What is reverse charge in VAT?

One key aspect of value-added tax (VAT) is determining who the taxable person is — that is, who must pay the tax authorities. A general rule is that suppliers must add VAT on every sale and then pay the VAT amount to the tax authority, but this rule has some exceptions. In this article, we’ll explain the reverse charge mechanism, one of the most notable of these exceptions.

The VAT reverse charge mechanism explained

How VAT normally works

Let’s start with a quick review of how VAT typically works.

VAT is an indirect tax on consumption. This means that only final consumers are subject to VAT, but they don’t pay it directly to the tax authority. Instead, sellers must add VAT to the sale price, and then transfer that money to the tax authority.

However, not all sales are destined for final consumers (B2C). Business-to-business (B2B) transactions also normally include VAT, but both parties will later deduct the VAT amount. Only final consumers aren’t able to deduct this tax and, therefore, end up assuming the cost of it.

Obviously, businesses tend to sell products or services at a higher price than they’ve bought them or their component parts for. As a result, the total VAT companies collect on their sales (that is, input VAT) is usually higher than the VAT they’ve paid on their expenses (that is, output VAT). At the time of the VAT return, companies will owe the tax authority only the net difference between output and input VAT.

This is how VAT typically works, but as mentioned, there are many exceptions, including the reverse charge mechanism.

VAT with reverse charge

In transactions that the reverse charge mechanism applies to, the responsibility for reporting and paying VAT is shifted from the supplier to the customer. (That’s why it’s called a reverse charge.) Consequently, the supplier won’t add VAT to the sale price, but the customer will be responsible for paying it in his VAT return.

The picture below compares a typical sale with a sale where the reverse charge mechanism applies.

As you can see, the net result is the same in both scenarios. The supplier gets to keep €100 from the sale, and the tax authorities will receive the difference between the VAT due on the sale (output VAT) and the VAT deductible on the purchase (input VAT).

If, for example, the client had no right to deduct input VAT, then the tax authorities would receive €19 in both scenario one and scenario two.

When to apply the reverse charge

The EU VAT directive differentiates between two categories of reverse charge mechanisms: intra-community transactions—that is, from one EU country to a different EU country—in which member states must appoint the buyer as the VAT debtor, and domestic transactions, in which member states can choose to do this.

Intra-community supplies

When an EU business buys goods from another business in a different EU country, the liability of paying VAT on that purchase will be reversed from the buyer to the seller.

In the case of the acquisition of services from another EU country, determining whether the supplier or the buyer is liable for VAT comes down to determining the place of supply of those services. The general rule is that the place of supply is where the buyer is established, and in this case, the reverse charge mechanism should be applied.

Some exceptions to this rule include transportation, chartering, services related to immovable property, and event tickets, where the place of supply is where service takes place, and the reverse charge is not applicable.

Domestic supplies

So, while the EU imposes the reverse charge on imports and intra-community supplies, it allows member states to define their rules within certain limits in the case of domestic transactions.

There are two main types of transactions where some member states have imposed the reverse charge.

• Most European countries have decided that suppliers without a permanent establishment in the country can use the reverse charge mechanism in the domestic supply of goods.
• Several countries also impose the reverse charge mechanism for the domestic supply of services between two taxable persons based in that country — that is, works on immovable property or concerning goods and services sensitive to fraud (such as metals; gas, heat, and electricity; phone cards; and gold).

Consequently, it’s always a good idea to consult the VAT legislation of the countries where you operate.

Triangulation

When two consecutive transfers of goods occur between exactly three VAT-registered companies in three different member states, that’s a specific type of VAT transaction called “triangulation.”

For example, Company A sells goods to Company B, which in turn sells those goods to Company C — but the goods are sent directly from A to C. These transactions caused tremendous administrative burdens on both taxpayers and tax authorities. As a result, the following simplification measure exists to combat this:

• Company A performs an exempt intra-community supply of goods to Company B.
• Company B, in turn, performs an intra-community acquisition of goods and will declare this as such in its VAT return.
• Company B performs an exempt supply to C, and C will declare this transaction in its VAT return.

As you can see, goods are supplied twice, and both times, the reverse charge mechanism is applied.

It’s important to note that rules for using triangulation are very strict. For example, if more than three companies are involved, the process is no longer considered triangulation, and one of the companies involved may need to register for VAT in another member state.

How to apply the reverse charge mechanism

Once you’ve established that the reverse charge mechanism applies, you must take a couple of important steps to ensure that you apply it correctly. Let’s look at this process from two perspectives: the seller’s and the buyer’s.

From the point of view of the seller

As a seller, the most important step when applying the reverse charge is ensuring that you’re dealing with a legitimate VAT-registered business. To do this, you should request the buyer’s VAT identification number and check whether it’s valid.

You can verify the VAT IDs of EU-based companies through the VIES tool. For companies based in countries outside the EU, you must use their national or regional equivalents.

If this verification is successful, you can send an invoice to the buyer, including both the buyer’s and the seller’s VAT numbers. The invoice will have no VAT amount and must indicate that reverse charge applies. Most companies use full legal references like “Exempt intra-Community supply – Article 138 (1) of Directive 2006/112/EC,” even though a simple reference like “reverse charge” suffices.

The European courts maintain that substance is more important than form. So, while you have to refer to the reverse charge mechanism on the invoice, the exact way you do this is less critical. In practice, including the reason for the reverse charge (for instance., triangulation) on the invoice is recommended, to avoid any doubts on the part of the local tax authorities.

You’ll have to include the net value of the sale in the next VAT return but not the VAT amount. Note that as a seller, you’re liable for the full VAT amount if the buyer’s VAT number is invalid — this is why verifying it is important.

From the point of view of the buyer

You’ll first need to communicate your VAT number to the seller so they can safely apply the reverse charge.

Then you should receive a correct invoice, including both the seller’s and your VAT numbers, the correct amounts, and a mention of the reverse charge.

In your next VAT return, you’ll need to declare both the purchase and the supplier’s sale on your tax return, mentioning the VAT amounts (which are not on the invoice). Failing to do so will result in fines — even though, in most cases, the tax authorities did not lose any money.

The difference between zero-rated, exempt supplies, and reverse charge

There are several reasons why an invoice may include no VAT. Reverse charge is one of them, but another reason may be if the transaction is exempt from VAT or has a VAT equal to 0% (zero-rated supplies). Zero-rated supplies are subject to VAT, but at a 0% rate, while exempt supplies are not subject to VAT at all.

Another way to see this is from the perspective of the EU VAT Directive. The EU defines certain supplies as exempt from VAT, such as those related to education, healthcare, or financial services. For supplies subject to VAT, the EU defines three VAT rate categories: standard rate, reduced rate, and special rate. Zero percent is a special rate, allowed only for some countries.

This subtle difference has several implications. For example, you may not deduct the input VAT associated to exempt sales, while you may do it on zero-rated sales. It also means that, if your sales are VAT exempt, you may not need to register for VAT at all may not be required to issue invoices on your sales.

Outside the EU

In this article, we’ve focused on EU rules, but it’s important to note that many countries outside the EU have their own versions of the reverse charge mechanism. Some countries, such as Switzerland, have aligned with the EU on most VAT matters and follow the same rules; others, like Australia, Japan, and India, apply the reverse charge in certain situations but with different rules than the EU.

Finally, we have the specific situation in the UK post-Brexit, where a distinction needs to be made between Northern Ireland, which still follows EU VAT rules, and the rest of the UK, which does not.

As always, it’s always important to analyze the local VAT rules when entering a new market.