxable. This approaches differs from VAT and has its roots in the historical origins of sales tax as a tax on TPP, dating back to the 1930s during the Great Depression. At that time, sales and use taxes were designed to apply only to transfers of tangible personal property in retail sales. As a result, many states have not adapted their tax policies to keep pace with the shift toward a service-based economy. For example, California has relatively low taxation of services, as its sales tax system is still largely focused on taxing TPP, while other states place more emphasis on taxing services.
As you can see, the variations in the definitions between VAT and sales tax add another layer of complexity to the mix, particularly for those operating globally.
How do VAT and Sales Tax rates differ?
VAT rates are determined at the national level and are generally the same across the country. In most countries, there is a standard VAT rate that applies to most goods and services, and there may also be reduced VAT rates for specific products or services intended to make essential goods or services more affordable.
For example, in the United Kingdom, the standard rate is 20%; a reduced rate of 5% applies to certain goods and services, such as children's car seats, while a zero rate applies to some items, such as books.
On the other hand, sales tax in the US is not determined at the federal level. Forty-five states, the District of Columbia, and Puerto Rico, along with many local counties and cities, impose some version of sales tax. Some states have a single statewide tax rate, while others allow local governments to impose additional local taxes, resulting in a patchwork of rates varying from city to city or even from one side of the street to the other.
Let's say you're purchasing a product in Chicago, IL. To calculate the total sales tax rate, you would add up three rates: 7.25% (state rate) + 1% (county rate) + 1.5% (city rate) = 9.75% total sales tax rate. As a result of this system, there can be significant differences in tax rates depending on the jurisdiction, with over 11,000 tax jurisdictions nationwide. Sales tax rates frequently change (there are hundreds of changes yearly), making it challenging for businesses to keep up with the latest rates.
Why does VAT have more formalities and stricter requirements than Sales Tax?
Strict requirements are inherent in the nature of VAT. It is a self-enforced tax at heart, meaning businesses are responsible for calculating and reporting their VAT liability. In addition, the VAT deduction mechanism, a fundamental element of the VAT system, provides an opportunity for VAT calculation errors or fraud, potentially leading to government revenue losses if not treated right. As a result, VAT has many strict requirements and formalities that may seem alien to the sales tax world, and the truth is that tax authorities take them seriously.
For example, in many VAT countries, including the European Union Member States, businesses must meet specific VAT invoicing requirements, such as containing certain information (see Article 226 of the EU VAT Directive) and being issued within a particular time frame.
Furthermore, many countries now require businesses to report their transactions in (near) real-time to the tax authority digitally. Digital reporting requirements and e-invoicing can help tax authorities to detect and prevent tax evasion by allowing them to monitor transactions and identify anomalies or suspicious activity. The nature and scope of these various requirements differ significantly across countries and frequently change, putting significant pressure on tax teams to stay abreast of the latest regulations.
Unlike countries with a federal VAT system, sales tax in the US is administered at the state and local levels. This means no federal government authority establishes a framework for invoicing and digital reporting requirements.
Furthermore, unlike VAT, sales tax is typically collected at the final sales and is not recoverable by businesses, as there is no tax credit mechanism. The lack of a tax deduction mechanism in sales tax means there is less room for errors or abuse by businesses and, consequently, less need for strict invoicing and reporting requirements.
Of course, businesses still have many areas to comply with in sales tax (think about exception management, for example); however, generally, it doesn't require as much record-keeping and reporting as VAT.
What is the difference in place of supply rules in VAT and sourcing rules in Sales Tax?
The place of supply rules (where to tax rules?) are an essential aspect of VAT worldwide, providing a framework for determining in which country or jurisdiction the VAT should be paid on transactions of goods and services.
For the supply of goods, the place of supply rules are mainly based on the physical location of the goods at the time of supply and whether delivery is involved. For supply of services, they depend on various factors, like the type of service being provided and whether the service is provided to a business (B2B) or a consumer (B2C).
These rules are complex, and navigating between them is quite challenging. This EU website provides a valuable resource for more information on the specific place of supply rules within the EU.
Similarly to VAT's place of supply rules, sourcing determines which taxing jurisdiction has the right to tax a transaction in sales tax. There are two main sourcing rules for sales tax in the US: destination-based and origin-based sourcing. It's important to note that sourcing rules can vary by state; some states follow one or the other, while others may split between origin and destination sourcing.
Destination-based sourcing is the most common rule in the US. It means that the sales tax is based on where the product or service is delivered rather than where the seller is located. Different from VAT, it isn't relevant whether the service is supplied in a B2B or B2C relation. All states follow destination sourcing for cross-border inbound (e.g., Ireland - Los Angeles, CA), interstate (e.g., NY-MA), and most states use it for intrastate transactions as well (e.g., FL-FL). For example, if a company in New York, NY, sells a product to a customer in Boston, MA, the sales tax rate applied would be the rate in Boston, where the product was delivered. The same applies to a sale within Florida: Orlando sales tax rate applies if a company in Miami, FL, sells a product to a customer in Orlando, FL.
On the other hand, origin-based sourcing means that the sales tax is based on the retailer's location or where the product is shipped, or the service is provided from. Some states, like Arizona, Illinois, and Texas, follow origin sourcing for intrastate transactions. For example, Phoenix, AR's sales tax rate applies if a company in Phoenix, AR, sells a product to a customer in Tucson, AR as that is where the retailer is located.
Sourcing rules are complex. If you operate in more states, it's essential to understand the specific rules for each state where you do business and to ensure that you perform tax collection properly and remit the correct tax amount based on the applicable sourcing rules in the proper jurisdiction.
How can Fonoa help?
While both VAT and sales tax aim to generate revenue for governments, they differ significantly in their approach, from what they tax to how they calculate tax rates. The differences and complexities of VAT and sales tax can make it challenging for businesses to navigate the tax landscape, particularly those operating in multiple countries or states.
As a tax technology company, Fonoa provides automated tax solutions that help businesses maneuver the complexities of VAT and sales tax.
Fonoa Tax accurately determines VAT and GST globally, as well as Sales Tax in the US, ensuring that your tax calculations are always up to date with the current legislation.
Fonoa Invoicing automatically generates locally-compliant tax invoices for transactions across the globe.
Fonoa Reporting allows you to comply with digital reporting globally and keep up with the evolving local reporting requirements, all with a single API and on a single platform.