In this article
- How does reverse charge work?
- Why do some countries use reverse charge?
- How does reverse charge differ for VAT versus GST?
- How does reverse charge work with GST?
- How does reverse charge work in the UK after Brexit?
- What is Optional Reverse Charge in the EU?
- How is zero-rated tax different from reverse charge?
- How to comply with the reverse charge mechanism and reverse charge taxes
- Quaderno handles reverse charge on your B2B sales
“Reverse charge?” — no, we’re not talking about making a collect call. (It’s not the 90s anymore!)
The reverse charge mechanism is a B2B tax maneuver that you need to know, especially if you’re selling digital products around the world. It’s a common practice in VAT and GST schemes, where the consumption tax is added step-by-step throughout the production process.
As a tax compliance tool, we have a lot of experience with reverse charging, so we’ve laid it all out for you. What is the reverse charge mechanism? How does it work, why do so many countries use it, and how can you use it properly? We gotcha covered.
“Consumption tax” is an umbrella term for any tax applied to consumer sales, but specific ones operate differently. Learn about VAT, GST, sales tax and more in our post about different consumption taxes around the world.
How does reverse charge work?
In most transactions, suppliers act as a tax middleman, collecting tax from the buyer and passing it onto the government. The reverse charge mechanism is designed to cut out this step.
The responsibility for tax reverses from the supplier back to the buyer, so that the tax money goes directly from buyer to the government. In some cases, the tax money just stays in the buyer’s bank account altogether, since the purchase is tax deductible and the government would issue a refund anyway!
At the point of sale
The buyer provides their tax registration number, which the seller confirms. This is a key step! The seller must check that each VAT number is valid. Then the seller produces a tax invoice, that is identical to any other sales receipt except the tax isn’t actually added to the total charge. Instead, the seller indicates they are using the reverse charge mechanism. Both the seller and the buyer keep this tax invoice on record.
In the tax return
Here’s how reverse charge VAT works when filing a tax return. The buyer makes the declaration of both their purchase (input VAT) and the supplier’s sale (output VAT) in their VAT return. These two declarations offset each other from a cash payment point of view, and the tax agency has full visibility of the transactions.
What does reverse charge look like in practice?
Once we had a reader reach out to our Support team to ask for an example of reverse charge in a “real life” scenario, so that they could better understand it as a business owner. From our experience, we found that really helpful, so now we’ll do the same here!
Imagine that Sarah SaaS sells a software subscription to Rebecca Retailer. Both of these parties are businesses that are registered in the same tax system. So what happens with the tax on this transaction?
Step 1: Sarah SaaS calculates tax but does not collect it at the point of sale
When Sarah SaaS realizes (or her checkout system realizes!) that the buyer, Rebecca Retailer, is a fellow tax-registered business, that’s when the reverse charge kicks in. The correct tax rate must still be applied to the sale, and the total tax due on the sale must be calculated and listed on the receipt.
BUT – the tax is not actually added to the total amount of the transaction that Rebecca Retailer must pay. Sarah SaaS’ responsibility is to simply record how much tax is due – but not to collect it. This is when the tax responsibility shifts, or is reversed, to Rebecca Retailer.
Step 2: Rebecca Retailer reports the tax directly to the government in her next tax return
Rebecca Retailer includes this purchase and the reverse charged tax in her reports when she files her next tax return. The purchase likely counts as a business expense. In such tax returns, the buyer is essentially showing: “Hey! I bought this, and here’s how much tax I owe on it. But I bought it for my business, and I’d get the tax back anyway. So I’ll just keep the money in the first place.” It’s a declaration and a refund all at once.
Why do some countries use reverse charge?
Obviously reverse charge simplifies the tax process for suppliers and buyers, but there’s another reason governments like to adopt it.
The reverse charge mechanism is actually designed to prevent tax fraud. For example, the EU loses millions of euro each year due to fake businesses collecting VAT, or buying items without paying the tax, and then disappearing into thin air. The VAT never makes it to the tax agencies, only into the fraudsters’ pockets. This is especially hard to regulate when the suppliers are foreign, as many are in the EU economies.
With reverse charge VAT, fake businesses never even come into contact with the tax money, and so they can’t disappear with it either. The national governments make sure that tax stays in domestic hands.
Countries where it applies
For an overview of consumption taxes in these countries and more, check out our guide on digital taxes around the world.
How does reverse charge differ for VAT versus GST?
In VAT systems, the buyer assumes the responsibility of paying the tax directly to the government, like we explained above. In GST systems, only specific goods or services trigger reverse charge, cutting out the seller as middleman and making the buyer report the tax directly to the government. It’s not a blanket rule like it is in the EU, for example. So, while both systems involve the buyer taking charge of the tax payment, the specifics differ between the two.
How does reverse charge work with GST?
Reverse charge works with Goods and Services Tax (GST) in countries such as Australia. Functionally, reverse charge is the exact same mechanism that we see in the EU and other countries that use VAT.
The difference in Australia is when the reverse charge mechanism applies – under what conditions reverse charge is actually required.
According to the Australian Taxation Office, reverse charge is only used in very specific cases. It does not apply to B2B sales in the country. That means that generally, B2B sales in Australia are always subject to the same 10% GST collection as any other sale.
Here are two conditions in which the reverse charge GST rule applies:
- Australian businesses are required to pay reverse charge GST on some offshore purchases.
- Australia also requires reverse charge in specific industries based on the goods they sell, such as the precious metals industry.
How does reverse charge work in the UK after Brexit?
Since the UK left the European Union in 2021, we’ve received lots of questions about how reverse charge works in those countries – that is England, Scotland, Wales, and Northern Ireland. The trade agreements were confusing, creating special cases for businesses based in Northern Ireland plus plenty of exceptions to the rules.
That said, we’ll do our best to simplify how reverse charge works in the UK after Brexit, based on our experience working with businesses who are based there or who sell there! Of course, because there are always exceptions, please consult with a tax professional if you have any doubts about your own situation.
When the seller is based in Great Britain (England, Scotland, Wales)
If you’re selling to an EU business, the reverse charge does not apply in most cases. If you’re selling to a business based in Northern Ireland, you should use the domestic VAT procedure.
When the seller is based in Northern Ireland
If you are selling to an EU business, the reverse charge still applies in most cases. If you’re selling to a business in Great Britain, you should use the domestic VAT procedure.
What is Optional Reverse Charge in the EU?
Since June 2022, the European Commission has extended an Optional Reverse Charge for sellers that are based in the EU. This is article 199 of the VAT Directive. It gives EU member states the option to apply reverse charge rules to additional cases, such as specific sales when the member state has suspicions about the seller or the transactions.
The goal of these optional reverse charge rules is to reduce VAT fraud, specifically Missing Trader Intra-Community fraud. This specific type of fraud is when a business collects VAT, or saves on VAT by being reverse charged, and then disappears before the tax return deadline rolls around. So the government never recoups that tax revenue.
How is zero-rated tax different from reverse charge?
Some of our customers have questions about zero-rated supplies – or products that are taxed at a rate of 0% – and how this interacts with reverse charge. The reality is that these two scenarios look the same on the outside: the seller does not collect any tax on the sale.
But technically and legally, these two scenarios function differently. Zero-rated tax means that no tax is applied to the transaction, while reverse charge simply shifts the responsibility for tax payment from the seller to the buyer. There is still tax in all reverse charge scenarios, it’s just not charged at the point of sale and is not collected by the seller.
How to comply with the reverse charge mechanism and reverse charge taxes
What you should do if you’re the seller
- Verify the buyer’s location and tax registration number. This is very important! Learn how to check if a business is VAT registered.
- Do not actually add any tax to the total cost.
- Make note on the tax invoice that you’re using the reverse charge mechanism.
What you should do if you’re the buyer
- Check the invoice to see that both the tax rate and amount are accurate.
- Make sure the invoice indicates the reverse charge VAT.
- Declare both your purchase and the supplier’s sale on your tax return.
Pitfalls to look out for
While the reverse charge mechanism does simplify tax handling for B2B transactions, it’s still possible to make mistakes! A misstep in reverse charging could mean you pay taxes that you don’t actually owe. (Yuck.) Here are a couple of pitfalls to avoid!
As a seller, there is some due diligence you must complete to ensure you’re not a victim of tax fraud yourself. The most important thing: make sure the buyer is a legitimate business. If they’re fake, they’ll disappear — saving money on the VAT they’ll never declare or pay. Then you’ll be on the hook for that money, either paying it yourself or hunting down a customer to collect VAT from an old sale. How can you make sure the buyer is a legitimate business? Verify the business’ location and tax registration number.
Also, make sure your invoice indicates that you’re reverse-charging the tax. Some authorities can be sticklers about this. The invoice is the official record of the reverse-charge mechanism, and if that record doesn’t exist… well… you might have to pay up.
As a buyer, your due diligence is pretty basic. Make sure your tax invoice shows the seller is reverse charging you. And of course, make sure you track what reverse-charged tax you owe in your return. If you forget to declare the purchase, then the government will follow up looking for the money. Then you not only miss the chance for the refund, but may have to pay fines on top!
Quaderno handles reverse charge on your B2B sales
All of those responsibilities of the supplier we mentioned up there? Quaderno can handle that for you, completely behind the scenes. Our service is full tax compliance, and automating reverse charge is definitely part of that. If you use Quaderno for automatic invoices and tax calculation, then the following will be done for you:
- Confirming the buyer’s location
- If in the EU, verifying the business’ VAT registration number (no fraudsters!)
- Sending a fully-compliant (and beautiful!) tax invoice, immediately after the purchase
- Indicating on the tax invoice that the reverse charge mechanism was used
All of these big and small responsibilities taken off your plate, and more. Want to give it a try? Sign up for our free trial and see how Quaderno can give you peace of mind – and several hours back per week!
Note: At Quaderno we love providing helpful information and best practices about taxes, but we are not certified tax advisors. For further help, or if you are ever in doubt, please consult a professional tax advisor or the Tax Agency.