Bridging The Atlantic - Common pitfalls for US businesses in relation to VAT

Summary: In essence, value added tax (“VAT”) is a tax on personal consumption or use of goods and services. Businesses charge VAT when supplying their goods or services to individuals who bear the cost of the VAT charge; thus these individuals are taxed on their consumption of those goods and services as measured by their expenditure. The business, having collected the VAT from the customer, will then pay that VAT over to the tax authority.

This article is a guide for US businesses in relation to VAT issues in the UK.

Understanding the Basics of VAT

In essence, value added tax (“VAT”) is a tax on personal consumption or use of goods and services. Businesses charge VAT when supplying their goods or services to individuals who bear the cost of the VAT charge; thus these individuals are taxed on their consumption of those goods and services as measured by their expenditure. The business, having collected the VAT from the customer, will then pay that VAT over to the tax authority.

The key difference between VAT and a sales tax is that VAT applies not only on the final supply to the consumer (i.e. a “B2C” supply), but also at every stage of the supply chain; so that manufacturers, wholesalers and other businesses carrying on (i.e. a “B2B” supply transactions) also have to charge VAT to their customers. In order to avoid a build-up of VAT along the supply chain, business purchasers of goods and services are allowed credit for the VAT they incur on the purchases.

The VAT system therefore distinguishes between two elements: the VAT which a business charges to its customers is called “output tax”, whilst the VAT that it incurs on its purchases is called “input tax”. Periodically, (usually every three months) the business will file a return with the tax authorities, accounting for its output tax and claiming credit for its input tax. It will pay the net amount to the tax authority.

In summary, VAT applies at every stage in the supply chain, but through the credit mechanism there is no real cost to most business participants in the supply chain; the true cost of the tax falls solely on the final consumer, who cannot claim credit for the VAT they have incurred. In this respect, certain types of business are treated in effect as final consumers and so do bear a VAT cost. These include banks and insurers, and others in the financial services sector to the extent that the supplies they make are exempt from VAT. [It is important to appreciate the significance of “blocked” input tax, as this can alter the economics of transactions so, for example, potentially an outsourcing transaction for a bank can carry a VAT cost].

The EU VAT system

There are currently [28] “member states” in the EU, each of which is required to operate the EU VAT system. Whilst the fundamental system of the EU VAT system is set out in European law, each member state has some discretion as to how to apply the detailed rules. For example, European law sets a minimum lowest VAT standard rate of 15%; member states have implemented this with standard rates ranging from 15% to 25%. Also, under European law there are special rules for the VAT treatment of supplies in specific sectors, such as finance, leasing transactions, tour operators, telecoms, and electronically supplied services.

There are territoriality rules which govern the national jurisdiction in which a supply of goods or services takes place for VAT purposes. It is important to be familiar with these rules as they will determine which member state, if any, is allowed to collect VAT and which country’s set of detailed rules will apply.

Differences between EU Countries

A simple example will demonstrate the problems that may arise in practice for US entities engaging in business in the EU. A US business enters into a supply contract with an EU purchaser under which the US business will make supplies to the EU customer. It is very important at the outset to obtain clarity and agreement on the VAT treatment of the supplies. Questions may arise about whether the supply is one of goods or services? does title to the goods pass to the EU business? is there a finance lease (which is treated by some member states as a supply of goods)? Very often the answers to these questions will be clear, but in complex arrangements it is quite possible that the commercial deal is finalised without agreeing on the precise legal mechanisms to achieve the commercial result.

If and when the tax authority identifies the issue, it could assess the supplier for VAT on its supplies, with interest and penalties, going back to the start of the contract. It is quite possible that the supplier and the customer will then have to negotiate who should bear the cost of the VAT and the penalties. If the contract does not clearly allocate this cost, the relationship between supplier and customer could come under tension, perhaps in extreme cases leading to a complete breakdown in relations and the termination of the contract.

Another issue: sometimes the liability to account for VAT on a supply falls on the recipient of the supply, rather than on the supplier. This is commonly referred to as the “reverse charge” mechanism. The recipient of the supply may still be able to claim credit for the VAT on the supply it receives, so it will both account for the VAT to the tax authority, and simultaneously obtain credit.

Where the reverse charge can impose a cost on a customer is if that customer cannot recover VAT because the supply to it is connected with exempt supplies made by the customer and so the VAT that it accounts for to the tax authority cannot be used to obtain a credit.

Clearly it is very important for US business transacting in the EU to know whether it is themselves, or their EU customers, who are liable to account for any VAT arising. However, there are many scenarios in which member states will have different approaches to this issue, and it will be vital for the US business to seek local advice in order to obtain jurisdiction-specific guidance.

Online services

There is an EU-wide special system for the provision of online services, designed to make it easier for non-EU businesses to fulfil their EU VAT obligations. Where this system applies, the business will be able to obtain a single VAT registration to cover its supplies in all member states, rather than (as would otherwise be the case) VAT registering in each member state where it has customers.

The principal advantage of this system is that provided that the supplier obtains information about where its customers are based, it accounts for VAT to the tax authorities of the EU member state where it has registered. That tax authority then passes on the appropriate amount of VAT to each of the member states in which the supplier has customers, rather than the supplier having to register and make regular VAT returns to each country in which it has customers from the very first sale in that country.

Another issue is that the VAT treatment of some types of online supply are currently unclear. For example, the VAT treatment of ebooks across most EU countries is to tax them at the standard VAT rate. However, two countries, Luxembourg and France, currently apply lower VAT rates. The European Commission has launched “infraction proceedings” against these two countries, arguing that all countries should, for the time being at least, apply their standard VAT rates. The UK currently applies the standard VAT rate of 20% on sales of ebooks, although BLP are taking a ground breaking case to the courts arguing that no VAT at all should apply, as certain types of supply in the UK (including “books” ) benefit from VAT being charged at a so called zero rate of VAT.

Interaction with Customs Duties

When importing goods into the EU, a charge to VAT will normally arise, even if there is no sale taking place. The import VAT charge will arise on the importer of record (ie the person who declares the goods at the port for entry into the EU). Customs Duties will also typically arise at the same time, and the rate of duty will depend on the precise definition of the goods in question. Border disputes as to whether a particular item falls within one classification or another are extremely common and there can be very significant benefits if favourable treatment is secured.

In some scenarios, the VAT and/or the Customs Duties may be deferred through “warehousing” the goods. There are several distinct types of warehouses, and it will be important to ensure that the most beneficial types is selected.

Establishment Test

In many circumstances, it will be important to determine where a supplier or its customer “belongs” for VAT purposes. This can be a vital factor in assessing whether VAT applies to a transaction (particularly where the supply is one of services), and, if so, whether it is the supplier or the recipient of the supply who needs to pay the VAT over to the relevant tax authorities and, where a customer has more than one establishment to which establishment is the supply made.

The rules for determining where an entity belongs are complex. They take into account where the entity has “established its business” and whether it has a “fixed establishment” from which the relevant service is supplied. These terms are explained, in a somewhat confusing way, in European Commission Regulation 282/2011.

The concept of where an entity has established its business is, in essence, where the entity’s central administration is carried out. In that context, one needs to take into account the place where essential decisions concerning the general management of the business are taken, the location of the registered office and the place where management meets. Where these factors point in different directions, one will take to take an overall view, giving priority to the “essential decisions” criterion.

Unfortunately, the concept of a “fixed establishment” is not much clearer. It means any establishment (other than the place where the entity has established its business) which “is characterised by a sufficient degree of permanence and a suitable structure in term of human and technical resources to enable it to provide the services which it supplies”.

The issue is made more complex because, the case law of the CJEU (the European Court which ultimately has jurisdiction over the interpretation and application of the EU VAT system) has held that, although the VAT system in general works on an entity by entity basis, in the context of these rules, the subsidiaries of an entity can sometimes impact upon whether an entity has a fixed establishment in a given jurisdiction. So for example this could arise where a supplier has contracted with an EU customer which has establishments in more than one member state and the issue, principally for the customer, is whether the place of supply is where the contracting party is based or if the supplies are consumed at another establishment as this will determine which member state’s VAT rules apply.

Obtaining a Ruling from the Tax Authorities

If there is any doubt about the VAT treatment of a transaction (for example, whether VAT is chargeable, who is liable to account to the VAT to the tax authority or, if that country’s tax authorities are prepared to give rulings, whether the purchaser is entitled to VAT recovery) it is often advisable to obtain a ruling from the appropriate tax authority. In that context, extreme care needs to be taken to ensure that the ruling request meets all of the conditions in that jurisdiction to enable the parties to rely on the ruling. These conditions will almost certainly include an explanation of the commercial context, an account of all the relevant facts and may also require references to legal authorities and relevant case law which the parties have identified.

Group Reorganisations

US businesses with operations and/or subsidiaries based in Europe may from time re-organise their internal structures to benefit from efficiencies or enhance their supply chain management with ancillary US direct tax benefits. These re-organisations can involve assets (such as contracts, IP or goodwill) being transferred from one establishment to another establishment within (or between companies based in more than) one member state.

Advice should be taken in order to anticipate the VAT consequences, and planning undertaken to minimise VAT costs – actual or cash flow – is always desirable. This is particularly because favourable VAT treatment on business reorganisations within a single member state, such as VAT free, TOGCs (or Transfer of Businesses as Growing Concern) or VAT grouping, do not usually extend to cross-border VAT transactions.

Taking advice at an early stage

It should be clear from the very brief comments above that the EU VAT system is replete with pitfalls for the unwary. Taking professional advice at an early stage can save significant cost and management time to avoid problems further down the line or at least to allocate risks between the parties.

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