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Taxation and Customs Union

How does VAT work?

An explanation of how the EU Value Added Tax system works. 

How does VAT work?

The EU Value Added Tax is an indirect tax collected at each stage along the supply chain. It is charged on the value added to goods and services at each stage of production and distribution. 

Taxable persons (i.e. a VAT-registered business) deduct the VAT paid to other taxable persons from the VAT they collected. This ensures that the tax is neutral for businesses that make onward taxable supplies, regardless of how many transactions are involved. 

As such, VAT is a tax on consumption that is ultimately borne by the final consumer and is charged, at the appropriate rate, on the sales price of the goods or services. 

How does it work? 

All VAT registered traders are given a VAT number. They must provide customers with an invoice that shows how much VAT has been charged. Thus, the customer knows how much VAT they have paid. If they are a registered trader, they can then deduct this amount from the VAT they collected, paying the rest to their national tax authority. 

With this system, double taxation is avoided, and tax is paid only on the value added at each stage of production and distribution. The final VAT paid is thus the sum of VAT paid at each stage. 


Stage 1: from the perspective of an iron ore mine 

An iron mine buys €200 worth of helmets with a VAT rate of 20%, for a total cost of €240. 

The mine then sells iron ore to a smelter. The ore is worth €1,000 and the VAT rate is 20%, so the smelter pays the mine €1,200. 

The mine then deducts the €40 VAT it paid from the €200 VAT it collected and pays the treasury €160. 

The treasury, having received €40 from the helmet seller and €160 from the mine, has thus successfully collected €200 worth of VAT. 

Stage 2: from the perspective of the smelter 

The smelter has now paid €200 VAT to the mine. In addition, it paid a furniture company €20 VAT (€120 total cost) for some chairs. 

The smelter sells €2,000 worth of steel plus 20% VAT for a total of €2,400. 

The smelter then deducts the €200 VAT it paid to the mine and the €20 VAT it paid to the furniture company from the €400 it collected from the sale of its steel, thus paying the treasury €180. 

The treasury, having received €180 from the smelter, €160 from the mine, €40 from the helmet seller and €20 from the furniture company, has successfully collected €400 VAT on the sale of steel worth €2,000. 

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