Reverse charge – the shift in tax liability
Although the reverse charge mechanism does not apply to any transactions involving goods or services within the United States, it is important to know that this mechanism must be taken into account when buying or selling on a cross-border basis within the European Union.
- How does this relate to US entrepreneurs?
- What is a reverse charge?
- Aims of the reverse charge mechanism
- When does the reverse charge procedure apply, and who does it concern?
- How do reverse charges appear on invoices? An example
- Summary: reverse charges invert the order of the VAT collection process
How does this relate to US entrepreneurs?
There are various rules that apply to US-based companies when a US-produced product arrives in the EU. After importing a product to one of the Member States, VAT (the equivalent of sales tax, which is a consumption tax levied on goods and services) is automatically applied to its onward supply to customers in other Member States. The place of taxation is usually the country of final destination for the respective goods.
In other words, if a product is exported beyond the initial import country, the supplier of the goods does not have to pay VAT on the transaction if the final customer has a registered VAT number. The reverse charge procedure then applies the local tax rate making the beneficiary of the transaction both the supplier and the recipient.
Generally speaking, when you issue an invoice, VAT is always taken into account. In other words, your client pays the entire sum, which includes value added tax. However, you, as a provider, are not allowed to keep such invoices, but must send them to the revenue office instead. The so-called reverse charge mechanism changes this in such a way that the responsibility switches from the seller to the buyer who then must pay the tax to the revenue office. What purpose does the reverse charge mechanism serve? Who does it concern, and what is to be considered?
What is a reverse charge?
According to fiscal law, the term “reverse charge” stands for the process of ascribing tax liability to the buyer – more specifically, the VAT liability.
In a normal case
In a reverse charge case
VAT is settled by the seller
VAT is settled by the buyer
In practice, this means that the buyer settles VAT-related costs on a delivery or service not with the supplier, but rather directly with the revenue office. However, a beneficiary who is entitled to input tax deductions may additionally offset the VAT to be paid in the form of an input tax. In this case, the beneficiary incurs both the VAT and the input tax costs, which then balance each other out.
Aims of the reverse charge mechanism
In practice, a reverse charge simplifies VAT payments (at least on part of the supplier) and reduces the corresponding bureaucratic costs. The European Union created this fiscal concept to act against violations such as tax fraud within the European Single Market. Since its implementation into the EU value added tax system reform of 1993, it has been especially successful in combatting so-called “missing trader schemes,” whereby tax-free, cross-border shipments are used to evade VAT payments. It is estimated that several billion euros are lost per year by this method.
Example: Goods are imported from the United States to France, where entrepreneur A acquires and subsequently passes them on to entrepreneur B in Great Britain. Entrepreneur A issues an invoice without including VAT figures. Entrepreneur B sells the goods from entrepreneur A to entrepreneur C in Great Britain. This time, however, entrepreneur B issues an invoice with relevant VAT figures. The VAT is refunded to entrepreneur C by the revenue office in the form of an input tax. However, instead of paying the VAT to the revenue office, entrepreneur B disappears from the market before the tax is due. From that point on, he is referred to as a “missing trader.” Entrepreneur C then sells the goods back to entrepreneur A and the entire process is repeated.
Despite the fact that suppliers do not settle VAT payments in cases of missing trader frauds, they are nevertheless claimed by beneficiaries in the form of input taxes. The reverse charge mechanism prevents such situations by keeping all VAT and input taxes under one roof. If the recipient wants to receive a refund in the form of input tax from the revenue office, he must also clearly specify the VAT included in the invoice. Since reverse charges make tax systems less susceptible to fraud, many European industries nowadays see this procedure as a mandatory part of any transaction. In the past, the construction industry and the suppliers of tablets and mobile phones were very common targets for such fraudulent operations.
When does the reverse charge procedure apply, and who does it concern?
Reverse charges apply to all shipments of goods or services issued on a B2B (business to business) basis within the EU. If a US-based company wishes to conduct intra-border transactions on a European scale, it can arrange for an EU-based agent to import and supply goods on their behalf. The agent will be considered the principal for VAT purposes. The mechanism applies only if the beneficiary is either an entrepreneur or a corporate entity.
Nonetheless, we must ask for what kind of transactions the reverse charge is actually designed. Generally speaking, all cross-border shipments within the European Union are taken into consideration. However, certain countries take note of specific items, as EU rules provide flexibility for EU countries to make national choices.
There are several additional exceptions and prerequisites to the reverse charge system, with each country having a say in its own set of regulations concerning the mechanism. In other words, there are various reverse charge regulations, which may differ from one country to another.
While keeping in mind that the reverse charge mechanism is applied across all EU countries for the majority of cross-border transactions, deliveries or services covered by the reverse charge in one country may be exempted from the fiscal procedure in question in another country.
Reverse charges also apply to small businesses. In the eyes of the European system, you are considered an entrepreneur once you participate in international transactions. This, on the other hand, does not entail any special benefits. It is important to remember that you need a VAT identification number if you operate across the EU.
How do reverse charges appear on invoices? An example
If you are an entrepreneur who provides services tied with the reverse charge mechanism, do not forget to mark them appropriately on invoices.
There is no prescribed wording when accounting for transactions involving reverse charges. It is, however, recommended that you mark them as either “VAT due to the recipient” or “recipient is liable for VAT.” You can also note this information by using other European languages (see table below for some examples):
In addition to providing such mandatory information, it is important that invoices issued to other EU countries include the VAT identification number of both the supplier and the beneficiary. When invoicing during the reverse charge procedure, make sure that you do not accidentally disclose the wrong tax figures, which often happens by force of habit.
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Summary: reverse charges invert the order of the VAT collection process
Since reverse charge regulations are very extensive, it is no surprise that many entrepreneurs are highly overwhelmed when facing the procedure for the first time. If you have any questions, you can consult a tax advisor to avoid mistakes right from the outset. A lot of hassle can be avoided by sticking closely to the following points:
- Check to see if the regulations apply to your type of business
- If yes, then the beneficiary must settle VAT-related costs with the revenue office, which can later be deducted in the form of input taxes
- Suppliers must issue a net invoice proving the need for a reverse charge procedure to take place
- Do not forget to clearly indicate this on your invoice along with VAT identification numbers