CHAPTER 1 BASIC STRUCTURE OF VAT. A. Introduction: Basic VAT requirements

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1 CHAPTER 1 BASIC STRUCTURE OF VAT A. Introduction: Basic VAT requirements Value Added Tax (VAT) is a tax on general consumption or expenditure. It is ultimately paid by consumers and collected on behalf of tax offices by registered businesses. This chapter uses an operational definition of VAT to discuss a number of VAT principles, concepts and rules, including the destination principle and the credit method. VAT belongs to the family of taxes know as goods and services tax (GST) and general consumption tax (GCT). Operational definition: VAT is currently the main method of collecting general consumption taxes in developed and developing countries. While there is no uniform definition of VAT, VAT laws include the key elements in the following operational statement. Persons (or entities or businesses) are required to register and charge VAT when they make or expect to make taxable supplies (or sales or turnover) for a consideration (or value or price) in the ordinary course or furtherance of an enterprise (or commercial or business activity). This statement is worth remembering and will be repeated, in whole or in part, throughout the book. The concepts in bold italics are the common elements but the brackets following them show that there may be other usages in VAT laws and business practice. Elements of the definition: As discussed in more detail in Section D, the statement embodies the following important principles, concepts or notions about VAT. Persons: VAT is collected on behalf of tax offices by only registered persons (natural or artificial) and it is added to the selling price of taxable supplies which means that even when non-registered firms sell taxable supplies, they cannot charge VAT. Taxable supplies: VAT is ultimately paid by consumers on taxable supplies of goods, property and services which mean that non-taxable (exempt or relief) supplies are excluded from the VAT base. Consideration: The supplies are made for a consideration (value or price) which can be given in cash or in kind by the parties to an exchange or third parties. Enterprise: Registered persons can only charge VAT on taxable supplies made in the ordinary course or furtherance of an enterprise or commercial activity which ordinarily means that they operate with a profit motive. Chapter 1 Basic Structure_Publish (2) 2/17/2010

2 - 2 - The following are further explanations of some of the concepts in the operational definition above. From the perspective of a registered business, the tax affects both sales (Output VAT) and purchases or expenses (Input VAT). Domestic and foreign supplies: As noted in Section B and Part II, supplies may be made as domestic and foreign or international trade transactions. The later are classified as imports or exports. Intermediaries and input tax credit (ITC): While a VAT is a tax on consumption, it may be paid by businesses. However, the credit method discussed in Section B allows registered businesses that pay VAT on inputs to claim a credit or refund under the appropriate input tax credit (ITC) rules discussed throughout the book. Registration threshold: As discussed in Section D, it is only registered persons that make taxable supplies, sales or turnover above a given annual amount that are required to register VAT in many countries. Profit motive: The profit-motive means that non-profit bodies (e.g., governments and charities) engaged in non-profit activities are not eligible to register for VAT. They will be eligible when they engage in commercial activities and make taxable supplies. The elements of VAT discussed are often confused with similar terms used in accounting, business and taxation. For example, an entity is called a business or enterprise and it can engage in business or a business enterprise. Where necessary, the context will be clarified in the relevant chapters. Section B describes the destination principle and credit method as the basis for VAT systems. Sections C and D discuss the mechanics and concepts of VAT while Section E summarizes the administration and compliance aspects of VAT regimes. B. Basis for VAT: Destination Principle and Credit Method VAT is a tax on general consumption expenditure but it is ultimately paid by consumers. It is collected by registered businesses that pay VAT on inputs, in line with the destination principle and credit method. Destination principle As a tax on household expenses, VAT is based on the final destination of consumption. The basis of the destination rule is that domestic supplies and imports are taxable because they are consumed locally while exports are excluded as foreign consumption. Domestic supplies: Registered businesses charge VAT on all domestic taxable sales or supplies at the appropriate VAT rate(s).

3 - 3 - Imported goods: Importers whether consumers or registered and non-registered businesses pay VAT on imported goods to customs offices. Imported services: Imported services are collected under a special self-assessment or reverse charge rule. VAT rate on foreign trade: Imports are taxed at the standard rate while exports of goods (administered by customs) and services (self-assessed) are taxed at a zero rate to avoid the imposition of a domestic tax on foreigners. In comparison, the origin principle imposes VAT on exports and zero-rates imports. It is not widely used, even in ideal situations such as an economic union. It is apparent that customs offices play an important role in administering the VAT on imports and exports of goods. These points are discussed further in Section C and in more detail in Chapters 11 and 12. VAT Credit method In comparison with the other methods of collecting general consumption taxes discussed in Section C, the credit method is based on a very simple notion, as stated below. A registered person should not add the VAT on taxable inputs (i.e., purchases and expenses) used to make taxable supplies (i.e., sales) to operating costs because the former can be offset against the latter through the input tax credit (ITC) process. The key elements in the statement above are (a) Output VAT on taxable supplies (i.e., sales or output); (b) Input VAT on taxable supplies (i.e., expenses, purchases or inputs; and (c) an offset or Input Tax Credit (ITC) mechanism that results in Net VAT. Output VAT is collected incrementally on taxable sales made to consumers and to registered and non-registered businesses. Output VAT = Taxable sales x VAT rate Input VAT is paid by registered and non-registered businesses on taxable inputs of purchases and expenses Input VAT is the reverse Output VAT charged by vendors. Input VAT = Taxable purchases and sales x VAT rate Input Tax Credit (ITC): VAT-registered persons can offset Input VAT related to Output VAT on taxable supplies through the ITC mechanism to give the net VAT. Net VAT = Output VAT less Input VAT

4 - 4 - Net VAT is positive when Output VAT exceeds Input VAT (i.e., signifies a payment) and negative in reverse (i.e., signifies a refund or credit). It is necessary to stress a few important points about the above, which underlie most of the discussions in various chapters of the handbook. It should be clear that a registered person must view the VAT mechanism from the perspective of both purchases and sales activities. In contrast, non-registered persons pay VAT on inputs but are not eligible to charge output VAT on sales (Chapter 3). Another critical point is that input VAT must relate to a taxable supply to qualify for ITC or VAT offset mechanism. To reiterate, once Input VAT is recoverable as ITC, it should not be added to costs. This process makes the VAT credit method more efficient than other general consumption tax methods such as single-stage sales and turnover taxes (Section C). Obligations of a registered person Table 1 explains a typical monthly VAT and ITC activity, where a registered firm charges Output VAT and pays Input VAT. This is the format that is mostly used in this handbook. Example 1: Practical illustration of VAT credit method concepts Desk Registrant Company makes taxable sales of 170,000 in April. The value of its taxable purchases and expenses were 135,000. The standard VAT rate is 10 percent. Table 1: Desk Registrant and Cos. VAT computation for April Transactions Cost/price Input VAT Output VAT Net VAT Purchases & expenses 135,000 13,500 Sales (output) 170,000 17,000 Total/Net VAT payable 13,500 17,000 3,500 Rate of VAT 10 percent The example above assumes that all sales and purchases or expenses are taxable. Secondly, it also focuses on the obligations of a single registered business which files VAT returns periodically to account for Output VAT, Input VAT and Net VAT. As noted in Section C, however, the credit method is also a total VAT concept for collecting the VAT due in the economy in multiple stages from several registered businesses along the production (import) and distribution (export) chain.

5 - 5 - C. Collecting VAT in stages As noted at the end of Section B, individual registered persons charge and account for Output VAT, Input VAT and Net VAT as part of an incremental process along the production (import)-distribution (export) chain. This section also compares the VAT credit method with other alternatives for charging general consumption taxes. VAT transaction cycle Table 2 illustrates a production-distribution chain with a registered business initiating the process by importing wheat to produce flour and bread in the economy. Table 2: Transaction chain (basic cost and price build-up) Importer Transactions Type Value Comments Initial cost (Imports) Imports 1000 Importer initiates transactions Additional cost + profit Value added 500 Value added or created at this stage Selling price Sales 1500 Input cost at next (manufacturing) stage Manufacturer Input cost Purchases 1500 Cost from import stage Additional cost + profit Value added 1000 Value added or created at this stage Selling price Sales 2500 Input cost at next (wholesale) stage Wholesaler Input cost Purchases 2500 Price from manufacturing stage Additional cost + profit Value added 800 Value added or created at this stage Selling price Sales 3300 Input cost at next (retail) stage Retailer Input cost Purchases 3300 Price from wholesale stage Additional cost + profit Value added 700 Value added or created at this stage Selling price Sales 4000 Final consumer price Tax rate 10% While no VAT or tax is considered at this stage, it is necessary to discuss some points. Initial cost: The table uses an importer to initiate the chain of activities. Some books use a farmer who does not pay VAT on the initial cost but charges Output VAT. Value added: This is a technical term which refers simply to the additional cost and profit at every stage of the chain. Supplies as input and output: The output (sales) at each stage is the input (purchases and expenses) at the next stage until the product or service reaches a final consumer.

6 - 6 - In most of the remaining examples, from a practical accounting perspective, the value added line will be expressed in very simple terms as the difference between the sales and purchase values shown on sales and purchase invoices. How VAT is collected in stages In Table 3 below, businesses charge Output VAT on taxable sales, pay Input VAT on taxable inputs, and account for Net VAT through the ITC process. Recall that registered persons do not add Input VAT related to taxable sales or supplies to operating cost because it can be recovered through the ITC process. Table 3: Illustration of multi-stage VAT Transactions Cost/ Input Output Net Comments Importer Imports (input) 1/ Price 1000 VAT 100 VAT 100 VAT 100 Import VAT/ITC to customs office Sales (output) Sales to manufacturer Value added/vat paid Output VAT less Input VAT Manufacturer Purchases (input) Purchases from importer Sales (output) Sales to wholesaler Value added/vat paid Output VAT less Input VAT Wholesaler Purchases (input) Purchases from manufacturer Sales (output) Sales to retailer Value added/vat paid Output VAT less Input VAT Retailer Purchases (input) Purchases from wholesaler Sales (output) Sales to final consumer Value added/vat paid Output VAT less Input VAT Total ITC/VAT / As explained in Chapters 10 and 11, importers take a credit for the Import (Output) VAT paid to the customs office. Hence, the 100 is both an Input VAT and an Output VAT. The following points regarding the VAT mechanism are worth noting, always bearing in mind that value added is the difference between output (sales) and inputs (purchases). The arrows show that Output VAT (column 4) charged by suppliers becomes Input VAT (Column 3) at the next stage also the basis for ITC or credit offsets. Column 5 shows net VAT as total Output VAT (1230 plus import VAT of 100 paid to customs) less total Input VAT (830 plus 100 contra entry for import VAT).

7 - 7 - Column 5 also shows that the VAT due at each stage is 10 percent of value added in Column 2 which is the more direct/addition method of calculating VAT. The automatic Output VAT and ITC process continues until a final consumer terminates the chain. To reemphasize, Table 3 assumes that importers pay Import VAT (both Output VAT and Input VAT) but not other domestic costs, as usually happens in practice. Alternative consumption tax methods VAT replaced several methods of collecting the general consumption tax in many countries. Some of these are explained briefly below. Alternative general consumption taxes: The ensuing paragraphs compare the VAT credit method to the other main methods of imposing general consumption tax. Retail sales tax (RST): The single-stage tax is collected from consumers at a stage where tax administration and compliance may be weak in many countries. As Table 4 shows, however, in principle, it generates the same revenue as VAT. Table 4: Retail stage sales tax Items Value/Tax Comments Retail price (ex-rst) 4000 Tax-exclusive price Retail Sales Tax (RST) % of 4000 Retail price (including RST) Tax-inclusive price Manufacturing stage sales tax (MST): MSTs used to be imposed in combination with import sales tax and selective service taxes in countries with weak administration and compliance. A pure MST would yield 250 (10% of 2,500) in addition to 100 on imports (which cascades because it is added to cost as an irrecoverable tax). Table 5: Manufacturing stage sales tax Item Manufacturing Imports Total Price (ex-mst/import VAT) Sales Tax (10 percent) Price (including RST) Turnover tax: As shown in Table 6 (i.e., manufacturing-stage from Table 2), the tax is on the tax-inclusive cost because the sales tax cannot be recovered.

8 - 8 - Table 6: Turnover tax Transactions Cost/ Input Output Net (Manufacturer) Price VAT VAT VAT Comments Purchases (input) Purchases from importer Add Input VAT 150 Irrecoverable Value added 1000 Sales (output) Includes irrecoverable VAT Value added/vat paid Output VAT less Input VAT The full impact of cascading through every stage of the production-distribution chain is is discussed in Chapter 20. Cascading and waiver of sales tax on inputs: As Table 6 shows, the sales tax on domestic purchases and imports are input costs which cascade because they cannot be recovered. To minimize or limit the impact of cascading, countries used to waive, suspend or defer the sales tax on selected business inputs (e.g., capital goods and raw materials). The businesses that benefited from this scheme were ring-fenced through a special registration process. The effect of waiving sales tax on inputs is similar to the deferral of the tax in the RST column shown in the summary in Table 7 below). Alternatives under VAT: Many VAT laws include Equalization and Margin Scheme regimes under the pure Output VAT less Input VAT mechanism described above. Equalization VAT: This approach applies a low VAT rate (e.g., 2 percent) to the Output or Sales without the option of ITC for the registered persons under the regime. Margin schemes: These use formulas to derive Input VAT/ITC because sales are presumed to be VAT-inclusive, as discussed in Chapter 5 under Consideration. Addition and subtraction methods: Under these methods, VAT is calculated directly in total on the (a) value added and (b) output and input values. The equalization and margin methods are discussed further in Chapter 6 (Input Tax Credit) and other chapters. The addition and subtraction methods are shown in Chapter 20 (Policy and Structure). Advantage of VAT ITC process The VAT credit method has several advantages over the alternative general consumption tax methods. Table 7 compares these main methods.

9 - 9 - Table 7: Comparison of RST and VAT Type of business Credit VAT Retail/service stage (RST) Manufacturingstage tax Turnover tax 1/ Importer (import) Importer (domestic) Manufacturer Wholesaler Retailer Consumer tax ,260 1/ Tax is levied at each stage of the transaction and then it cascades Efficiency of credit method: The goal of Input Tax Credit (ITC) is to minimize cascading and make the consumption tax regime more efficient. It is obvious from Tables 4 to 7 that the credit method does not distort and increase prices unnecessarily. Nonetheless, cascading may be difficult to eliminate completely from VAT because non-registered persons are not entitled to claim ITC and, therefore, have to add the Input VAT they pay to costs; since registered persons cannot claim ITC on exempt supplies, they also incur input VAT that cannot be recovered; and as a feature of the chain, VAT-inclusive costs continue attracting VAT until a supply reaches the final consumer to terminate the cycle. Cascading may increase revenues but it is an inefficient way of collecting taxes. It is explained with respect to turnover taxes in Chapter 2 as well as non-registration and exemptions in Section... and in Chapters 6 and 8. Effective administration and compliance: The VAT invoice-credit method is viewed as effective because of the self-policing and audit trail features. Self-policing: Registered persons must have an invoice, cash receipt or customs entry as evidence for claiming ITC for any Input VAT paid. Audit trail: The invoice and other VAT documents establish a trail which makes it easy for tax offices to perform audits and implement other enforcement programs. The administration of VAT is summarized in Section E and discussed in more detail in Chapters 12 to 19. VAT rates The VAT on taxable supplies is at a specific rate or rates that take account of economic and socio-political factors (e.g., redistribution and incentives). The main categories include

10 standard rate the most common rate imposed on the majority of taxable good and services (assumed to be 10 percent throughout this book); zero (0) rate applied to exports (to avoid imposing VAT on foreigners) and on selected domestic supplies (often in lieu of an exemption) as a form of providing VAT relief for households and businesses; preferential rate(s) sub-standard rate(s) may apply to (a) basic supplies (distribution); and (b) business inputs (tax incentive) is assumed to be 5 percent throughout this book); and punitive rate(s) super-standard rate applied to selected luxury goods and services (assumed to be 15 percent throughout this book). In Table 8, inputs attract 10 percent VAT while output attract different rates (standard, zero, preferential and punitive) or are exempt. Several countries simplify the VAT by imposing a single positive rate and zero-rating only exports. They use excises, tariffs, and income tax), exemptions, and expenditure policies to achieve non-revenue goals such as redistribution and investment incentives. Table 8: Illustration of the effect of tax rates/exemptions Transaction Standard Zero Preferential Punitive Exemption Comments Sales 100, , , , ,500 All sales are taxable Purchases 85,000 85,000 85,000 85,000 93,500 All inputs are taxable VAT computations Output VAT 10, ,000 15,000 na Different rates Input VAT 8,500 8,500 8,500 8,500 8,500 Taxable at 10 percent Net VAT 1,500 (8,500) (3,500) 6,500 na Price plus VAT 110, , , , ,500 Rates 10% 0% 5% 15% nil D. Basic VAT concepts and rules This section summarizes the basic VAT concepts in the following statement in Section A: persons are required to register and charge VAT when they make or expect to make taxable supplies for consideration in the ordinary course or furtherance of an enterprise. Supplies: These are classified as taxable (including zero-rated) and non-taxable (i.e., exempt) goods, property or services. Consideration: The consideration, price, amount or value is the basis for calculating VAT and may be paid in cash or in-kind, including an act or a forbearance.

11 Person: A person may be a natural individual (e.g., sole proprietor) or an artificial or legal entity (e.g., company, partnerships and trusts). Enterprise: A registered person must make or intend to make supplies in the ordinary course or furtherance of an enterprise, business or a commercial activity. The general and special aspects of these concepts are discussed in more detail in Chapter 2 to 11, with administration and compliance covered in Chapters 12 to 19. Supplies Supplies mean goods, property and services given by entrepreneurs in exchange for a price or consideration. The VAT issues relate to the nature, place, time and value of supplies. General nature of supplies: Several VAT rules and exceptions are based on the classification of supplies into goods, property and services. Goods are tangible or physical (similar to property but unlike services) and movable (unlike property). Property is also physical or tangible (again, similar to goods but unlike services) but fixed or immovable (unlike goods). However, some VAT and income tax laws refer to goods and intangible items as property. Services are intangible (unlike goods and property) and defined in residual terms [e.g., anything else apart from goods and property ; or anything that is not a good or property ]. Interest in property: This special group refers to a right, license, or similar interest in a tangible property. The interest is intangible but related to a tangible item. The residual definition and interest in property ensure that VAT laws cover all possible supplies, including the assignment of rights in property (e.g., a lease or rental of hotel accommodation has physical and intangible elements regarding the landlord and tenant). Taxable nature of supplies: All supplies or sales may be classified as taxable or non-taxable, with the latter being sub-classified into exempt and relief supplies. Taxable supplies are sales or supplies that attract Output VAT at specific standard, preferential, punitive or zero rate. Exempt supplies fall outside the VAT rate regime completely no rate or right to ITC apply to these supplies.

12 Relief supplies are taxable but the Output VAT is waived through zero-rating (or exemption) for certain persons, entities or end-users. The notion of zero rating is important because, unlike an exemption, it allows a registered person (e.g., exporter) to claim ITC. Mixed supplies: A mixed supply has taxable and non-taxable elements that can be classified further as multiple or composite supplies. Multiple supplies: Multiple supplies comprise two or more separate substantive or material supplies, normally taxable and exempt components. Composite supply: This is a single supply comprising primary and secondary or complementary elements. The latter is incidental to the principal supply. Input VAT relating to multiple supplies is apportioned but it is assigned in whole to a composite supply to be claimed or denied as ITC under the relevant rules. Table 9 shows the supply of goods with total value of 9,200 but categorized as multiple or composite supplies. Multiple and composite supplies are discussed further in Chapter 6. Table 9: Example of mixed supplies a) Supplies Elements Multiple Composite Taxable (10%) Exempt Total b) Output VAT Taxable supplies Exempt supplies Na 0 Total VAT Place of supply rules: A taxable supply must be connected with a country to attract VAT. In general, the term connection refers to the place of supply being where goods or services are made available, delivered or rendered (understood to mean commercial activity in a domestic market context); property is located (understood to mean location in the country or outside, which automatically influences the supply of related goods and services); and goods are brought into the country (referring to imports, as opposed to exports that are taken out of the country).

13 The rules in relation to property, goods and services are relatively easy for domestic supplies but, as discussed below, less so for imports and exports, notably imported services. The place of supply rules for imports and exports are as follows imports and exports of goods: the place of supply of imported goods is domestic while exports are sent abroad (both are cleared by customs offices); imports and exports of services: the place of supply of services is the recipient s place of business or location (the supplier s resident status is irrelevant); imports are taxed locally while exports are zero-rated; property: the sale of property located outside is not subject to domestic VAT (the location of the buyer and seller is irrelevant); related supplies are also taxed where the property is located. Imports and exports of services are intangible and, furthermore, it is difficult to hold foreign suppliers accountable for supplies made locally. Hence, the recipient is held accountable through a special scheme called the reverse charge rule discussed in Chapters 10 and 11. Time of supply: The time of supply determines when a registered person should charge and account for VAT. It has liquidity implications for firms and the government. In general, the time of supply depends on the earliest of the date on which the goods are delivered or made available to the buyer; the performance of services is completed by the supplier; an invoice (or cash receipt) is issued by the supplier or a customs entry is approved to show that goods are cleared through customs; or consideration for the supply is given or received (see next sections(?) for consideration). While tax offices use these rules to ensure that the VAT due is paid promptly, as noted in Part II and IV, they are normally used as compliance tools. In conventional business and VAT terms, the regular time of supply should be viewed from two perspectives financial accounting practice registered persons who keep cash records account for VAT upon actual receipt and payment of the consideration while the accrual rules are based on the time of issuing a VAT invoice (Chapter 15); and enforcing compliance tax offices invoke the earliest of the time of supply rules above to prevent tax evasion and avoidance that lead to revenue loss (Chapter 2).

14 As a general rule discussed in Chapters 11 and 12, the time of supply for imports and exports of goods is when they are cleared through customs offices under the relevant customs laws. Consideration (value of supply) A taxable supply must be made for a consideration to attract VAT. Consideration is the price, value or amount which a buyer agrees to pay for supplies in a formal or informal contract. It can be given in cash or in kind and is affected by several factors. Consideration given in cash: This is the use of currency, cheques and bank transfers to settle the agreed consideration. It is very prevalent in many countries. Coins and bank notes: The use of currency issued by central banks is common in developing economies and at the final distribution stage (e.g., retail). Bank transactions: The parties to a transaction may use cheques and bank debit or credit transfers denominated in domestic currency units to settle the consideration. The use of banks includes debit and credit cards in more advanced economies. These mean automatic payments from a bank account (debit card) and from a loan facility (credit cards). Consideration given in-kind: Consideration can be given in non-cash form, provided the parties agree to the value and it reflects an arm-length or market value. The two broad classifications of in-kind consideration are barter trade the supply of a product or service in full or partial exchange for other supplies of goods and services; and acts and forbearance exchanges in the form of an act (i.e., promise to do something) or forbearance (i.e., promise to refrain from doing something) are acceptable. Where the consideration is given in kind, the parties or the tax office put an express or implied monetary value on the exchange, in line with the market value rules discussed below. Consideration other factors and issues: Several factors may affect the determination of value or consideration in a business transaction. These include consideration given by third parties: the consideration may be given by a third party who is neither the giver nor receiver in the contract; consideration in foreign trade: the value of imports and exports is subject to foreign currency (e.g., exchange rate) and customs valuation rules to determine the domestic currency equivalent (Chapter 5 [Consideration] and Part II [foreign trade]);

15 market value: consideration must have a fair market value or be at arms-length, which is the value agreed between two unrelated parties for the same or similar product or service; and own use and gifts in-kind consideration is implied or arises (i.e., barter, forbearance or act)) when the owner of a business takes goods, receives services or offers supplies as gifts without making or receiving payment (i.e., presumed market value). Consideration implies commercial activity and, therefore, ordinary non-commercial activities (e.g., disposal of personal assets) and activities of non-profit bodies (e.g., clubs and charities) do not attract VAT, unless performed in pursuit of an enterprise. Persons or entities A person may be a natural individual or an artificial entity created by the law. In principle, only registered persons can charge and collect VAT on behalf of tax agencies. Types of persons: The term person may be used to describe an entity, enterprise, trader, business or taxpayer. They fall into two broad categories. Natural persons: These are mainly sole proprietorships with a loose business organization and small informal operations. It includes partners in their individual capacity, even though the partnership is often a legal entity. Legal entities: These are formed or incorporated by law and include corporations or companies, partnerships and trusts. The main feature is that they have a separate identity from the owners who own or create them. Some of these terms should not be confused since the literal meaning could be different. For example, the ordinary meaning of a taxpayer is the final consumer and, similarly, trade constitutes one particular form of business or enterprise. VAT registration requirements: A person is required to meet two basic conditions to register and charge VAT on behalf of a tax office. Taxable activity or supply: In general, as noted earlier, persons are eligible to register for VAT when they make or expect to make taxable supplies for consideration in the ordinary course or furtherance of an enterprise. Registration threshold: A secondary condition is that annual taxable supplies, sales or turnover must be equal to, or exceed, a threshold amount that varies from country to country (e.g., equivalent of US$20,000). As discussed in Chapter 13, there are significant implications from these two points. These are summarized in the bullet points below.

16 The general presumption is that non-profit entities lack a profit motive and, therefore, the focus of VAT is usually on business entities. The threshold requirement is meant to ease administration and compliance by removing small entities from the VAT net. However, VAT laws often allow businesses that do not fulfill this requirement to register voluntarily. It is a serious offence for non-registered persons to charge VAT and, furthermore for even registered persons to charge VAT on exempt supplies. Particularly, the implications of the profit motive and non-registration of small entities or, alternatively, imposition of flat rate VAT schemes are important and discussed in several chapters of this book. Non-profit entities: Non-profits that do not engage in an enterprise or commercial activity are not eligible to register. Non-profit entities fall into two broad categories government entities these are (a) core local and central government organizations (e.g., ministries); and (b) departments or agencies that supply public goods from taxes and levies (compared to payment for private goods); and non-government entities these refer to a variety of social organizations, clubs, associations, charities, societies etc., which supply goods and services for the benefit of members or society without a profit motive. Most core government supplies or public goods are deemed to be non-commercial because they are not optional and they are financed from taxes and levies. Note that these definitions do not cover government business entities that make profit and should register for VAT. The non-government organizations also operate on cost-recovery basis and provide services in return for subscriptions, dues or fees, donations, grants and similar incomes from members and outsiders (including the government). Enterprise (commercial or business activities) To be eligible to register for VAT, a person must make or expect to make taxable supplies in the ordinary course or furtherance of an enterprise (or commercial/business activity). Nature of an enterprise: The main features of an enterprise or commercial activity include meaning: an enterprise is an activity or series of activities performed in the course or furtherance of a business, profession, trade, venture, employment, vocation or commercial activity; and regularity and profit-motive these imply that a person engages in the activities noted above on a regular basis or continuously for profit.

17 In general, as noted later, these conditions could disqualify one-off and non-profit activities from VAT. In comparison, a person may be held accountable for VAT when engaging in some profitable, non-discrete and irregular activities (e.g., ventures). Non-commercial activities: In contrast, certain activities are viewed as non-commercial for VAT purposes, even though they may involve buying and selling. Examples include employee wages and salaries: the services by employees under a contract of service do not attract VAT compared to a contract for services by independent contractors (who may be working for the same employer); meritorious and cultural supplies: the activities of a wide range of non-profit entities such as religious and social bodies do not attract VAT they are given directly in return for contributions such as tithe, grants and donation; and personal transactions: the construction, purchase and sale of private assets (house or car) and do-it-yourself hobbies or activities are excluded, to the extent that they are infrequent and not associated with a business activity. An employer is deemed to be in control of employees but not independent contractors. To reiterate, a non-profit entity making taxable supplies in furtherance of an enterprise could be required to register for VAT. Employees are not required to register for VAT but the employer adds their wages and salaries to value added (Section B, Table 2). E. Accounting for VAT Registered persons must charge and account for Output VAT and claim ITC for only eligible purchases and expenses. This process may lead to excess credits that must be carried forward or refunded. This section discusses the key processes for fulfilling these requirements. Administration of VAT The administration of VAT by tax offices involves a variety of organizational and procedural considerations. The main concepts and procedures include self-assessment: self-assessment requires a taxpayer to file VAT returns voluntarily, which the tax office accept on face value before conducting audit and enforcement programs to ensure compliance with the law; organization: the VAT on domestic supplies is administered by domestic tax offices (including some separate VAT agencies) while customs offices collect the VAT on imports and exports of goods on behalf of the tax agency;

18 registration and filing: all eligible persons must register and file returns periodically (e.g., monthly or quarterly) to account for Input VAT, Output VAT and Net VAT (which may be a payment, credit or refund); accounting records: registered persons are required to maintain proper records including invoices, receipts, customs SAD/entries/declarations and debit or credit notes) for sales, purchases and expenses; taxpayer assistance: tax offices should be equipped to assist all categories of taxpayers to meet their obligations under the law; and compliance: tax offices must implement audit and enforcement programs based on a regime of offences, sanctions and appeals against taxpayers who fail to comply with their obligations voluntarily. Compliance is also necessary because it is an offence for non-registered persons to charge VAT on any supply and for registered persons to charge VAT on exempt supplies. Parts III and IV discuss these VAT administration and compliance issues in more detail, including the need for strategies and programs to guide field operations. Imports and exports: VAT on foreign trade is discussed in Chapters 10 and 11. The role of customs offices is limited to administering the Import VAT and zero-rating of exports on behalf of the domestic tax agency. In general, as noted in these chapters, imported services are subject to self-assessment or special reverse charge rules. Customs clearance: Customs offices administer the VAT on imports and exports of goods under relevant customs law and regulations. The legislation deals with the place, time and value of imports and exports. Customs offices collect import VAT on all taxable imports and provide documentary evidence (SAD/entry) to registered persons to claim ITC, especially on zero-rated exports. Reverse charge rule: This rule requires the domestic recipients of imported services to account for Output VAT due from foreign service-providers. In reverse, a VATregistered recipient of the service can claim the self-assessed amount as ITC in filing periodical VAT returns. Exports of services: Registered exporters of services zero-rate and account for VAT under the relevant VAT rules. The reverse charge rule is necessary because it is difficult from a practical perspective to hold foreign suppliers of services accountable for VAT. The recipient of an imported service must account for Input VAT and Output VAT simultaneously under the rule.

19 Importance of VAT invoices: As noted in Section..., the ITC process is the most important attribute of the VAT credit method. In strict revenue accounting and tax compliance terms, registered persons can only claim ITC when they issue a sales invoice or cash receipt for taxable supplies made to customers (failing which, the customer may demand a copy); produce or maintain a purchase invoice or cash receipts for taxable inputs of purchases and expenses from suppliers; produce a customs entry or declaration to show evidence of their taxable import and export (zero-rated) transactions; and produce a debit note or credit note as evidence of the reversal of original transactions (e.g., due to sales/purchase returns and damages). Invoices are critical for the success of VAT and they must be prepared and issued in prescribed form under the law (see Chapter 14). Only registered persons can issue a VAT sales invoice while it is an offence for non-registered persons to issue such an invoice. The latter may not use a purchase invoice to claim ITC, even if they possess valid copies issued by registered taxpayers. Strength of VAT credit method: The main advantages of producing an invoice to claim ITC arise from their self-policing and audit trail features (discussed in detail in Chapter 14 to 19). Invoices as prerequisites: The strength of the VAT credit method depends on the sales invoice or receipt which registered persons must issue to customers. A sales invoice becomes the purchase invoice or receipt which supports the ITC claim. This also applies to credit and debit notes used to reverse original invoice values. Self-policing feature of VAT invoices: The need to provide documentary evidence to support ITC or refund claims is important. It makes a VAT regime self-policing by compelling a registered person to demand a purchase invoices. In this regard, some registered entities deal with mostly or only registered entities to be competitive and cost-effective through the ITC processes. It also explains why there are large numbers of voluntary registrations in many countries. Invoice as an audit trail: The VAT invoices leave a trail which tax auditors and enforcement officers can follow to control non-compliance. For example, provided the taxpayer identification number (TIN) and address on an invoice are valid, tax officials can verify a VAT transactions more easily by tracing it to other registered taxpayers in the chain and thus preventing tax evasion and avoidance.

20 In essence, registered persons are keen to get an invoice to claim ITC, reduce costs and remain competitive by not adding input VAT to costs. Tax offices also rely on valid invoices to improve audits with a view to controlling fraud and other delinquencies. Potential weaknesses: Experience also shows that VAT regimes are susceptible to massive tax evasion and avoidance. Some reasons for this situation include volume of transactions: in practice, VAT regimes may be difficult to control because of the high volume of transactions, the rigor of keeping records (especially for small entities), and filing periodical (i.e., monthly or quarterly) VAT returns; policy measures: VAT regimes are often difficult to administer or comply with because they include many complex concessions for businesses and consumers (e.g., multiple rates and exemptions); and administrative capacity: taxpayers often use aggressive and complex methods (e.g., missing trader or carousel schemes involving fictitious zero-rated exports) to evade or avoid VAT while tax administrations often lack the facilities and staff to check these practices and enforce the law effectively. VAT is relatively new in many developing countries where taxpayer and tax office programs have been evolving only slowly. Tax agencies need sufficient budget resources to improve organization, enforcement and taxpayer services.