Questions and Answers: Value Added Tax (VAT)
European Commission - MEMO/10/633 01/12/2010
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Brussels, 1 December 2010
Questions and Answers: Value Added Tax (VAT)
What is VAT?
VAT is a consumption tax, charged on most goods and services traded for use or consumption in the EU. It is levied on the "value added" to the product at each stage of production and distribution. The "value added" means the difference between the cost of inputs into the product / service and the price at which it is sold to the consumer. VAT is charged when VAT-registered (taxable) businesses sell to other businesses (B-2-B) or to the final consumer (B-2-C). VAT is intended to be "neutral" in that businesses are able to reclaim any VAT that they pay on goods or services. Ultimately, the final consumer should be the only one who is actually taxed. Businesses are given a VAT identification number and have to show the VAT charged to customers on the invoices.
In the EU, there is a minimum standard VAT rate of 15%, above which Member States are free to set their own national VAT rates. Member States decide how to spend the revenue they receive from VAT receipts, except for a small percentage of this total which is paid towards the EU budget.
How does the current EU VAT system work?
Currently, a transitional system is in place for VAT on intra-EU transactions (see below). Under this system, when it comes to cross-border sales between businesses, VAT is collected in the Member State of destination (i.e. where the goods are sent to or where the recipient of services is established), in line with the rate and conditions of that country.
This means that the supplier of goods or services does not charge VAT, but the recipient is responsible for paying it. Both the supplier and recipient must conform to special reporting obligations. It should be noted that there are many exceptions to these rules. For example, VAT on transport is paid where the transport occurs and VAT on cultural events occurs where the show takes place.
The rules for intra-EU transactions differ from purely domestic transactions, where the supplier charges VAT and is responsible for paying it to the Treasury. The divergence between domestic and intra-EU rules for VAT poses problems for the Single Market, as it creates additional burdens for businesses operating cross-border and exposes the VAT system to fraud.
For goods or services provided to private individuals (i.e. business to customer), the taxation is the same for intra-EU transactions as it is for domestic transactions i.e. the VAT is paid by the supplier in the Member State where the sale occurs or where the supplier is established. However, there are certain supplies for which different rules apply e.g. distance sales, new means of transport, certain services etc.
How much revenue is raised through VAT every year in the EU?
In 2008, total VAT receipts in the EU were around EUR 862 billion. VAT receipts accounted for 21.4 % of the national tax revenues of EU Member States (including social security contributions), a rise of 12% since 1995. It is thus a major source of revenue for national budgets and in many Member States it is the main source. VAT receipts represented in 2008 on average 7.8% of the GDP of a Member State, a figure that has increased by almost 13% from 1995. Since the recession, the share of VAT revenues as part of total receipts has probably grown further in most EU countries.
How much of this revenue goes towards the EU budget?
VAT is part of the own resources of the EU budget, and Member States pay a small percentage of their total VAT receipts to the EU. Currently, this contribution from Member States is based on rate 0.3% of the national harmonised VAT base, with temporary reduced rates over 2007-2013 of 0.225% for Austria, 0.15% for Germany and 0.1% for the Netherlands and Sweden.
In 2010 it represents 14 billion Euro.
Why is there a transitional system in place for VAT at the moment?
In 1967, the Council undertook a legal and political commitment to introduce a VAT system tailored to the Single Market and operated across Member States in the same way as within a single country.
To complete the internal market by 1993, the Commission put forward proposals based on taxation in the country of origin, with a harmonised rate structure, and a clearing mechanism for the redistribution of VAT receipts to the Member State where consumption takes place.
However, given the lack of consensus and the need for goods to be able to pass freely within the EU while still allowing Member States to collect the tax revenue, the Council instead adopted a transitional system. The transitional system has enabled controls of goods at the EU’s internal borders to be abolished whilst allowing tax to be collected in the Member State of destination at the rate and under the conditions of that country.
This system was only supposed to last for 4 years, but Member States have been unable to come to agreement on a more permanent system based on taxation in the Member State where the goods originate. It is now high time to tackle the uncertainty about the future of the current (so-called transitional) VAT system and to choose a stable and definitive system by taking into account the views of all stakeholders as to the best way forward.
Why is there an EU minimum VAT rate?
A minimum EU VAT rate was established to coincide with the creation of the EU Single Market, which meant that fiscal controls at internal borders were no longer carried out. This minimum rate helps to avoid substantial variations in Member States’ VAT rates which could lead to distortions of competition between high and low rate countries and put the smooth functioning of Single Market at risk. The minimum level for the VAT rate has been fixed at 15% since 1992, with regular review of this rate. Member States are free to set their own rate at or above this minimum.
What are the rules with regard to reduced VAT rates, and what type of goods and services can benefit from these rates?
EU rules allow Member States the option of applying one or two reduced rates to a restricted list of goods and services, which are set out in Annex III to the VAT Directive. The reduced rate cannot be less than 5%, and the list of eligible goods and services must be strictly interpreted.
Some examples of goods eligible for a lower rate include: foodstuffs, medicines, medical equipment for the disabled, books on all physical means of support, newspapers, periodicals, passenger transport, admission to shows, theatres, museums, etc.
Some examples of services eligible for a reduced rate include: the transport of passengers and their accompanying luggage, admission to shows, theatres, circuses, fairs, amusement parks, concerts, museums, zoos, cinemas, exhibitions and similar cultural events and facilities, renovation of housing as part of a social policy, etc.
In addition, there is a multitude of derogations on the application of zero rates, super-reduced rates (lower than 5%), and reduced rates for products or services not usually eligible. This makes the whole system complicated and open to misinterpretation.
What is the situation with regard to VAT exemptions? What is exempt and why?
Supplies falling under a category exempt from VAT are sold to the buyer, normally a final consumer, without any VAT being applied to that sale. Exemptions from tax include for example, certain activities in the public interest (medical care, school education etc.) or certain insurance and financial services. Reasons behind the exemptions vary, at the time the exemptions were granted some activities were only carried out by public authorities, for some other it was very difficult to determine the taxable basis, for some others the VAT was too much of a burden, administratively or financially.
However, as the supply is exempt from VAT, deduction of the VAT paid on the inputs is not possible. For example, postal services are at present exempt from VAT. So if someone sends a parcel using the Post Office he is not charged VAT, but the Post Office has paid VAT on its inputs: the vans it uses, the post boxes it buys, and all the other things. It cannot reclaim or deduct this VAT. So a part of the value of the stamps you bought to send the parcel represents paying this "hidden" VAT.
Why does the VAT system need to be reviewed?
Value added tax (VAT) is a major source of revenue for national budgets, and is likely to be proportionally even more so as the economic crisis and aging populations take their toll on other taxes (such as labour and capital). Many Member States have recently increased their VAT rates as part of their consolidation efforts. Consumption taxes are considered, in general, to be a more stable revenue source, and more growth-friendly, than certain other taxes such as profits and income.
However, the VAT system currently in place is not well-fitted for today’s society. It was designed over 40 years ago, when services, modern technologies and globalisation had a far less prominent role in the economy than they do today. There are numerous shortcomings in the current VAT system which create obstacles to the Internal Market, cause burdens for businesses and prevent Member States from benefitting from the true potential of this tax.
While fundamental idea behind VAT is to have a broad-based, globally applied consumption tax, the wide and divergent use of reduced rates and exemptions by Member States means that only part of final consumption is being taxed at the standard rate. Moreover, inconsistencies in the application of reduced VAT rates also lead to distortions of competition within the Internal Market. Finally, the current VAT system is relatively vulnerable to fraud and a significant part of the VAT is lost this way.
Taking into account the above weaknesses, the VAT system needs to be reviewed to ensure that it is as efficient, robust and flexible as it can possibly be. A reform of the VAT system could greatly contribute to delivering on the EU’s 2020 Strategy, strengthening the Internal Market and supporting Member States’ budget consolidation.
What does the Single Market Act say in relation to VAT?
The Single Market Act sets out several initiatives to boost growth and strengthen the Internal Market. This includes creating a supportive legal and fiscal environment for businesses in order to reduce administrative burdens and promote cross-border activity. VAT is a key element in this respect. In its proposal No 20, the Single Market Act specifically mentions the idea of a new VAT Strategy. The current structure of the VAT system leads to disproportionate administrative burden for businesses whereas, with the latest technological developments, their administrative obligations could be reduced considerably, especially with regard to reporting and collecting VAT.
What are the key issues that are addressed in the consultation?
The Green Paper puts all aspects of the VAT system up for discussion and aims to get as wide as possible feedback on how to achieve a simpler, more robust and modern VAT system. The aim is to review the current regime in order to reduce collection and compliance costs, provide maximum flexibility for Member States and protect against fraud.
A first part of the consultation deals with the treatment of cross border supplies i.e. what would be the most efficient way to charge and collect VAT in intra-EU transactions. The second part concerns a wide array of key issues, such as how to ensure tax neutrality, the degree of harmonisation required in the single market and how to reduce "red tape" whilst ensuring VAT revenues for Member States.
Contributors to the consultation are also invited to raise any other issues that they feel might be relevant, which may not be specifically mentioned in the Green Paper.
What problems do businesses face under the current system?
Businesses that want to operate cross-border within the EU face additional VAT obligations and must apply special VAT rules which do not affect businesses working only at domestic level. This creates higher compliance costs and administrative burdens for businesses working in more than one Member State, and can act as a deterrent for businesses (in particular SMEs) from taking full advantage of the Internal Market.
What makes the current system susceptible to fraud and how can this be addressed?
Abolishing fiscal controls at the time of implementation of the internal market (1993) has been of enormous benefit for European businesses. The free circulation of goods within the EU has considerably reduced the administrative burden and costs related to cross border activities.
Nevertheless, the current European VAT arrangements are designed so that intra-EU supplies of goods between businesses are exempt in the Member State of origin, with taxation taking place in the Member State of destination. This exemption mechanism exposes the VAT system to fraud, in particular carousel or ‘Missing Trader’ fraud. This is when a fraudster purchases goods VAT-free in one Member State and resells them with VAT in another Member State. The fraudster then pockets the VAT and goes missing, without declaring anything to the tax authorities in the Member State of destination.
One way of tackling carousel fraud is to implement a “reverse charge” system i.e. making the customer responsible for paying the VAT, rather than the seller. The Green Paper seeks feedback from stakeholders on various options that could help to prevent fraud, such as cross-border reverse-charge or taxing intra-EU supplies. It also opens a discussion on new means for collecting VAT, which would guarantee that Member States get the VAT that they are due, prevent fraud and provide more legal certainty to businesses.
How much is lost every year because of VAT fraud?
Although, due to the very nature of fraud, it is difficult to put a precise figure on VAT losses on intra-EU transactions due to fraud, it is thought to be several billion euro each year. In 2009, the Commission published a study on the EU VAT gap1, which compared what Member States actually got in VAT receipts with what should have been expected. While this VAT gap covers more than just fraud (also legal avoidance and insolvencies), the study set the gap at €106.7 billion in 2006 within the EU-25. This represents an average of 12% of the net theoretical liability although several Member States were above 20%.
VAT fraud does not only affect the financial interests of the Member States and the EU. It also has an impact on honest businesses which find themselves unable to compete on a level playing field in those sectors which are affected by a significant amount of VAT fraud.
What has the Commission done to address the problem of VAT fraud?
In 2008, the Commission set out a coordinated strategy to improve the fight against VAT fraud in the EU. This Strategy included a series of targeted measures, including plans for legislative proposals (which have now all been put forward), and a longer-term reflection on how to fight the problem. One key element was to look increasing the efficiency of administrative cooperation between tax administrations, and establishing the legal base for establishing a network of national officials to detect and combat new cases of cross-border VAT fraud. This network – Eurofisc – is now operational and working to coordinate data exchange and establish an early warning mechanism to detect and prevent fraud.
Some types of fraud require specific measures, and the Commission has worked to support Member States in any way that it can to combat such activity. For example, when serious levels of VAT fraud were detected in the CO2 emissions trading scheme in 2009, the Commission acted very promptly, bringing forward a proposal for a reverse charge system which Member States could apply to tackle this problem (see IP/09/1376)
What are the next steps after the VAT Green Paper?
The Green Paper on the future of VAT launches a wide consultation process with all stakeholders on the current VAT system and the possible ways to strengthening and improve it. The consultation will continue until 31 May 2011. On the basis of the feedback received, the Commission will draw up a Communication before the end of 2011, setting out the priorities for a future VAT Strategy.
More information is available at:
For details on VAT rates per Member State, see
DG Taxation and Customs Union, Report 21 September 2009, Study to quantify and analyse the VAT gap in the EU-25 Member States, Reckon LLP