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Sooner or later, each person doing business will face the issue of value added tax. Due to its vastness this topic poses a problem not only to newbies in the business but also to longtime entrepreneurs.

We have prepared for you a series of posts on value added tax (VAT) in which we would like to outline the importance and function of this tax. In the first post we will explain and clarify the value added tax terminology.

Firstly, it should be noted that we distinguish between direct and indirect taxes. The main difference between them is in the person who pays them:

- direct taxes: levied DIRECTLY on income or property of individuals and legal entities - indirect taxes: paid by consumers in the prices of goods and services they buy

Value added tax is an indirect tax and one of the most important items of the state budget. Therefore, the state keeps an eye on its collection. In Slovakia, the current rate of value added tax is 20%, however, this rate is reduced to 10 % for drugs and other medical products.

A taxable person is a person who independently carries out any economic activity, whatever the purpose or result of that activity is. Therefore, we can say that a taxable person is primarily a business entity – a natural or legal person carrying out economic activities with the aim of achieving income from that activity.

Economic activity in terms of the VAT Act is any activity from which income is obtained, and includes activities of producers, traders and providers of services including mining, construction, and agricultural activities, activities performed as an independent profession under special regulations (doctors, lawyers, experts, interpreters etc.), intellectual creative activities and sporting activities.

The vast majority of newly-formed companies are not VAT registered, but there are different criteria and cases when it is better to be VAT registered and such a company chooses this option. This topic and its application in practice will be discussed in our next blog because it demands a larger space.

But how does the value added tax actually work? The whole principle of the value added tax lies in the fact that it adds up to the price that each buyer pays to the seller in the shop. It is simply the value that increases the price of goods and services.

As we said above, indirect taxes, including the value added tax, are taxes that final consumers pay indirectly as part of the price of goods and services they buy. However, the consumer is not the person who really pays it to the state.

This is a very important aspect that you need to remember. Although the final consumer pays the tax, but it is accrued by the seller from whom the consumer purchases goods / services.

We can illustrate the simplified diagram of the value added tax principle on the sale of T-shirts from the manufacturer to the customer via two intermediate steps (the manufacturer and the seller are VAT registered):

1) The seller buys a T-shirt from the manufacturer for 120 EUR (in fact, the T-shirt’s price is EUR 100 and EUR 20 EUR is VAT)

2) The seller sells the T-shirt to the customer as follows:

• The seller increases the original purchase price (to sell the product with a profit) by adding his margin, for example 10%: EUR 100 x 1,10 = 110 EUR (the seller’s price)

• But this is not all, the seller must add the value added tax to that amount - 20%: EUR 110 x 1,20 = 132 EUR (the seller’s price including VAT)

20€ input tax (seller’s purchase)

22€ output tax (seller’s sale)

22 less 20 = 2 EUR is the seller’s tax liability he is obliged to pay to the state.

During the tax period for value added tax, which may be one month or a quarter, this “received VAT = output VAT" is added to the" VAT on purchases = input VAT ".

At the end of the tax period the difference between them is calculated. If the difference is positive, we are talking about tax liability (the amount the entrepreneur must pay the state). When the difference is negative, it means excessive deductions which the state will return to the entrepreneur.

At first glance it may seem that being VAT registered is a disadvantage (in some special cases it is), but there are many reasons why entrepreneurs become VAT registered. This issue together with the differences between VAT registered and not registered entrepreneurs will be discussed in the following post.

Author: Corlonez advisory s.r.o. Date: 12.8. 2015