Article
3 min read
Author
Aaron Luria
Published
November 15, 2021
Last Update
June 28, 2024
Table of Contents
VAT example scenario
Reverse Charge Mechanism – its purpose and how it works
Reverse Charge Mechanism - Compliance
Value Added Tax (VAT) is an indirect tax that applies to the supply of goods and services. It gets its name because it taxes the additional value that a product receives as it passes through the supply chain, starting from the manufacturer all the way to the end client.
To get a better understanding of how VAT works, let’s work through a simple case:
The case involves three parties:
In our scenario, the following sales occur:
The applicable rate of VAT in the UK is 20%. The sales will result in the following invoices:
In the end,
The Reverse Charge Mechanism (RCM) is a tool used to combat instances of VAT fraud, such as missing trader fraud. In missing trader fraud, a party in the supply chain does not pass the tax they collect to the government, keeping it themselves. The RCM anti-avoidance legislation reverses the responsibility, making the buyer responsible for paying the VAT to its own VAT authorities.
RCM applies when you buy goods or services from suppliers in other EU countries. In order to implement the RCM, the seller and the buyer must both be VAT registered and issue a fully RCM-regulation-compliant invoice.
To get a better understanding of how RCM works, let’s continue with our coffee machine example. This time, let’s say Empresso is based in Italy, and ACE is a German company.
Upon selling 1 coffee machine, Empresso will issue an invoice to ACE for 100£ (100 + 0% VAT) and note that the “Reverse Charge” applies. ACE pays 100£ to Empresso.
ACE must calculate the VAT amount that should be applied based on the German VAT rate. This amount is recorded as the output tax on their VAT return. Since ACE will be reselling the coffee machine, ACE can reclaim the tax as input tax, resulting in a net-zero effect. In this way, the two entries cancel each other from a cash flow payment perspective. For the tax authorities, the applicable input and output taxes are recorded on the tax returns for the cross-border supply of goods or services.
Overall, in order to comply with the Reverse Charge Mechanism, the following provisions must be met:
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