Value added tax: Overview, definition, and example
What is value added tax (VAT)?
Value added tax (VAT) is a consumption tax levied on the value added at each stage of production or distribution of goods and services. It is typically paid by the end consumer, but collected and remitted by businesses at each point in the supply chain. The tax is applied to the difference between the cost of production and the sale price of the goods or services, making it a tax on the value added at each transaction rather than on the total sale price.
For example, when a manufacturer sells goods to a retailer, the manufacturer collects VAT on the sale price. When the retailer sells the goods to the consumer, they charge VAT on the final sale price, but the retailer can deduct the VAT already paid on their purchase from the manufacturer.
Why is VAT important?
VAT is important because it serves as a significant source of revenue for many governments around the world. Unlike other forms of taxation, VAT is revenue-neutral for businesses because they can reclaim the VAT they pay on their inputs. This makes VAT a fair tax system where the burden of the tax is ultimately passed on to the final consumer, who has no way to recover the VAT paid.
For businesses, understanding VAT is crucial for pricing, invoicing, and ensuring compliance with tax regulations. It also helps businesses manage cash flow by ensuring they are properly collecting and remitting the VAT they owe.
Understanding VAT through an example
Imagine a manufacturer produces a product that costs $100 to make. The VAT rate in the country is 10%, so the manufacturer sells the product to a retailer for $120 ($100 cost + $20 VAT). The manufacturer remits the $20 VAT to the tax authorities.
Next, the retailer sells the product to a consumer for $200. The retailer charges the consumer $20 VAT on top of the sale price. The retailer then remits the VAT collected from the consumer ($20) but can deduct the $20 VAT they paid to the manufacturer, so they do not need to pay any additional VAT to the tax authorities.
In this case, the consumer is the final taxpayer who ends up paying the $20 VAT, while both the manufacturer and retailer collect and remit the tax but ultimately do not bear the tax burden themselves.
Example of a VAT clause
Here’s how a VAT clause might appear in a contract:
"The Buyer agrees to pay the Seller the sale price of the goods as specified in this Agreement, plus any applicable value added tax (VAT) at the prevailing rate, which will be added to the total amount due at the time of payment. The Seller shall provide a VAT invoice for all payments received."
Conclusion
Value added tax (VAT) is a widely-used consumption tax that is charged on the value added at each stage of production or distribution of goods and services. It is an important revenue source for governments and is designed to be ultimately paid by the end consumer. Businesses need to ensure compliance with VAT regulations by properly collecting and remitting the tax, while also managing cash flow and pricing in light of VAT obligations.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.