INTRODUCTION

Thomas S. Adams, an American, was one of the first commentators to discuss the concept of a VAT. Other than flirting with a possible federal sales tax as a source for revenue to finance World War II, the U.S. Congress has not seriously debated a proposal for a federal tax on consumption.

Retail sales taxes account for a significant share of state and local revenue, and at least one state relies on a state-level value added tax.

As discussed in Chapter 2, a consumption-based tax can take the form of an individualized consumption-based income tax (commonly referred to as a “consumed” or “cash-flow income tax) or the form of a consumption-based tax on sales of goods and services (single stage sales tax or multistage value added tax). This book has focused on the latter. Indeed, because most countries with consumption-based taxes rely on European-style VATs, this book concentrated on that kind of VAT.

On January 7, 2005, President Bush established a panel to recommend revenue-neutral options to reform the federal tax system to make it simpler, fairer, and more pro-growth to benefit all Americans. The panel issued its report on November 1, 2005. Although the panel received many submissions and discussed the possible introduction of a federal sales or value added tax, the panel did not include a transactional tax on consumption to supplement or replace any of the existing federal taxes on income, payroll, and wealth transfers. The next section discusses the panel's report.

GENERAL INTRODUCTION

There are a group of services that pose particular problems under a credit-invoice VAT like the EU VAT. They are gambling, transactions involving money and other financial products that are priced to include implicit fees, and insurance (a particular kind of financial service). In all three cases, the value added by the service provider should be subject to a broad-based VAT, at least to the extent that they represent personal consumption expenditures. In all three cases, more than with other consumer goods (other than used goods) and services, a significant portion of the business inputs are obtained from consumers who are not registered for VAT purposes. As a result, those nonregistered suppliers do not issue VAT invoices and the casino, bank, investment firm, or insurance company is not entitled to claim credit for any VAT component embedded in the price of those acquired goods or services. If VAT were imposed on the consideration for these services or products, the tax would apply to more than the value added by the service provider. Absent administrable rules to tax only the value added, it is not surprising that the default rule was to exempt these services. Recently, rules have been developed to bring more of these services within the VAT base, but problems remain. The chapter starts with an easy to understand example, gambling.

INTRODUCTION

Most VAT regimes require registered (or taxable) persons to file returns (and remit tax). In most cases, a firm is required to register if it makes or expects to make at least the statutory minimum level of annual taxable sales in connection with its business or economic activity.

Not all sales by a person come within the scope of a VAT. For example, in most countries, an individual's casual sales do not constitute taxable business activity and are not taxed. Hobbies and similar activities that do not rise to the level of a “business” generally are not taxed. An employee could be treated as a person rendering taxable services to her employer and therefore a VAT taxpayer, but no country has done this. This chapter discusses registration (including some required registration by nonresidents), who is liable for tax, and what economic activity subjects a seller to tax under various VAT regimes. In a significant case decided by the European Court of Justice, the court ruled that a person who, without his knowledge, participated in a carousel fraud was engaged in economic activity and was entitled to claim input tax credits.

REGISTRATION

IN GENERAL

Registration is part of a self-assessment VAT system that typically is reinforced with harsh civil and criminal penalties for noncompliance. Many VAT systems define a taxable person subject to the VAT rules as a person who is registered (a registrant) or is required to register.

INTRODUCTION

For VAT purposes, most countries lump together insurance and financial services rendered by financial institutions. The typical pattern is to include insurance within the definition of exempt financial services. There are some exceptions.

Israel taxes insurance companies under a system administered by the income tax department. The Israeli tax is calculated under an addition method that includes wages and profits but does not allow any deduction for VAT paid on business inputs. New Zealand taxes insurance other than life insurance under its Goods and Services Tax (GST). South Africa and some other southern African countries follow the New Zealand pattern of taxing property and casualty insurance on the margin between premiums received and claims paid. Australia also is taxing property and casualty insurance under its new GST but departs from the New Zealand approach with respect to input credits available to insurers on claims paid.

The following is a nonexclusive list of insurance-related transactions that may be taxed, zero rated, or granted exemption from tax.

Thanks to our students at Wayne State, Harvard, and Michigan law schools for their contributions to the revision of this book. Thanks to Dean Frank Wu and Wayne State University Law School, and to Georgia Clark, Director of the Wayne Law Library, and her staff for the support that made this revision possible. Thanks to our colleague Richard Ainsworth and the two anonymous readers who made helpful suggestions on how we could improve our first attempt at comparative value added tax. Thanks to Karen Kissinger for her very helpful research assistance. Thanks to our faculty assistants, Olive Hyman and Lise Berg, for their assistance with various aspects of the manuscript. Thanks to John Berger, our editor at Cambridge University Press, and Peggy Rote, Laura Lawrie, and Dianne Scent for their help in the process of converting our manuscript to final text.

The cutoff date for this book generally was March 31, 2006, although we have included some material published after that date. In particular, we included some European Court of Justice cases, including those covering the Italian subnational tax (IRAP) and some VAT-abusive transactions. This book is not intended to be exhaustive. It therefore does not include all significant cases in all countries or even all English-speaking countries. It is designed to illustrate, analyze, and explain the principal theoretical and operating features of value added taxes, including their adoption and implementation.

INTRODUCTION

Excluding VATs that are covered only tangentially in this book, such as those in effect in China, Russia, and excluding those in civil law, non-English-speaking countries outside the European Union (EU), most VATs imposed at the national level can be classified in four groups. The most prevalent form of VAT is the harmonized VAT in the EU member states. The EU model has the most extensive case law on VAT issues. More recent entrants to the VAT family have expanded the VAT base and made other significant changes. Other customs or common market communities may move to harmonize their indirect taxes in order to provide for the free movement of goods, services, and capital within the community.

New Zealand departed from the EU model in a number of significant ways, including the expansion of the tax base for its Goods and Services Tax (GST) by limiting exemptions and zero rating and by taxing many government services. South Africa modeled its VAT after the New Zealand GST, but included some of its own unique features. For example, South Africa taxes all fee-based financial services.

Canada has a national VAT (its GST) and several provinces have harmonized VATs. The combined Quebec-national GSTs are administered by Quebec. The combined national and maritime provinces GSTs (the Harmonized Sales Tax) are administered at the national level. The Canadian GST is discussed elsewhere in the book.

INTRODUCTION

One of the most complicated problems in designing a VAT base involves the taxation of real (immovable) property. The tax base should consist of the personal consumption element in real property (for residential property, living quarters either owned or leased). In the United States, housing represents over 16 percent of total personal consumption expenditures. The difficulty is to identify the personal consumption element, especially for real property that may be used for business or personal purposes.

There are a number of possible techniques for taxing real property under a VAT. They must consider valuation and other administrative issues in the context of business versus personal, investment versus consumption.

ARRAY OF VAT TREATMENT OF REAL (OR IMMOVABLE) PROPERTY

A variety of approaches to the taxation of real property are available, even if they are based on the principles that a VAT is a tax on personal consumption, and the tax should not be imposed on the same value added to goods or services more than once.

Real property is a long-lived asset, even more so than other consumer durables. Ideally, the current use of consumer durables should be taxed each year. This approach raises significant administrative and practical problems. As a result, most consumer durables are taxed at the time of purchase (based on the consideration paid). This approach reflects a decision to tax the present discounted value of the stream of future personal consumption. The same approach could be used for real property.

INTRODUCTION TO INTERNATIONAL TRADE

For most countries with VATs, international trade is a significant component of their economies. A country with a VAT must define the jurisdictional reach of the tax; that is, the tax may be imposed on production within the country (an origin principle VAT), on domestic consumption (a destination principle VAT), or some combination of the two. Almost every country with a VAT relies on the destination principle to define the jurisdictional limits of the tax. Under a pure destination principle, imports are taxed and exports are completely free of tax (zero rated). With this system, it is important to identify the value of goods and services that are exported (and when they are exported) and identify the value of taxable imports and determine when they are taxable.

This chapter discusses the place of supply rules in the context of international trade, including the troublesome issues on cross-border transactions relating to the place where services are rendered.

The location or place of an international sale of services has become more significant with the advent of electronic commerce. A significant problem with electronic commerce is to determine if the sale is of goods or services. For example, if computer software, music, and videos are transmitted by electronic signals rather than in compact disks or other physical form, is the transaction a sale of goods or a sale of services?

TAX CREDIT FOR PURCHASES

BASIC INPUT TAX CREDIT RULES

Allowance of Credit – General Rules

Under the credit or invoice VAT used almost universally, tax liability for each period is calculated as the difference between the tax imposed or collected on taxable sales (output tax) and tax paid or incurred both on taxable purchases and on taxable imports (input tax credit). Some credit-invoice VATs are worded so that the input tax is deducted from tax on taxable sales (output tax). In this book, input tax credit and input tax deduction are used interchangeably to mean subtraction of input tax from output tax.

Unlike an income tax imposed on an income base that requires capital goods to be capitalized and depreciated and requires beginning and ending inventories to be taken into account in determining gross income from sales, VATs typically are consumption-based taxes that allow an immediate input credit for tax imposed on purchases of capital goods and inventory items. There are some exceptions discussed in this chapter.

Nations with VATs provide varying input credit rules. For example, in Mexico, there is a threshold condition. Only VAT on goods or services deductible for income tax purposes can qualify for input credits. The qualifying input VAT still may be disallowed, such as input VAT attributable to exempt supplies.

The EU Sixth VAT Directive contains extensive rules on the availability of input tax credits (or what under the Directive is referred to as deductions).

INTRODUCTION

Most VAT regimes impose VAT only on sales for consideration, and the sale is taxable if there is a clear connection between the sale and that consideration. This chapter examines the required link between a sale and the consideration received by the seller that is a prerequisite to a taxable sale.

The classification of a sale as a sale of goods or a sale of services may be significant for tax purposes. For example, in most countries, imports of most goods are taxed but imports of only specified services are taxed. A sale for a single price may incorporate elements of multiple supplies that are taxed differently. For example, a portion of the sale, if supplied independently, would be taxable at a positive rate, and another portion, if supplied independently, may be exempt from tax. It therefore is significant for VAT purposes if the transaction is respected as a single supply or is treated as multiple supplies. In some cases, a transaction that includes elements that are both taxable and exempt, the VAT legislation and case law may draw a distinction between mixed supplies (with main and incidental elements) that are classified as a single supply of the main element, and composite supplies that can be disaggregated and classified as multiple independent supplies. This chapter explores the question – “what is ‘the supply’ for VAT purposes?

The timing (or tax accounting) rules are used to identify the tax period in which a taxpayer must pay tax on imports, report taxable sales, and claim deductions or credits for tax paid on allowable imports and domestic purchases. When a VAT is introduced or the rate is changed, transition rules are needed to identify if sales and purchases are made before or after the effective date of the new or modified VAT.

VAT generally is imposed on the amount of money and the value of nonmonetary consideration received for a taxable supply. Special valuation rules are provided for particular transactions. This chapter covers the timing, transition, and valuation rules.

THE TIMING RULES

ACCRUAL, INVOICE, AND CASH METHODS – IN GENERAL

This section discusses the rules governing the basic methods of accounting for VAT. It does not discuss the innumerable varieties of special schemes for retailers that are available in many countries.

Some countries do not allow any person to use the cash method. Other countries permit registered persons who meet the statutory conditions (usually related to a lower level of taxable turnover) to report on the cash method.

The limits or prohibitions against the use of the cash method are imposed in order to prevent the mismatching that occurs if the seller can defer the payment of output tax to the government, yet the buyer can claim an immediate credit.

INTRODUCTION

This chapter covers the use of exemptions and zero rating under a VAT. As discussed in more detail in Chapter 2, the exemption may be an “item” exemption limited to particular supplies or an “entity” exemption applicable to all or most supplies by a particular kind of entity. Zero rating generally is provided for exports of goods (regardless of the nature of the goods exported) and exports of some services. An exemption may be provided for all supplies by a unit of government or nonprofit organization, the exemption may be provided based on the nature of the goods or services supplied, or may be provided for all supplies except those that compete with the private sector.

The next few parts of this chapter cover zero rating, exemptions, and mixed supplies, with attention focused on the complexity resulting from borderline cases involving “item” exemptions or “item” zero rating.

Part VI of this chapter discusses some of the special VAT problems associated with the nonprofit–governmental sectors and proposals to include certain services by these sectors in the VAT base.

ZERO-RATED SALES

IN GENERAL

A zero-rated sale is a taxable sale, subject to tax at a zero rate, and input tax on purchases attributable to that sale is creditable. The sale therefore is basically free of VAT. If a sale at retail is zero rated, the consumer buys the item free of VAT. If the zero rate applied only at an intermediate (such as wholesale) stage, and the retail stage were taxable, the tax not collected at the intermediate stage would be recovered on the retail sale.