Tax and VAT
Value added tax (VAT)
Value added tax is an indirect consumption tax assessed on the incremental value created at each stage of the supply chain, from initial production to the final sale.
What is Value added tax?
Value added tax is an indirect tax that governments levy on the sale of goods and services. Unlike a simple sales tax collected only at the final purchase, VAT is collected in stages. At every step of the supply chain, a business pays tax on its purchases and charges tax on its sales. The difference between the tax collected from customers and the tax paid to suppliers is the actual value added tax remitted to the government. Because it is a consumption tax, the final consumer ultimately bears the cost. As a business owner, you act as a collection agent for the tax authority. You must track these amounts carefully to file accurate returns. Keep in mind that specific VAT rates, registration thresholds and filing deadlines are set independently by each country's tax authority.
Output VAT - Input VAT
A positive result is the amount you owe to the tax authority. A negative result means you are owed a refund or a tax credit.
How Value added tax works
The mechanics of value added tax rely on a system of credits and offsets. When you buy materials or services for your business, you pay VAT to your suppliers. This is known as input tax. When you sell your finished goods or services to your customers, you charge them VAT. This is known as output tax. At the end of your tax period, you calculate the total output tax you collected and subtract the total input tax you paid. If you collected more than you paid, you send the difference to the tax authority. If you paid more than you collected, you can usually claim a refund or carry the credit forward. This continuous chain ensures that tax is only applied to the incremental value added at your specific stage of production.
- A manufacturer buys raw materials and pays input tax to the supplier.
- The manufacturer creates a product, adding value to the raw materials.
- The manufacturer sells the product to a retailer, charging output tax.
- The manufacturer remits the collected tax minus the paid tax to the government.
- The retailer repeats this process when selling to the final consumer.
Worked example
Suppose a local tax authority sets the VAT rate at 10 percent. Desert Oasis Trading buys raw wood from a supplier for 1,000 plus 100 in input VAT, paying 1,100 total. The company then manufactures custom furniture. Desert Oasis Trading sells the finished furniture to a retailer for 3,000 plus 300 in output VAT, collecting 3,300 total.
To calculate the VAT payable, the company subtracts the 100 input VAT from the 300 output VAT. Desert Oasis Trading will remit exactly 200 to the tax authority. The tax applies only to the 2,000 of value added during manufacturing.
Why it matters for your business
Understanding value added tax is critical because failing to comply can result in severe financial penalties. If your taxable turnover exceeds the threshold set by your country, you are legally required to register, charge tax on your sales, and issue compliant tax invoices. Poor record-keeping can also cost you money. If you do not accurately track the input tax you pay on business expenses, you will miss out on eligible deductions and end up overpaying the government. Using software like Paper & Pen, which creates invoices and posts journal entries, helps ensure your tax records remain accurate and organised.
Questions
Common questions
What is the difference between VAT and sales tax?
Do I have to register for value added tax?
Related terms
- Input VAT Input VAT is the value-added tax that a registered business pays on goods and services purchased for its own operations, which can typically be recovered from the tax authority.
- Output VAT Output VAT is the value-added tax that a registered business calculates and charges to its customers on the sale of taxable goods and services.
- Tax invoice A tax invoice is a legal document issued by a registered business to a buyer, detailing the goods or services provided and the specific amount of tax collected on that sale.
- VAT return A VAT return is an official tax document submitted to a government authority that summarises a business's total sales, purchases, and the resulting value-added tax payable or refundable for a specific period.
- Taxable supply A taxable supply is any provision of goods or services made in the course of business that is subject to value-added tax under local tax laws.
- Corporate income tax Corporate income tax is a direct levy imposed by a government on the net profits or taxable income earned by a registered company during a specific financial period.