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A value added tax (VAT) is a tax that is collected at each stage in the production and distribution of goods and services, as value to the goods is added. As a business adds value to a product (for example, packaging a product) the business must pay VAT on the added value (the value of the packaging). In other words, the business must pay tax on the difference between the selling price of the packaged product and the cost of materials and services purchased to produce the product. The VAT amount is collected when the business sells the product.
Note:
The term VAT in this guide encompasses all value added taxes. The guide generally does not use country-specific terms, such as TVA for Belgium value added taxes, or GST for Singapore value added taxes.Value added taxes (VAT) are assessed on most sales and purchases. Only a few goods and services are tax-free or not taxable in full.
Goods and services belong in one of three categories:
Taxable. A business that produces only taxable products must collect VAT on its sales and can request a tax credit for the VAT paid on its purchases (purchases of materials that make up the product).
Tax-exempt. A business that produces only tax-exempt products does not need to collect VAT on its sales and cannot request tax credit for the VAT paid on its purchases. Because the business cannot recover any of the VAT paid on purchases, costs can increase. Businesses that provide services such as loans, mortgages, life insurance, and property insurance are examples in this category.
Zero-rated (tax-free). A business that produces only zero-rated products is not required to collect VAT on its sales, but can obtain tax credit for VAT paid on its purchases. Businesses that produce basic food products or produce goods for export are examples in this category.
Businesses that produce a combination of the above categories must separately track the taxes paid for tax-exempt purchases and those paid for taxable or zero-rated purchases.
A simple VAT example for the production and sale of a book is shown below:
| Producer / Consumer | Purchase Price Paid | Purchase VAT | Purchase Total | Sales Price Charged | Sales VAT | Sales Total | Sales Paid to Govt* |
|---|---|---|---|---|---|---|---|
| Forester (log) | 0.00 | 0.00 | 0.00 | 10.00 | .70 | 10.70 | .70 |
| Mill (paper) | 10.00 | .70 | 10.70 | 15.00 | 1.05 | 16.05 | .35 |
| Printer (book) | 15.00 | 1.05 | 16.05 | 30.00 | 2.10 | 32.10 | 1.05 |
| Wholesaler | 30.00 | 2.10 | 32.10 | 35.00 | 2.45 | 37.45 | .35 |
| Retailer | 35.00 | 2.45 | 37.45 | 40.00 | 2.80 | 42.80 | .35 |
| Consumer | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 |
| Total Tax to Government | 2.80 |
* Paid to Govt = Sale VAT - Purchase VAT
The steps to calculate and pay a 7% VAT in the example above are summarized as follows:
Add VAT to the selling price of the goods or services. For example, when the mill sells paper, it adds 1.05 (7% of the 15.00 price charged) to the 15.00 sale price and sells the paper for 16.05.
Add all VAT paid to suppliers. For example, the mill paid .70 VAT to the forester.
For the current tax period, subtract the sum of the VAT amounts paid (step 2 above) from the sum of the VAT amounts received (step 1 above). This is the VAT owed to the government. For example, the mill remits .35 to the tax authority (1.05 added to its selling price less .70 paid to the forester). If a business calculates a negative amount, it can request a refund from the government.
Depending on the product category (taxable, tax-exempt, or zero-rated), the business may or may not be able to take advantage of all three steps. A business can add 7% of the selling price (step 1) only for taxable products. A business can subtract the sum of the VAT paid to its suppliers from the VAT owed on the value added (steps 2 and 3) only for taxable products and zero-rated products.