As an entrepreneur, you're going to encounter two main types of business taxes: value-added tax (VAT) and sales tax. Though similar in some ways, these two tax types have differences you need to understand.
Sales tax and VAT are both indirect taxes, meaning they're collected by businesses and passed on to the government. Which one you'll use depends on where you are based and who you sell to. The main difference is that sales tax is only assessed on the final product when sold to the customer, whereas VAT is assessed at each production stage.
For ecommerce businesses, dealing with different tax jurisdictions can add even more complexity.
If that already sounds confusing, don't worry: we'll clarify the distinction between the two tax types here.
What Is Value-Added Tax (VAT)?
VAT is the most widely used tax type worldwide. In short, it's a consumption tax collected in stages by all entities involved in producing and distributing a product, and it's ultimately passed on to the final consumer. More than 175 countries, including all European Union members, use a VAT system.
What does "collected in stages" mean? Well, VAT applies at every junction where value is added during manufacturing and distribution. That means it's collected by suppliers, manufacturers, distributors, and retailers on most goods and services sold to another business.
Companies pay VAT on their taxable purchases (input VAT) and charge it on their taxable sales (output VAT). The difference between the two must be remitted to the tax authorities. If input VAT exceeds output VAT, companies receive a VAT refund.
Let's say a manufacturer buys raw materials from a supplier. The manufacturer must pay VAT on the materials. When the manufacturer sells the finished product to a distributor, they will charge VAT. As such, the manufacturer deducts the VAT paid on raw materials that were previously purchased.
The system repeats for wholesalers, distributors, and retailers until the item reaches the final consumer. Since the consumer has no right to deduct input VAT, they bear the total economic burden.
It's also worth noting that VAT is a country-wide tax, with rates varying by country. Here are some examples of current VAT rates:
- United Kingdom: 20% standard rate. Items like goods and services, home energy, and children's car seats have a reduced rate of 5%. Food, children's clothes, and other zero-rated goods have no VAT (0%).
- Germany: The standard rate is 19%, with a reduced rate of 7% for certain goods and services (books, hotel accommodation, dental care, etc.).
- France: 20% standard rate, with reduced rates of 10%, 5.5%, and 2.1% for certain goods and services.
- Hungary: Highest VAT rate in the EU at 27%.
An Example of Value-Added Tax (VAT)
Let's test this concept with a concrete example. Suppose a small apparel retailer wants to make some new T-shirts. They start by purchasing raw materials (cotton fabric, dyes, etc.) from their domestic supplier. Since they're located in France, the cost is $20 plus $4 (20% VAT), for a total cost of $24.
The company now owes the government $4 VAT. They then turn the materials into 10 T-shirts, adding value through cutting, screening, and sewing - essentially transforming raw goods into new products.
They sell the finished T-shirts to a local boutique retailer for $10 per shirt plus 20% VAT.
For 10 shirts at $10 each, that's:
- Shirt price: 10 x $10 = $100
- 20% VAT: 20% of $100 = $20
- Total price: $100 + $20 VAT = $120
So, the company charges the boutique $120 ($100 price plus $20 VAT) and remits the $20 VAT charged. But they also get to deduct the original $4 VAT paid on raw materials. They owe the tax authority only $16 in net VAT.
Finally, the boutique sells each T-shirt to an end consumer for $15 plus 20% VAT ($3 per shirt). On 10 shirts sold for $15 each, they would collect:
- Shirt price: 10 x $15 = $150
- 20% VAT: 20% of $150 = $30
- Total collected: $150 price + $30 VAT = $180
The boutique sends the $30 VAT to the tax agency, with a $15 credit to offset the VAT they paid on their purchase from the apparel retailer. The final consumer pays $18 per t-shirt with no chance of getting the embedded VAT refunded or deducted.
Is everything clear up to this point? Great! Now that we have an idea of what VAT is, let's move on to explaining sales tax.
What Is Sales Tax?
Sales tax is a consumption tax imposed on the retail sale of goods and services. It's only collected by the retailer from the consumer at the point of final purchase.
Unlike VAT, sales tax is only levied on end consumers of products, not businesses. Rates vary widely across different states, counties, and even cities.
In the United States, most states and some local governments levy a sales tax, with rates varying widely from 0% to over 10%.
For instance, the state sales tax rate in California is 7.25%. But combined with county and municipal rates, the total sales tax paid by consumers can increase by a few points depending on location. Alaska, Delaware, Montana, New Hampshire, and Oregon currently have no sales tax.
Unlike VAT, sales tax is not collected until the final sale to the consumer as it doesn't apply to goods moving through production and distribution channels. In other words, companies don't collect sales tax on intermediate business-to-business transactions.
An Example of Sales Tax
Consider a sporting goods retailer operating in Houston, Texas, with an 8.25% sales tax rate. If the retailer sells a baseball bat to a local consumer for $100, they must collect $8.25 of sales tax from the buyer. The 8.25% includes the 6.25% Texas state sales tax plus the 2% Houston local sales tax. The retailer remits the sales tax collected to the state and city.
If they sell to a customer in Maine, they would charge $105.50 ($100 plus 5.5% sales tax) since the sales tax rate in Maine is 5.5%.
But what if they sell to a customer in the UK? Since it's an international sale going overseas, they don't need to charge any sales tax. However, they may be responsible for collecting and remitting the Value Added Tax (VAT) based on UK tax laws before exporting the product. International taxation introduces further complexity with customs, duties, and tax treaties between countries.
The good news is there's an easier way of calculating taxes. Most ecommerce platforms provide functionality like automatic tax rate calculation, generating legal invoices, and integrating with international tax and shipping carriers to facilitate compliance with international transactions.
Sounds good, right? Let’s take a look at how ecommerce platforms can help.
How Ecommerce Platforms Can Help with VAT and Sales Taxes
As a business owner, registering for, calculating, collecting, reporting, and remitting VAT or sales taxes is vital. Non-compliance can lead to audits, which can result in penalties and interest. In the worst-case scenario, legal prosecution may follow.
That's why it’s recommended that you choose the best ecommerce platform to meet your needs. Most have integrated features for taxation across multiple jurisdictions:
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Automatic Tax Rate Calculations: Ecommerce platforms automatically calculate the correct tax rates for different regions. You'll be able to charge your customers properly and reduce the risk of errors.
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Integration with Tax Authorities: These platforms integrate with local tax authorities, which means you'll have peace of mind knowing you're compliant with regional tax laws and regulations.
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Sales Tax Registrations for Multiple Jurisdictions: These platforms support tax registration across multiple states or countries. If you're a business that sells in various locations, having this feature simplifies the process.
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Tax Collection on Transactions: Ecommerce platforms automatically collect the appropriate tax amount during each transaction, which reduces manual workload.
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Tax Reporting for Reconciliation: The platforms generate detailed tax reports. You'll have an easier time reconciling your finances and managing tax liabilities.
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Data Exports for Recordkeeping: These platforms allow you to export tax-related data, which facilitates recordkeeping and provides the necessary documents for audits and compliance checks.
Inside of Shopify
Getting the right ecommerce platform can also help you deal with lots of the other complex elements of selling goods online, such as credit card processing, delivering a better customer experience, and more.
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I used to sell everything online. Today I teach others to do the same. As an ecommerce consultant, I explore opportunities and test new strategies to leverage what others have yet to see.
