VAT vs Sales Tax: Complete Guide to Scope, Services, and Rates

Scope of VAT vs Sales Tax

As more companies expand their global reach, more tax functions take on additional compliance responsibilities. Oftentimes, these requirements relate to tax categories that specialists within tax functions possess relatively little familiarity with. This is the case for a growing number of sales tax teams within U.S.-based multinationals striving to comply with value-added tax (VAT) compliance requirements throughout Europe and in other parts of the world, or the other way around.

On first blush, sales and use tax and VAT feature a comforting likeness: each is a form of a transaction-based tax. A closer inspection, however, shows the similarity does not extend much further. Although key rules and requirements look the same on the surface, when you dig a bit deeper, you’ll see fundamental differences. This post is part one in a two-part series that examines some key differences between sales and use tax and VAT in areas such as scope, the treatment of services, rates and exemptions.

The purpose of this brief analysis is to equip tax functions taking on new compliance challenges – whether that involves adhering to VAT rules or to some of the more than 10,000 different sales and use tax rates imposed by different government levels in the U.S. – with more clarity and confidence. I’ll start by taking a quick look of how the two forms of tax differ in scope.

What is Sales Tax and How Does It Work?

Sales and use tax is a transaction tax on the retail consumption of tangible personal property and a relatively select collection of services. The tax is collected at the time of the sale and only the final sale of the item (or service) is taxed. In the U.S., 45 States and the District of Columbia currently impose a sales tax, while five states – New Hampshire, Oregon, Montana, Alaska and Delaware – do not have one. That said, sales tax can be imposed not only by states, but also by counties, cities or special purpose districts. (Each of these jurisdictions may levy different rates, as I’ll explain in Part 2.) Sales Tax applies to sales made inside the same state. Use Tax applies to sales made outside the state and on purchases in which no tax was charged by the seller.

What is VAT and How Does It Work?

The scope of VAT differs markedly. VAT is a transaction tax on goods and services assessed at each stage of the supply chain and ultimately charged in full to the final purchaser. Almost all types of transactions are within the scope of VAT, including supplies of goods, as well as all types of services. This distinction is crucial to keep in mind. Additionally, VAT is primarily charged at the national level. The output tax is collected on the sale of goods and services, while the input tax is paid to vendors on purchases of goods and services. In Europe, VAT is often identified with different abbreviations – e.g., TVA (France), IVA (Spain), BTW (the Netherlands), etc. – depending on the country and its language. Goods and Services Tax (GST) is also a form of VAT.

Today, approximately 150 counties levy a VAT. European Union member countries currently follow, “in principle,” an EU VAT Directive that calls for national VAT legislation to be implemented. (The European Commission recently proposed a massive overhaul to its longstanding VAT rules structure.) Many other countries, including Canada and India, also charge forms of VAT, and some new economic unions, such as the Gulf Cooperation Council in the Mideast, are in the process of adopting VAT regimes.

Services and Rates Compared

In most U.S. jurisdictions, sales tax generally applies to the sale of goods – that is, to “tangible personal property” – unless a specific exemption exists. Services are generally, but not always, exempted from sales and use tax.

Many states have adopted what is referred to as the “True Object Test,” where the sales and use tax determination for a transaction involving both a tangible personal property and a service relates to the “true object,” “real object” or “dominant purpose” of the buyer’s purchases.

Under many VAT rules, services are far more likely to be taxable. This is the case for EU VAT rules, which define taxable services very broadly: the “supply of services,” according to the EU VAT Directive, “shall mean any transaction which does not constitute a supply of goods,” including the obligation not to do something and acting as an intermediary/agent for transactions. Additionally, liability to pay VAT may shift to the recipient of the service to account for VAT through self-assessment.

Key Differences Between VAT and Sales Tax

Sales tax rates and VAT rates also differ significantly. The average combined sales tax rate in the U.S. is 9.6 percent, while the average VAT rate in the EU is 21 percent (19 percent among OECD member countries). Sales tax is a multi-level tax (i.e., a combination of rates posed at state, county, city and special purpose levels), whereas in most cases VAT adheres to a single national rate. This is a major difference, considering more than 10,000 taxing jurisdictions and sales and use tax rates exist in the U.S.

There are, of course, other notable differences (e.g., input credits and exemption) between sales and use tax and VAT on which tax professionals will want to focus as they take on new compliance responsibilities.