As a company owner, you are responsible for declaring VAT taxes to the authorities. These 9 points will help you understand what VAT is, the benefits of correct VAT declarations and how freelance management systems help simplify working with VAT and freelancers on an international scale.
1) The VAT Concept
V.A.T. is an acronym that stands for Value Added Tax. Essentially, it is a tax on the things that we buy - a tax on supplies calculated by adding all of the costs involved in making and distributing goods or services, minus the amount that businesses can claim back during the production process for their "inputs": the VAT they have paid when buying the raw materials, goods and services acquired in making the finished product.
Compared to general taxes that have been with us for centuries, VAT is rather young. A German businessman named Wilhelm von Siemens is credited with coming up with the idea of a VAT in the 1920's. What was only an idea has since been built into a system by the more recognised father of VAT, Maurice Lauré, who was then the joint director of the French tax authorities. The VAT was implemented in France in 1954.
According to Tax Notes International, in the 1960's, manufacturing-level VATs were introduced in the old french colonies of Côte d’Ivoire and Senegal. In 1965, Brazil introduced a VAT that applied to all phases of production. It wasn’t until 1989 that the VAT became a worldwide success in 48 countries - primarily located in Western Europe and Latin America. The spread of the VAT in Europe was mainly due to the new rules implemented in the European Economic Community (now called the European Union). The then EEC believed that if they were to unify as one EU organisation then the VAT must apply for any member country that wishes to join.
Every country has its own set of more specific VAT rules and sometimes, VAT does not always need to be charged. As a business owner, understanding VAT can help you minimize and manage the paperwork to your best advantage. We go through the purpose of VAT, the different rates applies, the importance of declaring your input costs and the exemptions.
Its spread has gained a lot of traction since, and has now been implemented in more than 140 countries. It also appears to be working as it often accounts for one-fifth (if not more) of the total tax revenue in those countries.
2) The Advantages of VAT
The VAT is a consumption tax from consumer spending. Like any other tax, the purpose of the VAT is to raise revenue to finance government spending. Advocates of the VAT claim that they raise government revenues without taking away from success or wealth and the advantage of the VAT over other forms of sales tax is that it is harder to avoid; VAT is levied at every step of the supply chain.
It is collected fractionally, via a system of partial payments whereby taxable persons (i.e., VAT-registered businesses) deduct from the VAT they have paid on purchases from the VAT they have charged their clients. This mechanism ensures that the tax is neutral regardless of how many transactions are involved.
3) The Uneven Side of VAT
Other critics say that the VAT places an increased economic strain on lower-income taxpayers and bureaucratic burdens on businesses.
The VAT disproportionately affects the poor. Since the tax will be the same for the rich and the poor; the tax will be a higher percentage of a poor person’s income. Taxes on basic necessities such as food and water become out of reach from the people in need.
For example, Jenny and Susan are living in Amsterdam, and they both have to pay a Value Added Tax. Let’s assume for simplicity that the VAT is 5% on all purchases in Amsterdam. Jenny makes €50,000 per year and spends €6,000 annually on purchases such as food and clothing. Jenny pays €300 per year in value added taxes (€6,000 x 5% = €300).
Susan also lives in Amsterdam, but she only makes €20,000 per year. She spends €6,000 on purchases as well. She will pay the same €300 VAT as Jenny. However, the VAT is only 0.6% of Jenny’s income whereas it is 1.5% of Susan’s income.
Even though they are both paying the same amount of money, the VAT is a larger percentage of Susan’s money. The VAT represents a much larger chunk of lower income individual’s money than other individuals. Senior citizens and people that live on fixed incomes are also adversely affected.
In terms of bureaucratic burdens, it is important to understand as a business - self-employed or freelancer, VAT is not your money to keep. The government entrusts you to report and declare on a monthly, quarterly or yearly basis and the only money you will be able to keep for yourself is your income, after paying tax.
Businesses pay VAT on a quarterly basis by filling in a VAT return. For most contractors and other self-employed people, be they sole traders or limited companies, this simply requires them – or their bookkeeper – to ensure that their accounts are up-to-date every three months and that they do not see the extra cash received as their revenue.
4) EU RATES
So what percentage of VAT should you charge as a registered business? EU law requires that the standard VAT rate must be at least 15% and the reduced rate at least 5% (only for supplies of goods and services referred to in an exhaustive list).
Actual rates applied vary between EU countries and between certain types of products. In addition, certain EU countries have retained other rates for specific products. The most reliable source of information on current VAT rates for a specified product in a particular EU country is that country's VAT authority. An overview of the different rates applied in all EU countries is provided in the EU information.
Normally, if you are registered for VAT and you make sales to other businesses, you must issue a VAT invoice. Your VAT identification number must be shown on all invoices you give to customers, as well as the amount of VAT being charged and other standard items. In order to get a VAT number, you must register with the local tax authorities.
5) EU VAT Threshold
Small businesses whose yearly turnover is below a certain threshold may be able to benefit from graduated relief. If you are eligible for the scheme you still have to register for VAT but you will be able to receive a relief on part of your turnover. The relief gradually decreases as your turnover increases until the threshold - set by the EU country where your company is based - is reached.
These thresholds vary from country to country and special conditions may apply. Currently there are only a few EU countries that have implemented the relief scheme.
Below are the current thresholds in Europe:
6) VAT Exemptions
There are some exceptions to the general VAT rule. For example, if you provide a service to another business, that is not located in the same EU country as your company is based, the VAT will not appear on your invoice. This does not mean the service is not subject to VAT, just that the VAT would be accounted for and paid directly by your business partner in the other EU country.
Similarly, if you make an export of goods to a non-EU country, your invoice will not show VAT. Normally, the buyer in the non-EU country will be subject to importation rules of its country.
7) Calculating VAT
To calculate the amount of VAT a consumer or business must pay every quarter, you take the cost of the goods or service, and subtract any material costs previously taxed. An example of a 10% VAT in sequence through a chain of production can occur as follows:
A manufacturer of electronic components purchases raw materials made out of various metals from a supplier. The metals supplier– the seller at this point in the production chain – charges the manufacturer €1 plus a 10-cent VAT, and then pays the 10% VAT to the government.
The manufacturer adds value through its manufacturing process of creating the electronic components, which it then sells to a mobile phone manufacturing company for €2 plus a 20-cent VAT. The manufacturer remits 10 cents of the 20-cent VAT it collected to the government, the other 10 cents reimbursing it for the VAT it previously paid to the metals supplier - this is called input tax.
The mobile phone manufacturer adds value by making its mobiles, which it then sells to a retailer for €3 plus a 30-cent VAT. It pays 10 cents of this VAT is paid to the government; the other 20 cents reimburse the cellphone manufacturer for the previous VAT it has paid to electronic component company.
Finally, the retailer sells a phone to a consumer for €5 plus a 50-cent VAT, 20 cents of which is paid to the government. The VAT paid at each sale point along the way represents 10% of the value added by the seller.
8) Input VAT Tax Deductions
Once you’re a registered business, you’ll have to charge your clients VAT for all the goods and services that you sell them. You can then reclaim any VAT that you’ve paid on goods and services that you’ve bought for your business as input tax. When you buy goods and services yourself, you’re going to be paying the cost of someone else’s VAT.
You can offset the VAT on your purchases against the amount of VAT you’ve charged your clients and reduce the amount you will have to pay back to the authorities. If you are in business, you can usually deduct the VAT you have paid on your own business purchases from the VAT you charge your customers; you then only need to pay the difference to the tax authorities, and report these amounts to them in your periodic VAT returns. Sometimes, the VAT your business has paid exceeds the VAT you have charged to your customers. If so, the tax authorities should reimburse or credit you with the difference.
9) Reverse Charge
When freelancers work through a Freelance Management System (FMS) such as Flime, Upwork and Freelancer, the reverse VAT process is applied in order to simplify the bureaucratic burden and increase transparency with the tax authorities. Being based in the EU, companies like Flime can subcontract through the company platform and apply reverse charge to the invoices.
When you buy goods or services from suppliers in other EU countries, the Reverse Charge moves the responsibility for the recording of a VAT transaction from the seller to the buyer for that good or service. The recipient of the goods or services makes the declaration of both their purchase (input VAT) and the supplier’s sale (output VAT) in their VAT return. In this way, the two entries cancel each other from a cash payment perspective in the same return. It also eliminates or reduces the obligation for sellers to VAT register in the country where the supply is made.
Since its implementation into the EU value added tax system reform of 1993, it has been especially successful in combating so-called “missing trader schemes,” whereby tax-free, cross-border shipments are used to evade VAT payments. It is estimated that several billion euros are lost per year by this method.