Learn more about keeping your business compliant with sales tax requirements.
By Alex Zhong, Tax Accountant, 1-800Accountant (a BizFilings partner)
When it comes to paying taxes as a small business owner or operator, you’re probably already very familiar with transactional taxes - such as sales and use taxes. However, knowing the difference between VAT and sales tax is crucial to maintaining tax law compliance.
The United States has a sales tax rate that varies by state. However, if you plan to expand your business internationally, you need to have a solid understanding of the VAT system as well. We’ll cover the definition of VAT and sales tax, which countries use VAT, and how the two tax systems work.
VAT (value-added tax) is a consumption tax placed on a product when value is added at each stage of the supply chain. These stages include the very beginning with raw materials to the production process and then finally to the point of sale with the end consumer.
Suppliers, manufacturers, distributors, retailers, and end consumers all pay the VAT on their purchases. Businesses are responsible for tracking and documenting the VAT they pay on purchases.
Sales tax is a consumption tax imposed by each state government on the sale of goods and services. A conventional sales tax is levied at the point of sale when the retailer collects the sales tax and then passes it on to the government.
End consumers pay the sales tax on their purchases. Businesses issue resale certificates to their sellers when buying business supplies that will be resold since sales tax is not due.
Sales tax and VAT are not the same. The main difference lies in which stage in the sales process the tax is levied. Sales tax is levied at the final point of sale. Only the end consumer bears the responsibility to pay for the sales tax.
State and local municipalities often have different sales tax obligations (unless you live in Alaska, Delaware, Montana, New Hampshire, and Oregon where general sales tax is not imposed.)
On the other hand, VAT is an invoice-based system and is collected at every stage of the supply chain whenever the product gains more value. Each buyer in the transaction process is responsible for paying VAT, rather than just the end consumer.
Every seller in the production process charges VAT on the new buyer and then remits it to the appropriate tax authority. The amount in VAT collected at each sale is based on the new, increased value added by the latest seller.
Whether it’s a 10% sales tax or a 10% VAT, the amount of tax paid on each dollar is the same. However, the process for filing and remitting the taxes to the government is very different.
VAT is a consumption tax levied by all members of the Organisation for Economic Co-operation and Development (OECD), except for the United States. The United States does not have a federal sales tax but instead leaves it to the jurisdiction of the states.
Members of the OECD have different regulations and policies regarding their VAT systems and rates vary drastically by country.
Since 1991, Canada’s federal government has levied a 5% Goods and Services Tax (GST) on most goods and services. When businesses file their GST return, they can claim Input Tax Credits (ITCs) to recover the GST they paid or owe on their business purchases and expenses.
For zero-rated goods and services in Canada, businesses do not charge or collect GST. However, they can still claim ITCs for them on their GST return. Zero-rated goods and services in Canada include basic groceries, farm livestock, medical devices, and prescription drugs.
The European Union requires all member states to use the VAT system which covers the consumption of most goods and services. EU law only requires that the standard VAT rate must be a minimum of 15% and the reduced rate must be at least 5%. Actual rates between EU countries and between different products may vary.
Many United States business owners have never dealt with VAT and may wonder, “How does VAT work?” It’s easiest to understand VAT when looking at the different stages of a product from start to finish.
For example, a farmer grows cotton and supplies the raw material to a textile maker. The farmer must then pay the flat tax of the profit on the sale of the raw cotton.
The textile maker uses the cotton to produce a dress. The textile maker must then pay the flat tax of the profit he makes selling the dress to a clothing store. The textile maker minuses the taxes already paid by the farmer who supplied the raw materials.
At the end, the clothing store sells the dress to the customer (the end consumer.) The customer pays the flat tax minus the taxes already paid.
This is in contrast to a sales tax, in which the end consumer would bear sole responsibility for paying the tax which the retailer would then remit to the government.
The nuances of sales tax can be confusing for small businesses - which is where we can help. BizFilings has partnered with 1-800Accountant, a nationwide online tax preparation, accounting, bookkeeping, and payroll service provider.
Through their partnership, 1-800Accountant will provide free consultations to BizFilings readers and clients. Simply make an appointment with a specialist today to learn more.
Alex Zhong is a Tax Accountant in the Pacific team at 1-800Accountant. Alex studied at Queens College at the City University of New York and received a Bachelor's degree in Accounting, Finance, International Business and Economics. Alex has 8 years of experience in public accounting with a strong accounting and tax background. He specializes in business tax returns.
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