La Autoridad Común de Control de la Europol

As stated in chapter I sectionII section 2.1, the emergence and wide spread of VAT is due largely to the deficiencies of other forms of turnover tax—the cascading of taxes. VAT overcomes this by imposing tax on the “value added” at each stage in the production and distribution chain. How to compute the “added value” was an issue at the beginning of its adoption. There are a variety of methods available and the question is which methodology is the most appropriate to determine the value added of a particular business.

In theory, there are three distinct approaches: addition,69 _subtraction70 _{and credit} invoice (or tax credit). The first two methods are both accounts-based methods, which means calculation of the value added relies on data aggregated over a fixed period of

69 _{Under the addition method, the value added is determined by adding up its profit (not all elements}

have been taxed at previous stages, e.g. wages, income in the form of government subsidies, royalties and interest).

On a national scale, the addition method VAT has not been adopted anywhere. For further information, see Alan Schenk and Oliver Oldman,Value Added Tax: A Comparative Approach, Cambridge

University Press, 2007, p. 328.

70 _{This method is quite like the addition method, but it takes the opposite direction to calculate the}

value added. Total purchases in a certain tax period are deducted from total sales in that same period to arrive at the value added generated by the business. It is currently applied only in Japan. For further information, see Robert F. Van Brederode,Systems of General Sales Taxation: Theory, Policy and Practice, Kluwer Law International, 2009, 100.

time. Consequently, they cannot accommodate multiple rates, which precisely is required in the exercise of VAT, because company accounts neither separate different product categories within their sales that correspond to different sales tax rates nor distinguish inputs according to differential tax liabilities71_.

Unlike the addition and subtraction methods, the credit invoice method calculates the tax on a transaction-by-transaction basis, which enables it to overcome the disadvantage of not accommodating a multiple-rate consumption tax. In principle, the tax is charged on each transaction. By this method, a company will compute its tax liability by deducting the total amount of tax paid on procurement from the total amount of tax charged on its sales for a certain period (a statutory reporting period).72 In order to present how this method works more intuitively, Table 2 shows a simplified model73_.

Table 2. The function path of deduction of tax in credit invoice method VAT.

VAT rate 10% Sales Tax on Sales Total sales price

To Taxing Authority Producer 1(PI) 1,000 100 1,100 100 Producer 2(PII) 2,000 200 2,200 200-100=100 Producer 3(PIII) 3,000 300 3,300 300-200=100 Wholesaler 4,000 400 4,400 400-300=100 Retailer 5,000 500 5,500 500-400=100 Total 500

We assume that each stage of the production and distribution chain creates an additional value of 1,000 to a single product. We take Producer 2 (PII) as an example;

71 _{Alan A. Tait,Value Added Tax: International Practice and Problems, Washington, DC: IMF, 1988, p.}

5.

72 _{Generally a calendar month, quarter or calendar year.} 73 _{Van BrederodeSystems of General Sales Taxation, p. 22.}

PII gives PI 1,100 to purchase the product, of which, 100 is the tax amount. Then PII adds 1,000 in value and sells it to PIII for 2,200 (1,000+1,000+200), of which 200 is the tax amount. PII deducts 100 in tax paid to PI from the tax due (200) on his sale to PIII and remits the difference (200-100) of 100 to the taxing authority. Thus, PII, on its sale of the product to PIII, generates 200 tax due but also obtains a credit (100 paid for the obtain of the product from PI) for the tax paid to PI. To function well, each business is required to operate two book-keeping ledgers as records of the tax: one for the tax payable on sales (output tax), the other for the tax credit on procurement (input tax). Also, each business requires certification (an invoice, which will be detailed in the following section) from its suppliers to prove it has already paid VAT in order to claim the deduction. As in the example shown, tax is charged on each sale, and a tax credit arises regarding each purchase. Since the tax credit is based and depends on an invoice issued by the seller, this method is commonly referred to as the credit invoice method74_.

Of the three methods above, the addition method has not been adopted anywhere on a national level, but Israel applies it to the financial sector. The business enterprise tax which is charged in the US State of New Hampshire is also an addition method VAT levied on businesses with turnovers above a certain threshold value75_{. The subtraction} method is currently applied only in Japan. The credit invoice method of VAT is adopted in most countries that run a value added tax system. So what makes this third method so popular? In fact, both the subtraction method and the credit invoice method determine the value added from a subtractive perspective, that is, to deduct costs from turnover. The subtraction method takes a direct approach, like most other taxes that it first calculates the tax base out—total purchases in a certain tax period are deducted from total sales in that same period to arrive at the value added generated by the business. The credit invoice method applies an indirect subtraction, first it calculates the output tax on the sale, then determines the tax due by deducting the input tax from

74 _{Other names, such as tax from tax method and tax deduction method, are used.} 75 _{For further information, see Schenk and Oldman,Value Added Tax, pp. 328, 403.}

the output tax. According to Tait,76 _{there are four key reasons for the credit method’s} unsurpassed proliferation. The most important one is expressed above; rather than being accounts-based like the other two methods, the credit invoice method is transaction-based, which makes it superior from a legal and technical perspective. The second advantage is generated by the indispensable document in its self-function chain—a mandatory invoice, which creates the audit trail and makes the method per se more practical. Third, also as mentioned above, the transaction-based method can accommodate a multiple rate VAT,77 _{whereas the direct method cannot. The last} reason is that the credit invoice method is the most flexible one for calculating the tax liability by different time intervals (e.g. weekly, monthly, quarterly or annual).

The features of credit invoice VAT are remarkably similar all over the world: the broad tax base, the registered taxpayers,78 _{multiple positive rates,}79 _{and, most} importantly, business purchases are relieved from the tax through a tax credit deductible from tax due on sales, which is also the topic to be discussed in detail in this thesis.