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A thorough understanding of value-added tax (VAT) and sales tax can help you comprehend how taxes apply to commodities. One distinction between these taxes is their varying applicability on commodities and where they are purchased. These taxes are levied regardless of an individual’s wealth or income, and the percentages can be perplexing, even among members of the corporate tax community.

When you look at VAT vs sales tax, it’s important to note that they have distinct similarities and differences between them. VAT is a consumer tax that gains value from the point of manufacture to the point of sale. In contrast, sales tax is a consumer tax that the government levies on the entire value of a commodity at the point of sale. Both sales tax and VAT are examples of indirect taxes levied by the seller at the moment of purchase and paid to the government on the buyer’s behalf.

In sales tax, you pay the full amount the government requires at the point of sale, whereas with VAT, different parties pay portions of the tax amount according to a transaction. VAT is a multi-staged taxation system, while sales tax is a single point tax-paying system. While tax evasion is impossible in VAT, sales tax evasion is possible through various legal or illegal means.

What is a value-added tax (VAT)?

A value-added tax (VAT) is a sort of consumption tax that is levied on a product at each step of production. It gains value throughout the process, from the point of manufacture to the point of sale. The amount of VAT that the user pays is determined by the cost of the product minus the cost of raw materials used to create the product. Value-added tax collection encompasses the entire production, distribution, and consumption processes. VAT is used in a variety of agricultural businesses (plantation, forestry, and animal husbandry, to name a few), mining, manufacturing, construction, transportation, and commercial services, to name a few.

The government accesses VAT on every part of the production chain. This includes all processes, from buying the raw materials to putting the product on store shelves. Although they deduct previous taxes at each step, each person or organization in the chain still pays the same tax rate on their profits. Let’s follow an example to help you better understand the process.

Example: If you supply raw materials to a manufacturer, the government requires you to pay 10% of your profit from the supply. The manufacturer is also to pay 10% of the profit they make from selling the product to a store. This excludes the taxes you paid to supply the raw materials. It all ends with the retailer selling the item and paying 10%, minus the payments in the first two stages of the process.

Types of value-added taxes

Here are several types and descriptions of value-added taxes:

  • Production value-added tax

Production value-added tax means that when collecting value-added tax, only part of the production materials belonging to non-fixed asset items may be deducted. It excludes the depreciation of fixed assets from the tax base in the coming years. Consumption and gross investment are both subject to taxation. Production value-added tax is used to determine the gross national product (GNP).

  • Income-based value-added tax

Income-based value-added tax means that you can make a tax deduction on depreciated fixed assets when collecting the value-added tax. This type of tax excludes depreciation cost in the tax base in subsequent years. In addition, consumption and net investment are both subject to the tax, and the tax object of this type of value-added tax is roughly equivalent to income.

  • Consumption value-added tax

Consumption-type value-added tax means that there is a one-time deduction of all taxes from the value of fixed assets. With this method, as far as it concerns the entire society, the government excludes the means of production from taxation. The tax object of this type of value-added tax is only equivalent to the value of social consumption materials. Thus, it’s named consumption-type value-added tax.

When do you pay VAT?

You may pay VAT in the following situations:

  • You have a permanent establishment, e.g. a facility like bookkeeping facilities, or when parties enter a contract.
  • There are taxpayers whose business activities reach the monetary threshold in a tax jurisdiction.
  • There is a specific activity or legal service that requires it.

What is a sales tax?

A sales tax is a type of consumption tax levied by the government on the exchange of goods and services. It is a regressive and indirect tax levied on consumption rather than an individual’s contribution to the economy (income tax). It is also known as the Goods and Services Tax (GST) in some nations.

Read Also: Energy And Environment Taxes in Canada

Unless you live in a region where there is no charge on region sales tax, business owners are required to collect sales tax at the point of sale. Collecting taxes for all of your local businesses may necessitate the acquisition of a sales permit. Knowing your region’s sales tax requirements is essential, especially if you sell and send goods to other regions.

All retail sales are subject to sales tax. States, towns and other local governments choose whether there is a sales tax, what sorts of goods or services it applies to and the rates levied. Wholesalers who sell goods or supplies to manufacturers or licensed retailers within the industry are free from paying sales tax in some jurisdictions. In these cases, you can only pay tax on retail sales and purchases as a consumer. Here, the step-by-step gradual accumulation of tax funds throughout the process is nonexistent.

When you purchase any item, the price you pay is higher than the sales price because of the additional sales tax. This includes regional and local taxes at varying rates. Excluding specific goods and services, you can calculate sales tax as a percentage of the item amount. Knowing the different sales taxes helps you to comply with regional obligations and to evaluate your purchasing decisions.

Factors that determine who pays sales tax

The regional government makes some exceptions to the payment of sales taxes for goods and services. Here are a few different factors to consider:

  • Location

Determining when to charge sales tax depends on the seller and buyer’s physical location, the business’s filing status and the kinds of goods or services you render. If you live in the same location as the seller and that region has a sales tax, the government expects you to pay the sales tax which the region levies. If you live in another region from the seller, there’s no sales tax in most cases.

Exceptions to this rule come into play when a business has a physical presence in the region but is based elsewhere. This is called a ‘nexus’. It includes places of business such as stores, offices and warehouses.

  • Status (exempt status)

A region’s regulations may exclude nonprofit organizations, schools and government agencies from paying taxes. As a result, the corporate tax institutions grant them tax-exempt status. It’s also common to exempt tax for re-sold items and raw materials used to produce goods and certain necessities, such as food, clothing (up to a certain cost) and other essentials. Any of these transactions may require a tax-exempt certificate to be kept on file by the seller supplying the tax-free goods.

  • Goods or services

Although each region has its own rules that govern taxes on sales, most regions agree that prescription drugs, food and animal feed are tax exempt. Some other regions also consider labour or services to be tax exempt. In most cases, though, a large percentage of all goods and services have sales taxes.

How do VAT and Sales Tax rates differ?

  • VAT

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.

  • Sales Tax

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?

  • VAT

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 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.

  • Sales Tax

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 triggers the tax administration requirement?

VAT collection is required under the following circumstances:

  • Permanent establishment – Existence of a facility, bookkeeping facilities, or ability to enter contracts
  • Registration threshold – Taxpayers with business activities that exceed the monetary threshold in a tax jurisdiction
  • Sometimes a specific activity triggers a VAT registration obligation (e.g. legal services)

Sales tax obligations are triggered by:

  • Nexus — e.g. taxpayers with a physical presence in a tax jurisdiction or who meet economic nexus thresholds

Before the 2018 South Dakota v. Wayfair Supreme Court ruling, nexus depended on a company’s “physical presence” in the state. But in a post-Wayfair world, if your business sells goods in any state — even if you don’t have physical presence in that state and the transaction is online only — you may now be obligated to register in that state and collect sales tax if you exceed the “economic nexus” threshold. Sales tax automation software can help you understand and determine if you have met the nexus threshold.

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