Deductible VAT - an overview of an important chapter in taxation and accounting

Publishing date: 25 November 2022

Among all the taxes and duties that finance public expenditure, redistribute revenue fairly and stabilise economic activity by correcting any imbalances, value added tax, or VAT, is of considerable importance.

In the area of VAT-related taxation, there are also issues that may give rise to the need for tax advice on deductible VAT and all the problems associated with this multifaceted issue of how VAT is deducted in various scenarios. This article attempts to shed more light on this area of deductible VAT by trying to bring more clarity to some of the general issues involved.

Contents:

1. Some clarification on what is meant by deductible VAT in particular and VAT in general from a tax accounting perspective 

2. How to deduct VAT? Value added tax base

3. VAT deduction and the mechanism by which this tax-accounting operation operates

1. Some clarification on what is meant by deductible VAT in particular and VAT in general from a tax accounting perspective 

Before going into the deductibility of VAT, it should be noted that value added tax is an indirect tax and not part of the general category of taxes. Thus, like any tax, VAT is a compulsory contribution in money, payable by both natural and legal persons, which is paid to the state budget without any equivalent consideration as an immediate result of collection.

In contrast to taxes, it is worth adding that taxes are in fact payments made by natural and legal persons in return for services which they usually receive in return from the various public bodies or authorities, services which may relate to certain operations of drawing up or issuing official documents or satisfying certain legal interests of the parties.

As an indirect tax, VAT is levied on commercial transactions involving the supply of movable goods, their sale and import, the provision of services and, in general, all similar transactions. The only major difference between taxes and duties is precisely this consideration which, in the case of duties, the taxpayer is entitled to receive immediately after payment. Of course, from the point of view of the obligation to impose, taxes can be assimilated to taxes.

It should be noted that VAT, as an indirect tax, is based on the deductibility criterion and, as the name implies, is linked to the concept of 'value added'.

In order to better understand the concept of VAT, it is worth pointing out a few clarifications on the concept of value added. From an economic point of view, value added refers to new value created by an economic entity as a result of a production cycle. In this sense, value added can be defined as the difference between the sale value and the purchase value of goods and services on the same level of the economic cycle. More precisely, value added is the difference between the value of the finished products and services which an economic entity markets and the value of the goods and services which the same entity uses in the process of producing the former.

If we look at it from an accounting point of view, strictly speaking, value added is the difference between the output of an accounting period, the trading margin and the consumption received from third parties or the entity's trading partners. In this definition of value added, output for the year is represented by output sold, output in stock and intangible and tangible fixed assets. Trade margin is the difference between the value of sales of goods and services and the cost of acquiring them for sale. Finally, third party consumption is the economic entity's expenditure on raw materials and materials and on external services hired to carry out the purpose of the entity.

2. How to deduct VAT? Value added tax base

In order to arrive at the VAT deduction, it is necessary to understand the object on which this indirect tax, or so-called tax base, is levied.

In the field of VAT, the taxable amount is the value received for goods supplied or services rendered. The taxable amount of VAT is determined on the date on which the goods are delivered and the services rendered in full. The taxable amount may also be established at another date, namely the date on which the invoice is drawn up. It should be noted here that the taxable amount is deemed to have already been determined when the invoice is drawn up, even if the contractual relations between the economic entities provide for actual payment in the form of instalments or defer payment until a certain date.

It is of interest to know what may or may not be included in the VAT taxable amount in order to reach a simpler understanding of VAT deduction.

Thus, the VAT taxable amount may include:

• The price of the supply of services, negotiated and established by contract;
• The price of the goods agreed by the buyer and seller, with the proviso that, in this case, in addition to the price mentioned, other ancillary costs or charges necessary for the supply of the goods and the excise duties imposed by law on certain categories of products in accordance with the State's tax policy are also included in the VAT taxable amount;
• The commission agreed between the partners in an intermediary transaction;
• The customs value of the products plus customs duties, excise duties and other taxes imposed on imported goods;

VAT is not included in the tax base:

• Price reductions in the range of rebates, discounts, discounts, etc., which sellers may grant to buyers on certain occasions to boost sales;
• Penalties for non-fulfilment of contractual obligations or terms and damages awarded by the courts in case of disputes;
• Interest that the entity may charge under the contractual provisions for different scenarios: late payment, hire purchase or lease sales;
• Value of packaging of goods for those packages that circulate between suppliers and customers on an exchange system and without invoicing.

A VAT rate is applied to the tax base thus established, the amount of which may vary according to the State's tax policies.

3. VAT deduction and the mechanism by which this tax-accounting operation operates

As is already known, the value added obtained in any economic activity is that which allows the payment of the factors of production (investments, wages, etc.), taxes to the State, interest and loans taken out, and the benefits to the holders of capital (shareholders of private companies). This makes it possible to determine the tax base on which VAT is charged.

The complex problems raised by VAT deductibility can be much more easily resolved by using professional tax advisory services which can be of real help in ensuring the correctness of these types of financial and accounting operations.

As far as the mechanism for determining VAT is concerned, the calculation involves calculating the VAT collected which is charged on the sales of an economic entity and calculating the deductible VAT which is charged on the value of the purchases of the same entity in the same year. A difference and comparison of size is made between the two types of VAT, and if the VAT collected is higher than the deductible VAT, the amount of VAT payable to the State can be determined. Conversely, if the VAT collected is less than the deductible VAT, the amount of VAT to be recovered by the entity is determined.

As regards the VAT deduction mechanism, it can be described in several steps.

• The first step is to check the transaction for VAT liability. If it is found that no VAT is due on the transaction under consideration (either because it is exempt with a right to deduct or because it is non-taxable), it can be concluded that the tax in question is not deductible. Otherwise, the second step can be taken.
• The second step is to check the right of the purchaser of the good or service to deduct VAT. In this case it should be noted that only VAT-registered entities are entitled to deduct VAT paid on purchases of goods and services. Non-taxable entities do not have this right. This verification must also include an analysis of the area of applicability in the sense that the right of deduction is limited only to VAT paid or due for goods and services which will be used for subsequent taxable commercial transactions, to exempt transactions with a right of deduction, to non-taxable transactions which nevertheless give a right of deduction, and to transactions which are not taxable in Romania but which, by similarity, would give this right if they had been carried out on national territory.

Therefore, if it is found that the VAT deduction relates to a taxable entity which is not excluded from the scope of the right of deduction, the third step of the mechanism can be applied.

• The third step of the VAT deduction mechanism is related to the verification of the fulfilment of the conditions laid down by the law that the destination of the goods/services must meet in order for the related transactions to be included in the scope of VAT deduction.

Thus, entities are entitled to deduct VAT paid on purchases made if the goods and services which are the subject of the purchases are for the purpose of carrying out economic transactions which:

• are taxable;
• are exempt with a right of deduction
• are in the field of exempt banking or insurance, but for which the right of deduction may be exercised if the customer of the entity is non-EU or if the operations in question relate to goods which will be transported outside the EU;
• relate to the transfer of assets if the tax would have applied to this operation;
• originate in commercial activities where the place of supply of goods or services is deemed to be outside Romania if VAT would have been deductible if the transaction had taken place in Romania.

The fulfilment of these conditions leads to the fourth step of the VAT deduction mechanism.

• The fourth stage of the deduction mechanism is linked to checks on the existence of potential exclusions or limitations of the right of deduction. Tax legislation provides for some situations where the right to deduct VAT is not granted depending on the tax policies of the State. Limitations on the right to deduct VAT operate where the taxable entity is involved both in transactions or supplies of goods and services which give rise to a right of deduction and in such transactions which do not give rise to such a right.
• Finally, the last step in the verification of the deductibility of VAT is the analysis of the legal conditions to be fulfilled in this respect. Thus, in order to be entitled to deduct VAT, the taxable entity must have a set of supporting documents which may consist of:
• an invoice drawn up in accordance with the relevant legal provisions;
• the customs import declaration in the case of VAT paid on the importation of goods or in the case of tax deferment;
• invoice for the intra-Community acquisition of goods or similar;

Once the documentation set has been checked and completed, the taxable entity is deemed to have a full or partial right to deduct VAT.

In conclusion, the issue of deductible VAT is of significant importance in all commercial transactions, and the correct accounting treatment of this item is the key to normal activity, free of tax problems and possible penalties from the competent authorities.

*This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.