The reverse charge VAT is an alternative or improved framework to collect value-added tax. It does not require the supplier of goods or services to pay VAT.
Instead, the customer or the end-user is responsible for showing the value-added tax on sales. The system helps tax authorities to reduce tax evasion. It also helps them to regulate many businesses that would otherwise avoid value-added tax compliance.
Let us discuss how reverse charge VAT works and what you can do as a business to prepare for compliance purposes.
What is Reverse Charge VAT?
A reverse charge VAT occurs in a series of business-to-business transactions that end up neutralizing the VAT effect.
In this arrangement, the seller no longer is held responsible for VAT. The mechanism works for the production of goods and services. The VAT charge does not come into effect unless the goods are exported out of the country or used by the end-user.
Under the normal VAT calculations, a supplier accounts for the value-added tax on the production of goods or services. The producer or the supplier charges VAT at the source. The amount is added to the gross price of production.
Under the normal VAT arrangements, the manufacturer or the supplier is responsible for depositing the applicable value-added tax to the tax collection authorities. However, that often results in misreporting of VAT returns in many jurisdictions. The reverse charge VAT mechanism aims to eliminate that risk.
How Does Reverse Charge VAT Work?
Unlike the normal VAT scenario, the end-user of a business transaction is responsible for filing value-added tax with the authorities. Effectively, this arrangement takes out the supplier’s responsibility to make value-added tax payments.
The receiver of the goods or services charges an input and output VAT charge. In other words, the receiver acts as a supplier and a customer at the same time. The net effect of both transactions nullifies the value-added tax for the originating source of supplies.
Tax authorities set rules for defining the threshold amount of sales for value-added tax requirements. For instance, the VAT threshold in the UK is £ 85,000. All businesses exceeding sales above this threshold need to register for VAT. Also, the VAT rate can differ from one jurisdiction to another. In many EU tax jurisdictions, the applicable VAT rate is around 20%.
Similarly, the tax authorities in a jurisdiction provide rules and regulations for the reverse charge VAT mechanism. The rules may differ slightly for domestic and international transactions. However, the working mechanism remains the same where the originating source of a sale does not incur any value-added tax charge.
Where Does Reverse Charge VAT Apply?
The tax regulatory authorities set out value-added tax compliance regulations including the decision on the reverse charge. The value-added tax rate is also defined.
The supplier of goods or services receives an order from the buyer. They manufacture products or provide services to the buyer. Unlike normal VAT calculations, the supplier does not include a VAT charge in the invoice.
The supplier would charge the customer for the product costs and shipping charges only. The invoice would include a note on the reverse charge VAT mechanism. For compliance purposes, the invoice would also include the VAT registration number of the receiver of the goods/services.
When manufactured goods are resold by the receiver to a retailer, they charge an output VAT to that retailer. If the buyer was the end-user, they will calculate the applicable VAT charges. It would then make the VAT payment to the tax regulatory authorities in its jurisdiction.
All other regulations are applicable in a similar manner. For instance, the compliant need to be a VAT registered business. It needs to meet the threshold limit and other compliance requirements as well.
Reverse Charge VAT Involving More Than Two Parties
What if there are more than two parties involved in a transaction of goods purchase? There may be more than two parties involved in a service contract as well. For instance, a contractor, a sub-contractor, and the end-user of the services.
The first supplier of the goods or services will follow the same procedure as we discussed above. It will not charge any value-added tax to its customer. Instead, it will include a reverse charge note on the invoice and the VAT registration number of the client.
The second party will include an input and an output VAT amount in its invoices respectively. Both amounts will cancel out each other and will have a nil effect on the cash flow of the company. The second party also does not make an actual value-added tax payment.
The end-user of goods or services will receive a reverse charged value-added tax on its invoice. This end-user (suppose a retailer) would include the value-added tax amount to its products and will charge the customers. Thus, the collected VAT becomes the responsibility of the final user of the product/services.
Let us consider a couple of simple working examples to understand how the reverse charge VAT mechanism works.
Suppose a company ABC is a manufacturer of sports goods in the UK. It is a VAT-registered business and its annual sales exceed the threshold limit.
The applicable VAT rate is 20% in the UK. Suppose it receives an order of £ 40,000 from a retailer XYZ in the UK.
ABC company will not include any value-added tax to the invoice of £ 40,000. Instead, it will only include a note of reverse charge and VAT registration number of XYZ for reference.
XYZ will charge input and an output VAT of £ 8,000. Its net effect will cancel for the transaction made with ABC company.
When XYZ makes retail sales, it will charge its customers at 20% for every item sold individually. Thus, XYZ will now make a collective VAT payment as normal to its tax regulatory authority.
Suppose XYZ is an agent company that does not sell goods directly. Suppose it sold the goods adding its markup of £ 10,000 (total £ 80,000) on the goods purchased from ABC company in the example discussed above.
XYZ will do an input and output VAT transaction with ABC company as outlined earlier. Thus, it will have no cash flow impact.
Now, suppose XYZ sells these goods to another company Rock Sports in the UK. XYZ will not charge for any value-added tax here. Instead, it will include the VAT reference number of Rock Sports and note on reverse charge.
Rock Sports will now make an input and an output VAT transaction of £ 16,000 at a 20% rate. Thus, canceling the net effect with XYZ.
Rock Sports will now make retail sales to its customer. Thus, the VAT payment at 20% will now be made by Rock Sports instead of XYZ company.
The pattern continues if there is more than one wholesaler involved in a transaction. The reverse charge does not apply at the source for one transaction. The receiver claims an input and an output VAT for the same amount.
Preparing for Reverse Charge VAT
A business that is a VAT registered business will need to adjust for the reverse charge mechanism. VAT requirements and threshold limit of sales vary by jurisdiction.
Here are a few general steps to keep in mind when preparing for reverse charge compliance.
- Identify your trade contracts where you are supplying or receiving goods/services other than as an end-user.
- Confirm from your suppliers if they’re compliant with the reverse charge mechanism.
- Identify your clients that are end-users of your product or service.
- Inform your sub-contractors or wholesaler partners of the reverse charge framework.
- Prepare your invoicing system and update it accordingly for the reverse charge mechanism.
- Finally, provide your employees with sufficient information and training on handling the reverse charge compliance issues.
What Information Should be Included in Your Invoices?
The first step you should take is to update your invoice template. It must include a note for the reverse charge VAT instead of the VAT percentage as you normally do.
Although the exact information should be according to the local tax compliance requirements, you can include these few key points in your invoices.
- Your company name, address, and contact details
- Receiver’s company name, address, and contact details
- A unique invoice identification number
- A note on the reverse charge VAT mechanism
- VAT registration number of the receiver
- Date, product details, discounts, and the net amount of the invoice
What is the Importance of Reverse Charge VAT?
In some cases, a company would make several transactions to avoid the minimum threshold of applicable VAT on a single transaction. In other cases, a company would charge VAT to its wholesale client but would not deposit it.
Several such scenarios affect VAT collections. The reverse charge framework is an alternative to the normal value-added tax collection system. It introduces a collective threshold sales limit as well as eliminates the VAT at the source.
The reverse charge reduces the risk of tax evasion. However, it does not come as a risk-free framework and tax authorities still need to impose strict measures to make it an effective system.