August 11, 2023 | 5-minute read (874 words)
The method of taxation for the production of goods and services can vary widely from country to country. While production costs may be lower in one country than in another, differing tax structures can impact your bottom-line revenue in the long run. Especially if you’re accustomed to simply following the sales tax structure established in the United States, which largely passes production taxes onto end consumers.
In this article, we’re taking a closer look at value-added tax (VAT), and how this tax can impact your costs, from production and distribution, to final sale.
What is value-added tax?
Value-added tax, also called VAT or the Goods and Services Tax if you’re in Canada, is an indirect tax that is applied to products as they move step-by-step through production — before they’re sold to the end consumer. At each stage of the production process, a set percentage of VAT is levied, based on how much value that step added to the product. At the end of production, the end consumer pays a final VAT total based on the final cost of the product, minus the VAT tax that has already been paid during the production process.
While VAT is commonly used in over 160 countries around the world, and especially in the European Union, it’s not used in the United States. Instead, the U.S. charges sales tax on goods.
How is VAT levied?
VAT is considered a consumption tax. That means it’s paid when a company or consumer purchases goods or services. This differs from a progressive income tax, which applies to the income earned by companies and individuals. According to some, this makes VAT more fair because it spreads the amount of tax owed between producers, distributors and consumers, compared to sales tax and income tax, which are both more heavily levied against the individual.
The specific amount of VAT paid on a good at any stage in the production process is based on the gross margin added to the product during that stage. In other words, the tax is based on how much more valuable the product becomes as a result of that production step, minus the amount of VAT that has already been paid.
Here’s an example of how VAT works across a three-stage production process:
1. Raw materials
A fabric producer takes raw materials and turns them into cloth and thread. They sell this cloth and thread to a suit maker for $30. In this example country, the VAT rate is 20%, so the fabric producer charges the suit maker $36 total, and sends $6 VAT to the government.
The suit maker uses the cloth and thread purchased to make a suit, adding value to the raw materials. When finished, the suit maker sells the suit to a retailer for $120, which includes $18 of VAT. The suit maker must pay $12 of this VAT to the government, but keeps the other $6 as a repayment for the VAT they paid to the fabric producer.
3. Final sale
The retailer sells the suit to a customer for $300, which includes a VAT charge of $36. The retailer must send $18 of that VAT back to the government, but keeps the additional $18 as repayment for the VAT they paid to the suit maker.
This basic example of VAT shows that, while complicated, VAT can often be a pass-through cost for businesses. In many cases, VAT can be fully reclaimed through the normal course of business operations, when the goods or services move to the next production stage. That keeps revenue flowing into the country’s government, without overly burdening the businesses that provide it.
In short, VAT can have a neutral impact on businesses, if they sell their goods at a high enough margin to offset the VAT rate. However, depending on the length of the company’s production cycle, it may take several months to reclaim those earnings.
If you manufacture goods in a country that levies VAT, there are three types of VAT tax you should be aware of
Depending on the country and type of good or service, there are three types of VAT that can be applied.
Standard rate VAT is the rate that applies to the majority of goods and services. In the European Union, the minimum standard VAT is 15%, though some countries may charge 20% or more.
The second type of VAT, reduced-rate VAT, can be applied to some goods and services, like some fuels, certain art and antiques, repair services, and some building services.
Finally, some goods and services qualify for special rates — a VAT of as little as zero. Special rates can apply to some necessary goods and services like children’s clothing, medication and books, as well as exports.
Managing VAT requires careful reporting and strategic planning
VAT is a complex tax. But, when understood and accurately accounted for, it doesn’t have to negatively impact your operations in VAT countries. By integrating VAT timing into your strategic planning, your company can optimize its cash flow, reduce production time, and reclaim VAT quickly and more efficiently. Remember, taxation isn’t just a hurdle to overcome — it’s an opportunity to innovate and excel.