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What is VAT?

What VAT Is & How It Works

Before a business can sell its product to a customer, it needs to be completely sure that it’s ready to begin selling. That’s where the production stage comes in: products and goods need to go through production to gain value during each step of the way.

Products gain a little bit of value at each stage of their manufacturing process, all the way from their initial point of production to their final point of sale. It’s no wonder, then, that some countries choose to collect a tax from a product at each manufacturing stage. That tax is called a VAT (Value-Added Tax), which taxes the value of a product or good at every point along its production stage.

All this to say that VAT isn’t taxed on streams of income, like a traditional income tax. Instead, VAT taxes the consumption of products sold domestically and applies to all product transactions that take place in a certain country. To understand the way VAT works, let’s take a look at a quick example of how VAT applies to goods and services.

Let’s say that a company that manufactures car parts buys raw materials for $11, which includes a 10% VAT ($1 out of $11). Then the raw materials are processed into parts which are later bought by an assembly company at $20 plus 10% VAT for a total cost of $22. Since the cost for the raw materials was including VAT ($1) then the assembly company will only pay the government $1 (their VAT is $2 but since they have already paid the manufacturing company a $1 VAT, this value gets deducted from the amount they would need to pay).

Let’s say Company A, a car parts manufacturer, buys raw materials for $10 + 10% VAT for a total cost of $11. The raw materials are then processed into parts which are later bought by Company B, an assembly company at $20 plus 10% VAT for a total cost of $22. Since the cost for the raw materials included $1 VAT, Company B will only pay the government $1 (their VAT is $2 but since they have already paid Company A $1 VAT, this value gets deducted from the amount they would need to pay).

1. Let’s say that a company that manufactures toy car parts buys raw materials for $11, which includes a 10% VAT.

Raw Materials = $11 → VAT Rate 10% → VAT paid to the government = $1

2. Then, the manufacturing company processes these raw materials into parts which are then bought by an assembly company at $22 (Since the cost includes a 10% VAT rate, the price for the parts is $20 + $2 VAT for a total).

Parts = $22 → VAT Rate 10% → VAT value that needs to be paid to the government = $2

However, since during the manufacturing process the manufacturing company added a $1 VAT to the parts’ value, then the assembly company will deduct this from the amount they would need to pay in VAT.

VAT value that the assembly company needs to pay the government = $2 → Assembly company has paid $1 in the parts price (VAT included by manufacturers) → $2 – $1 = $1 → The assembly company would need to pay $1 in VAT to the government.

This process repeats until it is passed on to the final buyer of the goods, who will be paying the sum of the VAT paid by the other buyers through the different production stages.

Value Added Tax Calculation Example
Production & Purchase StageCostVAT ChargedTotal CostVAT Paid
Purchase of Raw Materials$10.00$1.00$11.00$1.00
Purchase After Manufacturing Stage$20.00$2.00$22.00$1.00
Purchase After Assembling Stage$30.00$3.00$33.00$1.00
Final Sale Stage$40.00$4.00$44.00$1.00
VAT charged to the final buyer   $4.00

As this example demonstrates, VAT applies to each stage of the supply chain including the manufacturing, distribution, and final sale of a product. This means that VAT is assessed and collected at each stage of production rather than at the end of a transaction, making it different from a traditional sales tax.

Although VAT and sales taxes can raise similar amounts of revenue, a sales tax is rendered at the end of a sale rather than during production. With VAT, goods are taxed each time they gain value during production rather than taxing the sale of a good itself.

Countries That Collect VAT

As of 2021, there are more than 160 countries worldwide that use some form of a VAT system. Although systems to apply VAT on goods are most common in the European Union, many other industrialised countries use value-added taxation as well. The majority of industrialised countries that form the Organisation for Economic Cooperation and Development (OECD), for example, use some kind of VAT system.

Generally speaking, industrialised countries that levy a VAT on goods and products sold have been using their VAT systems since the 80’s. Notable among industrialised countries that do not use a VAT system is the United States, which considers the VAT as regressive and less-effective than a progressive sales tax. Some countries refer to VAT (Value-Added-Tax) as GST (Goods and Service Tax), and some of the differences between the two are around taxation rate, tax-free items and exemptions, and some registration requirements that would be specific for each country.


How to Track and Manage VAT With Quickbooks

Start automatically tracking and calculating your VAT in seconds with QuickBooks Online’s pre-filled tax rates.

If you’re gearing up for tax season and want to kick off the new financial year right, you need a way to keep your VAT and other tax information in one place. Businesses of all sizes and in any industry can rely on QuickBooks’ VAT tracking software to avoid last-minute surprises come tax season.

Want to create custom, professional invoices that you can send in minutes from either your mobile device or personal computer? QuickBooks’ features let you send payment reminders and match your payments to invoices automatically so that all your expenses are organised for tax season. Create invoices with tax, discounts, and shipping costs

calculated for you and organise your financial statements in one place with QuickBooks’ business reporting. You can even customise your reports with tax payable and owning information as well as cash flows and outflows.

Let QuickBooks automatically track your VAT and calculate it for you each time you create a new invoice or expense. Do away with manual data entry and get automatic, accurate calculations and record-keeping whenever, wherever with QuickBooks’ VAT tracking software starting at just $8 per month.

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