What Is VAT Used For? Understanding Value-Added Tax

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VAT, short for “value-added tax,” is a tax that gets added to the price of goods and services and collected by the businesses that sell them. Unlike traditional sales taxes that are charged only once at checkout, VAT is added at multiple points as a product moves from production to sale, with each business or vendor along the way collecting the tax and passing it on to the relevant government. 

While the United States does not use a VAT, more than 170 countries use it in some form, including the United Kingdom (20%), Mexico (16%), and South Korea (10%).

In this article, learn what VAT is used for, how it works for customers and ecommerce businesses, when online sellers need to register for it, and how to manage VAT when selling internationally.

What is VAT?

VAT is a type of consumption tax—meaning it’s charged on the purchase of goods and services rather than on income or profit, the way income tax is. It’s also classified as an indirect tax, which means the government doesn’t collect it directly; rather, businesses collect VAT from customers and remit it to tax authorities. The cost ultimately is paid by the end consumer rather than the business itself. 

In some countries, this same type of tax is simply referred to as a goods and services tax, or GST, instead of VAT, though the underlying mechanics are similar. For example, while Australia uses “GST,” the United Kingdom uses “VAT.”

VAT vs. US sales tax

VAT and sales tax are both types of consumption tax that raise government revenue based on purchases. In both systems, the retailer collects the tax from the customer and remits it to tax authorities. 

The key difference is where and how often each tax applies. 

For customers in most countries that apply VAT, the full tax-inclusive price usually must be shown up front—on the shelf tag, product page, or wherever the price is displayed to them. Tax is broken out separately (if at all) at the receipt stage, not before. In the US, sales tax is typically applied at checkout, added on top of the listed price, since rates vary by state and sometimes even city or county.

In a VAT system, the tax also applies at various stages of the supply chain—from raw materials and manufacturing inputs, to wholesale and retail. But businesses can use tax credits or strategic pricing to offset VAT paid on their own business inputs. 

When a business buys materials, inventory, or sometimes services (depending on the country and service), it pays VAT on that purchase (known as input VAT). When it later sells its product, it collects VAT from the customer (output VAT). Rather than remitting the full output VAT to the tax authority, the business subtracts what it already paid in input VAT and remits only the difference. This prevents the tax from compounding at each stage of the supply chain, so businesses don’t absorb the cost themselves—or overly inflate list prices to recoup the costs.

Another difference is the level of government that sets the tax. US sales tax is set by state and local governments, rather than the federal government. VAT, meanwhile, is generally set at the national level. Canada is somewhat unique among VAT/GST-collecting countries in that its GST is federal and is 5% nationwide, but some provinces add, or harmonize, provincial tax through an additional harmonized sales tax (HST).

Selling between the US and VAT countries

VAT is designed to apply to goods and services that are actually consumed in-country, so exports from a VAT country are commonly charged zero VAT. This zero-rating applies specifically at the final export sale—the transaction where the goods cross the border to a foreign buyer. Earlier stages of the supply chain are unaffected by the zero-rating. Domestic suppliers and manufacturers still charge and collect VAT on their sales leading up to export.

Conversely, if a business in the US (where no VAT is applied) wants to sell to a customer in the EU, the VAT gets applied on the import side. The EU customer pays VAT when the goods enter the EU, so in this case, the tax is still collected based on where the goods are consumed, not where they were produced. 

What is VAT used for?

Governments used VAT primarily to raise government revenue that funds public services, like healthcare, education, and infrastructural improvements. 

Because VAT is collected at multiple points in the supply chain, rather than only at the point of final sale, tax authorities get more consistent visibility into transactions, which can also help reduce opportunities for VAT fraud. Each business in the chain reports what it charged and what it paid at each point along the supply chain, creating a paper trail that follows all transactions associated with the production and sale of the good or service. 

How does VAT work for ecommerce businesses?

For ecommerce businesses in countries that apply VAT, VAT must be paid on inputs and collected on outputs. A VAT-registered business generally can reclaim VAT paid on eligible input VAT costs. At the end of a reporting period, the business pays the government the difference between the output VAT it collected and the input VAT it paid, known as net VAT.

For example, say an ecommerce clothing company buys $500 worth of zippers from a manufacturer, and pays 20% VAT on that purchase, or $100 in input VAT. The business then sells the finished products for a combined $5,000, and charges customers 20% VAT, collecting $1,000 in output VAT. At the end of the tax period, the business owes the government the difference: $1,000 in output VAT minus $100 in input VAT, for $900 in net VAT owed.

VAT directly informs the final price a customer pays, since tax is typically added to or baked into the selling price. 

When do online sellers register for VAT?

• EU registration thresholds
• The EU’s One-Stop Shop system
• UK registration threshold and the import VAT rule

When a business needs to register to collect VAT, and at what rate, depends on the jurisdiction. VAT thresholds are the revenue level at which a business must start charging VAT. Thresholds, rates, and exemptions all vary by country (and sometimes state or province). And some sales, such as certain medical services or some mobile data plans, are zero-rated—meaning VAT is charged at 0%—or exempt—meaning no VAT is charged and input-VAT recovery may be restricted.

Because these rules shift by jurisdiction and can change over time, it’s worth consulting a qualified tax professional before you start selling in a new market to determine whether you can voluntarily register, or whether it’s mandated by law.

EU registration thresholds 

For businesses selling in the European Union, required VAT registration depends on where a business is based and how much business it transacts in other EU countries. 

If an EU business’s combined sales to customers in the EU outside its home country stay below €10,000, it can generally continue charging its home country’s VAT rate. For EU sellers, once sales cross that threshold, the business must charge VAT based on each customer’s location instead. 

A non-EU business, like a US company, has no home-country VAT rate to fall back on, so it doesn’t get this exemption. Instead, it’s generally liable to charge the destination country’s VAT rate starting from its very first sale in the EU.

The business obtains a VAT identification number from each qualifying country’s tax authority to use on invoices. Governments typically provide these numbers through online application systems, like the EU’s One-Stop Shop system, described below.

The EU’s One-Stop Shop system 

The EU sets a minimum standard VAT rate of 15%, though individual member countries can and do set higher rates. For example, France charges a standard VAT rate of 20%, Italy charges 22%, and Sweden charges 25%. 

To simplify compliance across many EU countries, the EU offers a Union One-Stop Shop (OSS) scheme, which lets EU-based sellers report and remit VAT for all their EU sales through a single registration rather than registering separately in every member country. 

Non-resident businesses (those based outside the EU) that ship physical goods worth €150 or less to EU customers can use the Import OSS (IOSS) to collect VAT at checkout instead of leaving customers to pay it upon delivery. 

Participation in this scheme impacts how a business represents tax in their pricing. If a non-EU company registers IOSS, it takes on the responsibility for charging and collecting VAT directly at checkout. The same EU pricing rules apply to it as to any EU seller—the price shown to the customer must be the full, VAT-inclusive price, not something added on at checkout.

A separate Non-Union OSS scheme applies to non-EU businesses selling digital products or services to EU customers, where VAT is based on the customer’s location rather than the seller’s.

UK registration threshold and the import VAT rule

Domestic businesses selling in the UK generally need to register for VAT once their VAT taxable turnover from UK sales—meaning the total value of everything sold that is not VAT-exempt—reaches £90,000 within a 12-month period. 

A separate rule applies to import VAT for orders valued at £135 or less.

Import VAT refers to the VAT charged on goods entering the UK from abroad. It applies any time goods cross into the UK from outside it, not just when a non-resident seller sells directly to a UK customer. A UK business importing T-shirts from a clothing manufacturer in China, for example, pays the same import VAT at the border as a US business would pay shipping an order over £135 to a customer in the UK directly. The difference is the UK seller can reclaim that import VAT as input VAT since it isn’t the end consumer. Meanwhile, the US seller’s UK customer bears the cost with no way to reclaim it. 

The £135 threshold is, in essence, a rule about who collects that import VAT and when. If the value is below £135, the foreign seller collects VAT upfront, like a domestic VAT. For values above £135, it’s collected from the customer directly at the border, by the delivery courier or customs, when the package arrives.

How to manage VAT when selling internationally

For businesses selling internationally, managing VAT may seem complicated—but it doesn’t have to be a manual headache. To ease the burden, Shopify offers features like Shopify Tax and Managed Markets that automate VAT calculation, collection, and invoicing so nothing slips through the cracks. 

• Configure tax registrations and product categories with Shopify Tax. Shopify Tax calculates destination-based rates using a product’s tax category and a business’s active tax registrations, so products are taxed at the correct rate automatically.

• Generate compliant VAT invoices. Shopify Tax can generate VAT invoices that meet the formatting requirements customers and tax authorities expect in the EU and UK. A VAT invoice gives the customer a formal record of the tax they paid (which businesses need in order to reclaim that VAT as input VAT), and it gives tax authorities a paper trail to verify that VAT was properly charged and reported. 

• Monitor obligations with tax burden insights. Shopify Tax’s liability insights can help a business see when its sales are approaching a registration threshold in a given country, before that threshold is crossed.

• Automate VAT collection with Managed Markets. Managed Markets can automatically collect VAT and duties on eligible international sales, so customers see the full landed cost at checkout instead of getting billed on delivery.

• Keep accurate invoices and records. Detailed records of VAT collected and paid support accurate VAT returns and make it easier to reclaim input VAT on eligible purchases.

Managing taxes—especially as they impact the pricing your customers see—can directly impact your bottom line. “Not knowing duties, taxes, and fees upfront is a major problem for people,” says Colton Draper, founder of LAZRUS Golf, a golf equipment brand that sells internationally. After automating VAT and duty collection, LAZRUS Golf saw 74% year-over-year sales growth and a 55% improvement in Eurozone conversion rates.