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Growth

Value-Added Tax (VAT) explained

Morgan Williams

Content

Author

Morgan Williams

Date

February 5, 2024

Category

Growth

If you sell digital products or services, collecting and paying VAT on the sale of digital items in some countries is a necessity. For example, all business-to-consumer sales in the UK are subject to VAT regardless of value. On the other hand, sales in the United States do not include VAT. What does all of this mean for you?

Let us explain. We'll educate you on VAT tax, what it is, and why it is important for sellers of digital products to understand. — Hint: It's because you likely generate some international sales!

What is Value Added Tax (VAT)?

Value Added Tax (VAT) is an indirect consumption tax levied on a product or service at each point of its production and distribution cycle, encompassing both tangible goods and digital services. It's structured around the incremental value added at each stage, ensuring that the tax is reflective of enhancements made to the product or service.

Under a VAT regime, businesses act as tax collectors for the government, applying the tax as a percentage of the sale price. Ultimately, the burden of VAT falls on the end consumer, who pays the tax as part of the purchase price.

The intricacy of VAT lies in its credit mechanism, where businesses are allowed to offset the VAT paid on their inputs against the VAT charged on their outputs. This ensures that the tax is effectively levied on the additional value created at each stage, preventing a cascading effect of tax on tax.

Globally, VAT systems are prevalent but exhibit variations across different jurisdictions. These differences can be seen in specific VAT rates and the rules governing its application, highlighting the necessity for businesses to thoroughly understand the VAT obligations in every market they operate.

VAT Rates across Europe

Country Rate
Austria 20%
Belgium 21%
Bulgaria 20%
Cyprus 19%
Czech Republic 21%
Germany 19%
Denmark 25%
Estonia 20%
Spain 21%
Finland 24%
France 20%
Greece 24%
Croatia 25%
Hungary 27%
Ireland 23%
Italy 22%
Lithuania 21%
Luxembourg 17%
Latvia 21%
Malta 18%
Netherlands 21%
Poland 23%
Portugal 23%
Romania 19%
Sweden 25%
Slovenia 22%
Slovakia 20%

How does VAT work?

Let's look at how VAT can impact sales of your digital product. — We admit, it's a little bit complicated.

First, your company registers for VAT with the tax authorities in the proper jurisdiction. Then you can follow the path of selling your product. (We'll make a few assumptions using math with round numbers for this example.)

  1. Let's start with a single sale of your digital product, such as a software download, for $100. The applicable VAT rate is 10%.
  2. When you issue an invoice to the customer for $100, it will indicate the VAT amount. The total amount on the invoice is $110 ($100 product price + $10 VAT).
  3. The customer pays you $110. You are collecting $10 in VAT amount on behalf of the government.
  4. Lets assume your company incurs costs for software development tools and services when building the product, paying $50. On these purchases, the company pays $5 in VAT (assuming a 10% VAT rate).
  5. Your company can deduct the $5 VAT paid on purchases (input tax) from the $10 VAT collected on sales.
  6. This results in a net VAT owed to tax authorities of $5 ($10 collected minus $5 paid). You must remit this amount to tax authorities at the end of the VAT reporting period.
  7. The consumer who purchased the software download for $110 bears the total VAT burden because it is part of the final sale price.

If you think this is complicated, you're right — it can be, but having a Merchant of Record ensures that VAT is taken care of on your behalf, so you don't have to think about this element of online sales.

VAT vs. Sales Tax

The prevalence of sales tax versus VAT (Value Added Tax) is highly dependent on geographic location. Both serve as consumption taxes, but their application and geographic usage vary significantly. This distinction becomes particularly relevant for businesses engaging in international sales, where employing a Merchant of Record could offer substantial advantages by mitigating the complexities associated with tax obligations.

VAT is implemented as a multi-stage tax, applied at each stage of the production and distribution process. It allows businesses to remit VAT on the net value added of their goods or services, with the provision to deduct tax paid on their inputs. This mechanism ensures that the tax burden is effectively passed along the supply chain, culminating with the end consumer who bears the cost of VAT included in the purchase price.

Conversely, sales tax is a single-stage tax imposed directly on the final sale to consumers. It is calculated as a percentage of the sale price, with no provisions for businesses to claim deductions for tax paid on business inputs. This makes sales tax a straightforward, albeit less nuanced, system compared to VAT.

The headache of global VAT compliance

Navigating global VAT compliance on your own can feel like steering through a minefield blindfolded. For businesses expanding internationally, the allure of new markets comes with the daunting challenge of managing VAT obligations across different jurisdictions.

VAT's complexity demands meticulous registration, calculation, collection, remittance, and invoicing, overwhelming even the most organized finance departments. It's an open secret that many companies have tried to simply "close their eyes" to the risk of an unexpected sales tax assessment, but the reality its — these surprise headaches are becoming more and more common.

Let's review what you have to do to get the minimum level of baseline compliance.

Registration requirements

Before collecting VAT, you must register in each jurisdiction with a taxable presence. This process, complicated by varying rules, thresholds, and procedures, can consume significant time and resources, diverting attention from core business activities. You literally may have to have 50 separate accounts (each with its own idiosyncrasies): the IRS, the CRA, the European Commission, India, Revenu Quebec, China State Tax Administration, HMRC (UK), Australian Taxation Office... and on and on!

Calculation and collection

Calculating and collecting VAT is complex, with rates and rules varying significantly between countries. This variability requires constant system updates to avoid fines or legal issues stemming from mistakes. Maintaining this database in real-time is not going to be something you want to spend your time relative to other business activities that move the needle.

Remittance obligations

After collecting VAT, remitting it to the appropriate authorities involves navigating international banking and currency conversion, and ensuring timely payments to avoid penalties. Managing payment deadlines across multiple jurisdictions is an administrative burden.

Compliant invoicing

Ensuring invoices are VAT-compliant according to each jurisdiction's requirements is challenging. Non-compliance risks disputes with customers and penalties from tax authorities, requiring significant effort for businesses with a large volume of international transactions. Invoices are often simple one-page pieces of paper — but it's the little, annoyingly precise details that make them legally compliant.

We're biased, but we think using a merchant of record is a no-brainer solution to take away the pain from the headache you'll get from all these moving parts.

Your Merchant of Record and VAT

Lemon Squeezy is the merchant of record for all sales through our platform. That means we take care of many of the headaches generally associated with selling goods online, including VAT and Sales Tax.

Take away all VAT concerns by selling your digital products with Lemon Squeezy

Here are just a few of the benefits of having a Merchant of Record for your digital product sales:

  • We'll help you navigate international tax regulations to ensure your sales are VAT-compliant in various jurisdictions (ideal if you operate globally).
  • As a Merchant of Record, Lemon Squeezy handles the collection of VAT on behalf of your business. Then, we manage the remittance of VAT to the respective tax authorities, streamlining the process for your team.
  • International VAT regulations can be complex and vary from country to country. We stay current on changes in VAT rates, thresholds, and reporting requirements and manage it all for you behind the scenes.
  • Having a Merchant of Record can help you mitigate the risk of non-compliance and associated penalties by ensuring that your VAT obligations are met.

VAT is easy-peasy with Lemon Squeezy

You don't have to think about VAT with Lemon Squeezy as your Merchant of Record. We take care of it for you. This is possible because Lemon Squeezy is technically selling products on your behalf; therefore, we are liable for all the complicated bits.

From payments and taxes to subscriptions, Lemon Squeezy makes it easy for digital sellers to manage the financial aspects of business without headaches. It's an all-in-one payment platform for running your SaaS business. It includes payments, subscriptions, global tax compliance, fraud prevention (including AI fraud prevention), multi-currency support, failed payment recovery, and payment integration.

Get Started with Lemon Squeezy
Sell your SaaS or digital products with Lemon Squeezy and we'll handle global sales taxes for you
If you want to sell digital products or SaaS online, check out Lemon Squeezy and open your own store - or follow us on Twitter @lmsqueezy.
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