Question: What do more than 160 countries have that the United States does not?
Answer: A value-added tax (VAT)
VAT is a broad-based consumption tax, chargeable at every stage of the supply chain, up to the retail stage, that generally allows the recovery of input tax for businesses and results in the effective taxation of the added value at each stage.
Why doesn’t the United States have a VAT even though so many other countries do? Karen Christie, principal in the U.S. VAT practice at Ernst & Young LLP in New York City, points to several reasons, including the perception that a VAT potentially would have a disproportionate impact on low- and moderate-income households, as well as the concern that an additional revenue source ultimately could lead to greater spending and governmental expansion. Also, the increase in the tax administrative burden for U.S. companies cannot be overlooked.
From a federal perspective, Christie explains, fiscal policymakers are concerned that a VAT will be enacted not as a replacement tax but as an add-on tax to raise additional revenues. “This leaves the potential that the VAT could become a cash cow or money pump, whereby increases in the VAT rate over time raise additional revenue and lead to an increase in the size and scope of government,” she explains.
Some are concerned that a VAT, which is fundamentally a tax on household consumption, is a regressive tax, affecting the low-income segment of the population more because they consume a higher proportion of their income compared with high-income households, according to Christie. “Adjustments in the VAT base to exclude items consumed more heavily by low- and moderate-income taxpayers could undermine the economic benefits of a VAT by requiring a higher tax rate to raise the same revenue on the narrower tax base, and could also add to the complexity of the VAT, which, in turn, increases the tax administrative burden even more,” Christie asserts.
States State Their Case
Another reason the United States does not have a federal VAT: resistance from the states. Forty-five states, the District of Columbia, Puerto Rico, and several U.S. territories levy a sales tax, Christie notes. “A VAT at the federal level would be similar to state sales taxes. States would likely strongly resist any federal attempt to usurp their sales tax authority, because they rely on sales tax revenue,” she says.
“If a VAT is enacted in Puerto Rico, it could well become a testing ground for a VAT at the state level, potentially serving as a catalyst for the consideration of VAT in other states.”—Karen Christie
States would also likely be forced to keep their rates within a narrow range. Because the VAT rate would probably begin relatively high, it may leave states little room to lower their sales tax rate to increase their competitiveness with other states.
On the other hand, she explains, from a state taxation perspective, the landscape might be in store for change. Puerto Rico has been seriously considering the introduction of a VAT system: A VAT bill has been put forward by Puerto Rico’s governor as a key part of the administration’s current tax reform package. Although the first presentation of the package was defeated April 30 in the Puerto Rico House of Representatives by a margin of 22-28, the package may be presented again for a vote. If eventually adopted, the VAT in Puerto Rico would replace its sales tax, help reduce residents’ individual and corporate income taxes, and help address the territory’s deficit. “If a VAT was enacted in Puerto Rico, it could well become a testing ground for a VAT at the state level, potentially serving as a catalyst for the consideration of VAT in other states,” she says.
On a global level, however, VAT is becoming more prevalent. In the last decade, asserts Christie, the international tendency of taxing consumption rather than income has further accelerated. Therefore, she explains, VAT, being the primary consumption tax, has also become more prevalent. More countries apply a VAT system, and at higher tax rates year by year, for a variety of reasons, according to Christie. These include:
- Taxing consumption—especially in an economic downturn—yields higher and more stable tax revenues.
- The predictability of VAT revenues is a factor large sovereign bond holders and creditors—such as International Monetary Fund, the World Bank and investment funds—acknowledge and prefer, hence pushing indebted countries toward the increase of VAT rates, as well as the introduction of VAT (e.g., the Bahamas and Puerto Rico).
- Taxing consumption rather than income has also been preferred by many countries due to income tax competition reasons. Countries trying to attract capital investments tend to reduce corporate income taxes and payroll taxes (preferably below the rates of the surrounding countries) to gain a better rating in location studies preceding large investments. The revenue thus lost in income tax competition is then typically made up for via extra VAT revenues—VAT typically being neutral for most businesses in its ongoing application.
- VAT is self-administered by the taxpayers and should therefore be a tax relatively easy to enforce by the authorities.
In addition, economic pressures can lead to the introduction of VAT. Qatar recently announced that it may introduce a VAT. The loss of revenues from the decrease in fuel prices is likely a driver for this, according to Christie.
On the Horizon: India, Malaysia
As a reflection of the rapid proliferation of VAT, numerous jurisdictions have introduced a full-fledged VAT system recently (e.g., Malaysia) or are in the process of proposing such a system to be implemented in the near future (e.g., India).
“One of the peculiarities of indirect taxes is that they are very strongly intertwined with the economy,” Christie adds. “Their tax object usually is an economic transaction, such as the sale of a good or the provision of a service. If the nature of these transactions or the way that such transactions are handled changes, this immediately has a strong impact on indirect taxation.”
A striking example of such a change that has disrupted indirect taxes is the boom in e-commerce, says Christie. E-commerce may be defined as trading in products or services using computer networks, such as the Internet. “The Internet had a huge influence on the behavior of consumers, as it became possible to buy a wide range of goods online without going to a store. It further enabled consumers to purchase services from abroad without paying VAT that would otherwise have been levied on the same service purchased locally,” Christie says.
Over the last few years, e-commerce has been the fastest-growing sector in many countries. The Internet economy is anticipated to account for 5.3 percent of gross domestic product in the G-20 countries in 2016, she adds.
Such an important development implies big changes. It can lead to a distortion of competition between local vendors and foreign vendors, and it can have a significant impact on VAT revenues, particularly in relation to scenarios involving sales to final consumers (B2C transactions). The international community reacted quickly to this new reality, and already in 1998, the Organisation for Economic Co-operation and Development (OECD) member states agreed on the Ottawa principles on the taxation of e-commerce:
- Rules for consumption taxation of cross-border trade should result in taxation in the jurisdiction where consumption takes place.
- An international consensus should be found on which supplies are held to be consumed in a jurisdiction.
- For the purpose of consumption taxes, the supply of digitized products should not be treated as a supply of goods.
- Where a business acquires services and intangible property from suppliers outside the country, countries should examine the use of reverse charge, self-assessment, or other equivalent mechanisms.
- Countries should develop appropriate systems to collect tax on the importation of physical goods, and such systems should not impede revenue collection and the efficient delivery of products to consumers.
However, even though the above principles have been further analyzed and elaborated on by OECD’s Base Erosion and Profit Shifting (BEPS) Action 1, Christie asserts, the taxation of electronic services remained a patchwork in most countries. In recent years, governments around the world have become active in implementing new rules, realizing that incomplete legislation causes significant losses in revenue. The European Union (EU) implemented rules surrounding such digital B2C sales a long time ago, but it has further enhanced these rules over time to meet changes in the way companies operate as a result of e-commerce. A recent example is the EU’s introduction of new rules as of January 2015 for the place of supply of B2C electronic services.
These services are now subject to VAT, for both EU and non-EU suppliers of such services, where the customer (rather than the supplier) is established or resident. This requires service providers to register and pay VAT in the EU member state of the consumer. “But it is not just in the EU that the changes are being felt; similar rules have been or will shortly be introduced in many countries, including Albania, Australia, Iceland, Japan, New Zealand, Norway, South Africa, South Korea, and Switzerland,” Christie notes.
“Many VAT authorities around the world already require VAT returns and other statistical documents to be filed electronically.”—Karen Christie
There are several concrete examples of increased scrutiny of VAT, as well as recent and anticipated legislative and case law developments, according to Christie. “Most VAT authorities around the world already require VAT returns and other statistical documents to be filed electronically,” Christie explains. However, many countries from all parts of the world now also require additional accounts and invoices to be filed electronically, including:
- Brazil: The country has a long-standing requirement to submit invoices, tax returns, and a lot of other financial data electronically.
- China: VAT invoices are issued and printed through the Golden Tax System—a tax-control system connected to the database of the tax authorities. VAT returns are also primarily filed electronically.
- Italy: The country mandates electronic invoicing for supplies to public administrations.
- Malawi: The Malawi Revenue Authority implemented the required use of Electronic Fiscal Devices (EFDs) for VAT operators. The amendments make it mandatory for all VAT operators to acquire and use these machines for each sale transaction.
- Mexico: There is a new requirement for the chart of accounts used during the relevant period, trial balances, and information relating to journal entries to be filed electronically with the Mexican Tax Authority.
- Rwanda: There is an increased use of the Electronic Billing Machines (EBMs), which were introduced recently to improve VAT collections.
Tax and customs authorities in all parts of the world are using technology and data analytics tools to help them collect and protect tax revenues, notes Christie. By gathering more information and using it more effectively, they are better able to target taxpayers and transactions. Data extraction is also helping them perform “smarter” tax audits to identify underpayments and systemic weaknesses. They are also looking to encourage taxpayers to take compliance seriously—not only by increasing audit activity and the penalties for noncompliance but also by rewarding taxpayers who can demonstrate their systems are compliant, she notes.
The network of agreements for the exchange of information between jurisdictions has grown substantially since 2000, when the OECD first published its list of countries that did not cooperate in applying its information standards. As a next step, the OECD is exploring further opportunities for automatic exchanges of information and joint tax audits, including elements of indirect taxes, with tax authorities in different countries directly collaborating in planning and carrying out an audit. Such systems are already in place within the EU, according to Christie.
Brazil’s VAT System
Brazil is a large country with twenty-six states and a federal district with more than 5,600 municipalities. The VAT system is complex and includes:
- Municipal = ISS (a services tax)
- State = ICMS (state sales tax)
- Federal = PIS, COFINS, and IPI (contribution to the social integration program, social contribution on billing, and federal excise tax)
- Tax Executive asked Ernst & Young’s Karen Christie to break down the Brazilian VAT system:
“From a VAT returns perspective, in the past, the taxpayers were required to send the information regarding those VATs on a monthly basis to the states in which they were established. There was a VAT return called SINTEGRA that was used for the states to share information, but it wasn’t fully effective.
“From an invoice perspective, there was one invoice for each transaction involving movement of the goods, but the information contained in those documents was not shared among the Brazilian states.
“The Brazilian tax scenario had no effective communication between federal, state, and municipal tax authorities since the returns were filed only within one municipality, state, or at the federal level, and the information on the invoices was not shared.
“Aiming for a rationalized, standardized, and consolidated system, the Brazilian government started to introduce new changes to improve the interconnectivity between the tax authorities. Starting in 2007, when it was introduced, the Nota Fiscal Eletronica has been an electronic invoice that is required to be issued for the movement of goods. This electronic invoice is sent to the IRS and the state tax authorities.”
In 2009, Christie says, the Brazilian government introduced detailed federal electronic returns:
- SPED–Fiscal: filed monthly by each taxpayer, with information regarding state VAT (ICMS) and federal VAT (IPI).
- SPED–Contabil: filed monthly by each taxpayer, with information regarding journal register and supporting records, general ledger and sub-ledgers, and daily trial balances and balance sheets.
With the success of the SPED Fiscal and Contabil, in 2012 the government introduced another federal return for the PIS/COFINS:
- SPED–Contribuicoes: filed monthly by each taxpayer, with information regarding the other two federal VATs (PIS and COFINS).
“The aim of introducing these electronic filings and electronic invoices was to provide more transparency regarding taxpayers’ activities and taxation toward tax authorities,” Christie says. “Now, the Brazilian tax authorities are integrated on the different levels of taxation by standardizing and sharing accounting and tax information, which means, for taxpayers, that tax returns are more rationalized, standardized, and consolidated. This allows broader data cross-checking for tax purposes, providing more efficiency to detect irregularities and to speed up the tax examination processes using data analytics.”
OECD Guidelines on VAT
The OECD guidelines on VAT are currently in draft form, being developed using a building-block approach, according to which nothing is approved until everything is approved. However, the guidelines are now comprised of a sixty-page document with a preface and three chapters that the OECD Committee on Fiscal Affairs (CFA) officially approved on January 29, 2014.
These constitute the international standard for the application of VAT/GST to international trade. With a view toward reducing the uncertainty and risks of double taxation and unintended nontaxation, the two core topics of the guidelines are currently the principle of neutrality and the place of taxation of services and intangibles.
As far as neutrality is concerned, the OECD has developed and approved guidelines stressing, in effect, that the burden of value-added taxes themselves should not lie on taxable businesses, and businesses in similar situations carrying out comparable transactions should be subject to equivalent levels of taxation, Ernst & Young’s Christie notes.
With respect to the place of taxation of services and intangibles, the overarching principle is that VAT should be levied ultimately in the jurisdiction where final consumption occurs. This is known as the “destination principle,” Christie explains.
Editor’s Note: This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. The views expressed are not necessarily those of Ernst & Young LLP.