Explaining VAT and the Reverse Charge Mechanism
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By Aaron Luria
Value Added Tax (VAT) is an indirect tax that applies to the supply of goods and services. It gets its name because it taxes the additional value that a product receives as it passes through the supply chain, starting from the manufacturer all the way to the end client.
VAT example scenario
To get a better understanding of how VAT works, let’s work through a simple case:
The case involves three parties:
- Empresso, a manufacturer of coffee machines. The manufacturer is located in the UK.
- ACE Ltd., a multi-branched electric merchandise company in the UK that buys and sells appliances to retailers.
- Deelight, a local retailer in the UK that sells to consumers.
In our scenario, the following sales occur:
- Empresso sells 5,000 coffee machines to ACE Ltd, at a unit price of 100£ + VAT.
- ACE Ltd. sells the machines to Deelight, at a price of 200£ + VAT
- Deelight sells the machines to retail customers at a price of 250£ + VAT.
The applicable rate of VAT in the UK is 20%. The sales will result in the following invoices:
- Empresso issues an invoice (for 1 coffee machine) for 120£ (100+20% VAT) and will transfer 20£ to the tax authorities.
- ACE issues an invoice (for 1 coffee machine) for 240£ (200+20% VAT). At this stage, they can offset the VAT paid to Empresso (input VAT) against the VAT received from their buyers (output VAT). That means instead of transferring 40£ to the tax authorities, they apply the 20£ already paid to Presso and only transfer 20£.
- Deelight sells 1 machine to the end client, collecting 300£ (250+ 20% VAT). Deelight is also entitled to offset their VAT, transferring 10£ instead of 50£. The end client does not get any entitlement to offset their paid VAT.
In the end,
- Empresso did not pay any VAT, collected 20£ in VAT, and transferred 20£ in VAT.
- ACE paid 20£ in VAT, collected 40£ in VAT, and transferred 20£ in VAT
- Deelight paid 40£ in VAT, collected 50£ in VAT, and transferred 10£ in VAT
- The consumer paid 50£ in VAT. Note that in the end, all the VAT sent to the government came from the consumer.
Reverse Charge Mechanism – its purpose and how it works
The Reverse Charge Mechanism (RCM) is a tool used to combat instances of VAT fraud, such as missing trader fraud. In missing trader fraud, a party in the supply chain does not pass the tax they collect to the government, keeping it themselves. The RCM anti-avoidance legislation reverses the responsibility, making the buyer responsible for paying the VAT to its own VAT authorities.
RCM applies when you buy goods or services from suppliers in other EU countries. In order to implement the RCM, the seller and the buyer must both be VAT registered and issue a fully RCM-regulation-compliant invoice.
To get a better understanding of how RCM works, let’s continue with our coffee machine example. This time, let’s say Empresso is based in Italy, and ACE is a German company.
Upon selling 1 coffee machine, Empresso will issue an invoice to ACE for 100£ (100 + 0% VAT) and note that the “Reverse Charge” applies. ACE pays 100£ to Empresso.
ACE must calculate the VAT amount that should be applied based on the German VAT rate. This amount is recorded as the output tax on their VAT return. Since ACE will be reselling the coffee machine, ACE can reclaim the tax as input tax, resulting in a net-zero effect. In this way, the two entries cancel each other from a cash flow payment perspective. For the tax authorities, the applicable input and output taxes are recorded on the tax returns for the cross-border supply of goods or services.
Reverse Charge Mechanism - Compliance
Overall, in order to comply with the Reverse Charge Mechanism, the following provisions must be met:
From the Supplier/Seller point of view
- Verify that the buyer is registered with VAT in their jurisdiction and provides their VAT number.
- Note on the invoice that the RCM is being applied.
- Do not charge VAT to the invoice (0%).
From the Client/Buyer point of view
- Make sure that no VAT is charged.
- Make sure that the invoice indicates that the RCM is applied.
- When filing the VAT return, make sure that both the input VAT and output VAT have been included so that the net VAT is nil.