Sales tax and VAT (value-added tax) are similar in principle: they are taxes, imposed by governments, on consumer goods and services. In the U.S., sales tax is the primary form of taxation on consumer goods. VAT can be considered a sales tax equivalent; it’s used by more than 170 other countries.
The primary difference between sales tax and VAT lies in how they must be handled by businesses that sell goods or services.
This article will explain everything you need to know about sales tax and VAT, as well as how to make sure your business stays compliant if it’s selling internationally. Noncompliance with tax regulations can result in fines, penalties, and other serious consequences.
What is sales tax?
A sales tax is a fee, imposed by a local government (a state or city, for example), that is added to the final price of a product or service. Typically, this fee is a percentage of the sales price. This percentage varies and is determined by:
- The type of product or service being sold. For example, software as a service might be charged at a higher rate in certain cities.
- The rate of sales tax in the state where the transaction happens.
- The rate of sales tax in the area (the city or county, for example) where the transaction happens.
The impact of sales tax on business operations
Sales tax affects a business in many ways. The final price that consumers pay for a business’s products and services will vary depending on where the purchase takes place. And businesses must understand varying tax codes because they are responsible for charging the correct tax rate when they make a sale.
After that, businesses need to remit the tax amounts they’ve collected to the proper tax authorities on a regular basis. Depending on the size of your business and where you operate, you may need to remit taxes quarterly, annually, or monthly. And this frequency may vary from state to state.
Businesses must also keep track of where they have established nexus (a physical presence or a certain level of economic activity): many states impose sales tax only if a seller has nexus in the state — laws about nexus vary from state to state, as do nexus criteria. (The concept of nexus is also relevant to VAT.)
It’s up to the seller to understand the various tax codes in all the areas where they do business and to properly collect and remit the correct amounts. This is not the consumer’s responsibility.
What is VAT?
A VAT system is a different method of taxation; it’s used by more than 170 countries, including all EU nations. This type of taxation system levies a consumption tax on goods and services at each stage of the production process.
Unlike a sales tax system, where consumers pay taxes at the final point of sale, a VAT system distributes the responsibility for paying taxes evenly among different parties.
As a product is being created, each business along the production chain will need to pay VAT. The tax rate will depend on the value of the product at that stage of development and the area where the sale is occurring. If you are not the original creator of the product, then the previous manufacturer should’ve already paid VAT. This VAT will be deductible for parties later on in the process.
Once the product reaches the final consumer, the consumer does not get a deductible based on VAT previously paid at other stages.
On average, VAT rates hover around 15%. In some parts of Europe, the rate is as high as 20%, and in some areas of Asia, it dips down to 12%. This is much different than the average sales tax rate in the U.S., which is around 7%.
The impact of VAT on supply chains
VAT systems have a major impact on supply chains. Multinational companies must manage various VAT taxes, sales taxes, and other regulations as they conduct their business. Understanding VAT will be very important if you use international goods in your supply chain.
VAT compliance also directly impacts a business’s cash flow. Understanding tax obligations can improve cash flow, but a lack of preparation can lead to challenging situations.
Structural differences between sales tax and VAT
Sales tax and VAT systems operate differently, but they have the same goal: to produce revenue based on the sale of goods and services. There are some specific structural differences between these two systems, including the way the taxes are collected, the way invoices are tracked, and the visibility of the taxes to the consumer.
Single-stage vs. multi-stage collection
One of the biggest differences between a sales tax system and a VAT system is how the taxes are collected. With a sales tax system, taxes are collected only when the consumer purchases the final good or service. VAT, on the other hand, is collected at many stages of the production process — basically, any time a new business adds value to the good or service.
Invoice-based tracking and tax credits in VAT systems
Tax credits complicate things further. With a VAT system, multiple parties may share responsibility for paying tax. But different parties also get credits for VAT that has already been paid.
Here’s an example: Say a farmer sells some cherries for €1 to a baker in a place where the VAT is 10%. The farmer would be responsible for collecting 10 cents and remitting it to that place’s tax agency. The baker then uses the cherries to make a tart, which he sells in his bakery for €3 with a 10% VAT, meaning that the baker needs to collect 30 cents tax. But since the farmer already remitted 10 cents, that reduces the baker’s tax burden, the amount he needs to remit, to only 20 cents. When all is said and done, the tax agency receives 30 cents on this transaction; the amount is just split between two parties.
With a sales tax system, the final buyer would simply pay 30 cents sales tax on the transaction in one transaction.
Tax visibility to the consumer
Another important difference between these two systems is how visible the taxes are to the consumer. With a sales tax system, consumers see a sticker price and can calculate how much tax will be owed at checkout (as long as they know the sales tax rate where they are). And at checkout, the consumer is typically shown exactly how much was paid fortax and how much was paid for the product or service.
With VAT, taxes are sometimes included in the item’s sticker price, making it more difficult for the consumer to identify what money is going toward tax and what money is being paid for the item. However, VAT is shown on receipts in many countries, providing transparency for the end consumer.
Compliance differences and requirements
Both sales tax and VAT systems present complexities and challenges, but noncompliance could have serious financial consequences.
Sales tax compliance
When it comes to sales tax compliance, businesses are required to monitor their transactions. If they establish physical or economic nexus in an area, then they will need to start charging, collecting, and remitting sales tax there. It’s up to the business to determine how to apply the correct tax rates and submit their payments to the right tax agencies. Since different states and local areas have different tax rates, businesses need to do some research to ensure that they are charging the right amounts and remitting their taxes at the right frequency.
VAT compliance
VAT systems are a bit more standardized, but they’re still complex due to tax credits and multi-stage collection. Companies are required to research and understand their tax obligations and remit the proper amounts at regular intervals. While tax credits may help businesses pay less overall, tracking and reporting every transaction can take a lot of time and attention.
Comparative example: sales tax vs. VAT in action
Here are some illustrative examples:
Sales tax example
Under a sales tax system, a consumer might go to a clothing store and purchase a pair of jeans priced at $50, and the price tag would say $50. The local tax rate is 8%, so the consumer pays $54 at the cash register. The clothing store will remit $4 of that amount to the local tax agency.
VAT example
Under a VAT system, a consumer might go to a clothing store and purchase a pair of jeans priced at €50, but if the tax rate in their area is 8%, the price tag would say €54 (the consumer price including VAT). So the consumer will pay €54.
But as the pair of jeans was being produced, different businesses would have paid VAT for the things that they’d purchased (for instance, the textile company might have paid VAT to the cotton producer, and the jeans designer might have paid VAT to the textile company). However, these companies can then claim credits for the VAT amounts they’d paid — each business in the supply chain can deduct the VAT they paid from the VAT they charge on their sales. This system ensures that the final consumer bears the full cost of the VAT, while businesses pay VAT only on the value they add to the product.
Advantages and disadvantages of sales tax and VAT for businesses
Around 19 countries, including the U.S., have adopted a sales tax system. More than 170 countries have adopted either VAT or GST (similar to VAT) tax systems.
Advantages of sales tax
One of the biggest advantages of using a sales tax system is that it simplifies the tax collection process. The tax is charged at the final sale. Disadvantages of sales tax
One of the biggest disadvantages of sales tax systems is that businesses can have a hard time understanding their tax obligations in different jurisdictions, as tax rates vary from state to state, and often from city to city or county to county.
Advantages of VAT
One of the biggest advantages of a VAT system is that the government gets more consistent revenue through the production process. Taxes are also more evenly distributed throughout the process, reducing the risk of noncompliance. Governments tend to find this process more efficient because businesses are more likely to comply and track their taxes because they have the chance to earn and claim credits.
Disadvantages of VAT
The number one disadvantage of VAT systems is that they lead to higher administrative costs for businesses. Businesses need to extensively track their transactions and collect and remit VAT. International businesses can also find it challenging to comply with multiple VAT laws in different areas.
Global business considerations: When do VAT and sales tax apply?
Are you wondering when you’ll need to collect sales tax and when to use a VAT system?
The answer depends on many factors, including where you’re conducting business and where you have established nexus. To identify whether a tax nexus exists, you’ll need to know how much money you’ve collected by conducting transactions in various jurisdictions. Then, you’ll need to research the tax laws in those areas.
Choosing the right approach for compliance
The right approach to tax compliance depends on your business’s specific needs. Compliance is crucial, so it’s necessary to formulate a tax strategy. These are a few things to consider.
Understanding needs across multiple jurisdictions
If you do business in multiple states, jurisdictions, local areas, or countries, you need to understand how taxes work in all of them. You cannot apply your local tax rate to a transaction that occurs in a different jurisdiction.
Using technology for compliance
Remaining compliant with various tax laws and regulations in multiple states and countries can be overwhelming and take your focus away from your business’s important day-to-day operations.
So in many cases, it’s a good idea to outsource your tax compliance needs to a professional. Technological tools can also greatly simplify the process of monitoring your transactions, charging the correct rate of tax, and remitting what you owe.
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The costs of noncompliance
The costs of noncompliance are high. Not complying with sales tax or VAT requirements will, at minimum, result in significant financial consequences. Penalties and fees could derail your business, especially if you can’t come up with the funds to cover previous noncompliance.
Noncompliance could result in criminal charges. This is especially true if you’ve continued to ignore tax laws despite being contacted by tax agencies, educated about your tax obligations, and sent attempts to collect payments from you.
The bottom line
In the U.S. and some other countries, only the final consumer of a product is charged sales tax. Before this final sale, sales tax is not collected or considered. In many other countries, however, a VAT system requires that sellers collect and remit taxes at various stages of the supply chain. Instead of the taxes being calculated at the final sale, suppliers, manufacturers, retailers, and distributors will all need to collect and pay VAT on taxable sales.
If your business is selling goods (to consumers or to other businesses) outside of your local community, you’ll need to have a firm understanding of tax laws. You must remain compliant with not only your local tax codes, but also your state tax laws and federal ones, too. If you conduct business internationally, then there may be additional laws, like VAT regulations, that you need to comply with.
Things can get complex fast! But Numeral simplifies the whole process for you, so you can reach 100% tax compliance in all the areas where you do business. Numeral monitors all your sales, registering your business in states or areas where nexus has been established, and collecting the proper amount of taxes on your transactions. The Numeral team will also ensure that your business remits the proper amount to tax authorities as it becomes due.
