If you are a business selling across the globe you would have likely came across the term “reverse charge” frequently. If you are business and happen to buy a product or service from abroad and if you are wondering why VAT is not charged in your invoices, it could be a case of reverse charges.
The concept of reverse charge
Reverse charge is a mechanism in indirect tax in which liability of paying taxes is on the recipient of the goods or services rather than the supplier.
As a traditional rule, businesses charge VAT on supplies and deduct VAT on purchases and pays to the Tax authorities. If the customer is a normal taxable person, then he can recover the VAT charged by claiming it back on his VAT declaration. This results in a system of fractionated payment, whereby the VAT on the final price to the final consumer is paid to the tax authority by different taxable persons in the supply chain in direct proportion to their ‘value added’. This interplay of VAT payment on supplies and VAT deduction on purchases is traditionally considered as the main feature of VAT, providing for an in-built, largely self-policing control mechanism.
The reverse charge mechanism is a deviation from this rule where the supplier does not charge VAT on the invoice and the customer pays and deducts VAT simultaneously through the VAT return. For this reason, the supplier will likely ask for at the VAT number or the TAX ID from the customer to decide whether to charge VAT on the invoice. As the customer in some case, is entitled to full deduction, deducts this VAT on the same VAT declaration, the net result is nil and no payment is to be made. The reverse charge is not applied to supplies to private individuals and the supplier has, in that case, to charge and pay to the Treasury the total amount of VAT. There is no fractionated payment in a reverse-charge system as the total VAT is paid only at the end of the supply chain.
Why reverse charges ?
Reverse charges are usually introduced to limit opportunities for fraud and reduce the administrative burden for taxable persons.
According to a policy document in EU, the reverse charge was introduced following a request by the EU member states that are particularly affected by loss of revenue due to VAT fraud, especially carousel fraud. According to the European Commission, the VAT gap (the difference between the expected VAT revenue and the VAT actually collected by tax authorities) in the EU has reached nearly €160 billion, of which about €50 billion is attributable to cross-border fraud (in 2013). The possibility to apply the reverse charge mechanism exists in the current system as well; however, its application is not generalised and is limited to a certain list of sectors. Its application is also limited in time. It was introduced by EC directive 2013/43/EU. Since then majority of countries acorss the world has adopted the concept of reverse charges. The application of reverse charges is especially significant for digital transactions.
What is 'carousel' or 'missing trader' fraud?
In the EU, carousel fraud typically involves cross-border transactions between businesses. Under the EU's current VAT system, intra-EU business-to-business (B2B) cross-border supplies are exempted from VAT, whereas the obligation to pay the VAT to the government budget lies with the vendor of the goods and services on the destination market (the vendor is the VAT collector). In essence, the cross-border movement of goods in the EU is split into two transactions:
- the intra-EU supply of goods is exempted from VAT
- the intra-EU acquisition of goods is subject to VAT in the country of destination, where the VAT collector is the vendor
How does a missing trader or carousel fraud scheme work?
The scheme involves several companies selling goods or services, imported VAT-free from a supplier (the so-called conduit company) in another EU country, to each other on a domestic market.
One of the companies in the chain, usually the one that imported the goods, does not pay the VAT to the state budget despite charging it to the next buyer, thus committing fraud. This company usually very quickly disappears without trace following the transaction (hence the 'missing trader'). This makes the tax collection impossible in the state in which goods or services are consumed. The other buyers in the chain, meanwhile, redeem the VAT from the state budget after selling the goods further. The goods or services may in reality not even move, or may only exist on paper.
The 'carousel' starts turning again when the final buyer in the chain on the domestic market re-sells the goods to the first supplier, i.e. the company that brought the goods into the country, allowing the whole process to start again. This last transaction, being a cross-border one, would again be exempt from VAT. The scheme can also function on the domestic market only.
The reverse charge mechanism is a measure that shifts liability for final VAT payment to the government budget from the vendor to the customer. In this way it aims to reduce the risk of VAT fraud.
Types of reverse charges and when to apply reverse charge?
- Domestic reverse charge for non-established suppliers
- Domestic reverse charge on specified goods and services
- Reverse charge for cross-border / intra-community sales
- VAT reverse charge on triangular transactions
- Reverse charge on postponed import VAT and suspensive regimes (Refer Article 202 of the EU VAT Directive)
How does it work?
The supplier is supposed to issue an invoice without vat and the invoices should have the VAT number of the recipient. Usually, it should also contain a note that reverse charge is applied. On the other side the recipient receives the invoice without VAT. At the time of submitting VAT returns, they will manually calculate the VAT amount and report it in both input and output vat returns as deductible and due respectively. However, they will not pay any VAT to the tax authorities on this invoice .
The invoice format remains same as the tax invoice. Except that you will need to add the taxes as 0% similar to the way you indicate zero rated items. You will also be required to add a note to indicated that reverse charge is applied on the invoice as in case of UK. The exact text required in the invoices will change depending on the country regulations.
Where is it applicable?
Reverse charges is applicable in many countries including but not limited to EU, UK, Norway, Australia, Japan, and India.
Article 194 of the VAT Directive is used for Domestic reverse charge, and article 138 of the VAT Directive is used for intra-Community supplies of goods.
- Mandatory reverse charge (art. 195 to 198 of the VAT Directive)
- Optional reverse charge for non-resident suppliers (art. 194 of the VAT Directive)
- Optional reverse charge for specific transactions (art. 199 of the VAT Directive) The reverse charge mechanism can be implemented by the Member States in specific cases in accordance with the following provisions of the VAT Directive:
- Special authorization issued by the European Council on the basis of Article 395 of the VAT Directive (or on the basis of a standstill provision of Article 394);
- Option to apply the reverse charge mechanism to the supplies of goods or services defined by and under the conditions laid down of the Articles 199, 199a and 199b of the VAT Directive
VAT reverse charge mechanism applies in different kinds of transactions:
- Reverse charge on specific goods and services
- Reverse charge on domestic transactions performed by foreign suppliers
- Reverse charge on intra-EU transactions
- Reverse charge on postponed import VAT
Domestic reverse charge in UK
In UK reverse charge applies to specified goods and services. You can find the list of these goods and services here. Refer to our country guide on UK to know more about reverse charges in United kingdom.
Cross Border reverse charge in UK
The reverse charge applies to almost all B2B supplies of services except exempt supplies. If you’re a UK recipient of services from a non-UK supplier the following rules apply to you. The reverse charge applies where:
- the place of supply is the UK
- the supplier belongs outside the UK
- you belong in the UK
- the supply is not exempt (this includes exempt supplies subject to an option to tax)
- for supplies not within the general rule, you’re VAT registered in the UK
In India, reverse charge is applicable in 2 scenarios
- Supply from Unregistered to Registered Person on specified goods/services and specified person
- specified goods and services
Section 9(3), 9(4) and 9(5) of Central GST and State GST Acts govern the reverse charge scenarios for intra-state transactions. Also, sections 5(3), 5(4) and 5(5) of the Integrated GST Act govern the reverse charge scenarios for inter-state transactions.
Importance of validating the Tax ID
- Before applying reverse charge, it is tax authorities recommends the sellers to validate the VAT IDs provided by the customers. The tax number provided by the customer might sometimes be wrong or in some cases, in order to purchase goods or services at a lower price, some customers intentionally enter a tax number that belongs to another entity to avoid taxes. Failing to charge tax in such cases can lead to losses as you(seller) are liable to pay taxes to the authorities.
- You can validate the VAT numbers manually from official databases of the tax authorities. To make it easier for you we have collated the list of national VAT databases here.
- Validating VAT numbers one by one will be a tedious and time consuming process. This method will also be challenging to you if you are offering a self serve signup merchanism for your customers. This is where VAT validation providers like Lookuptax comes to your rescue.