Understanding VAT in Europe
For people from other regions, the rationale behind the European Union VAT rules seems hard to grasp; a common EU VAT system that is fragmented into 28 national systems that is not as neutral as it claims to be due to its complexity, the embedded legal uncertainty, and the extra compliance costs.
The current status of the EU VAT system is best explained against the background of the creation and expansion of the EU itself. One of the key objectives of the EU is to have a barrier-free internal EU market which implies that Member States should surrender their sovereign power for VAT rules and control over their VAT revenues and agree to cooperate with the 27 other Member States.
With such cultural diversity within the EU however, unanimity is often hard to find and not all Member States are equally willing to let go of their sovereign power on certain matters. In other words, the driving force behind a further harmonization and simplification of the EU VAT system is the European Commission itself, rather than the individual Member States. This explains to a large extent why the EU VAT system is so complex and why it contains so many exceptions and (often far from ideal) compromise solutions.
VAT in Europe is in general regulated on an EU level via VAT Directives, Regulations and Case Law adjudicated in the European Court of Justice. The EU VAT legislation is aimed at coordinating and harmonizing VAT for the purpose of the proper functioning of the internal EU market. For this purpose, the VAT Directive 2006/12/EC defines the core principles of the ‘common’ EU VAT system and contains rules to avoid territorial conflicts between EU Member States. However, this VAT Directive also contains many ‘optional rules’ for the Member States and leaves significant discretionary powers at a national level.
From a business perspective, it is fair to say that the main benefit of the EU Directive is that it defines the essential concept of the ‘common’ VAT system and regulates the levying power of the individual Member States. However, as there are many different methodologies at a national level, the EU VAT system in practice is rarely perceived as one ‘common’ system.
How does the system work?
VAT in Europe is a consumption tax, charged on most goods and services traded for use or consumption in the EU. VAT is intended to be neutral for businesses in that businesses are able to reclaim any VAT that they pay on goods and services. Ultimately, the VAT should be borne by the final customer. Businesses are given a VAT identification number (by each Member State) and have to show the VAT charged to customers on their invoices.
The key parameters influencing the VAT treatment of a transaction are:
- The VAT status of the parties involved (taxable person vs.end-customer, VAT registered or not)
- The type of supply (goods vs. services)
- The countries involved (national transactions vs. intra-EU transactions vs. transactions with non-EU countries)
Goods that are sold for export outside the EU, or services which are sold to customers established in a non-EU country, are in principle exempt. Imports are, however, taxed in order to have a fair system in which EU producers can compete with suppliers from outside the EU on equal terms in the EU-market.
Currently, a transitional system is in place for VAT on intra EU transactions. When it comes to cross-border sales between businesses, VAT is collected in the Member State of destination (i.e. where the goods are sent to or where the recipient of services is established), in line with the rate and conditions of that country. This means that the supplier does not charge VAT, but the recipient is responsible for paying it via his VAT return. Both the supplier and the recipient must conform to special reporting requirements. The rules for intra-EU transactions differ from purely domestic transactions, where the supplier charges VAT and is responsible for paying it to the Treasury.
For goods or services provided to private individuals, the VAT is generally paid by the supplier in the Member State where the sale occurs or where the supplier is established (origin principle).
Trends and evolutions
In December 2010 the EU Commission published a ‘Green Paper on the future of VAT’, in which it set out its plan to create a simpler, more robust and efficient VAT system. As a result of this plan, the following trends can be identified:
- Increased focus on combatting VAT fraud
- Initiatives to reduce VAT reporting and invoicing complexity
- Slightly less focus on form, but significantly more focus on substance
- Initiatives to reduce the complexity of the rules (e.g. tax base, rates, exemptions)
- A further move to taxation in the Member State of destination
- Review of some rules that do not take the internal EU market aspect into account (small business schemes, VAT grouping provisions)
- Ensuring neutrality of VAT by reviewing complex and divergent rules on the right of deduction and providing a mechanism for resolving any remaining double taxation issues
- Providing a level playing field for non-EU and EU suppliers (treatment of small consignments and other internet sales)
On the other hand, Governments are clearly seeing VAT as a source of revenue that doesn’t stifle the growth of businesses. During recent years, many EU Member States have either increased their VAT rates to compensate for a reduction in the personal/corporate tax rates, or are planning to do so.
Risks to manage
Although VAT in Europe is – by its concept – supposed to be neutral for businesses, in reality it is far from neutral and businesses therefore need to carefully manage the following risks:
- Avoiding unrecoverable input VAT. For certain types of costs, and in some situations, a VAT deduction is not allowed. Furthermore, VAT recovery can be subject to certain formal requirements (e.g. the need to have a compliant invoice) and to adhere to certain deadlines.
- Avoiding assessments for output VAT. Where a VAT exemption has been applied that cannot be sufficiently justified on the basis of the required underlying evidence, the VAT authorities can claim the VAT in the hands of the supplier, even if the supplier did not collect any VAT from their customer.
- Even slight formal infringements can lead to high penalties (up to 200%) and late payment interest.
- Avoiding unnecessary VAT compliance costs. Can you imagine the impact of operating multiple (up to 28) VAT registrations on your resources and systems?
- Avoiding significant VAT pre-financing. Even though you may be allowed to recover input VAT, it may, in some cases, take years before you actually receive a refund of your VAT credit.
Managing these risks across 28 national systems can be very complex with authorities having quite often unique interpretations of the rules. Accordingly, it is essential that any organization doing business cross-border has access to a VAT expert with knowledge of the EU and the national VAT rules, especially since many VAT issues can only be avoided by careful upfront planning.
The members of the Indirect Taxes Group at PKF are very experienced in organising prompt VAT advice and able to coordinate VAT projects involving multiple countries. If you are looking for a contact in Europe, please get in touch with Marco Herrmann.