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How does the reverse-charge mechanism work?

How does the reverse-charge mechanism work?

“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.

And since this is a key part of digital tax compliance, 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 the reverse-charge mechanism actually works

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. 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

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.

In their tax return, 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, so I’d get the tax back anyway. 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 the reverse-charge mechanism?

Obviously reverse-charge simplifies tax proceedings 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 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, artificial businesses never even come into contact with the VAT or GST, and so they can’t disappear with it either. Using reverse-charge, the national governments make sure that tax stays in domestic hands.

Countries where it applies

Many countries allow to apply reverse-charge in B2B transactions, including the EU, Norway, Australia, Japan, and India. Please contact the local tax authorities for more information.

For an overview of consumption taxes in these countries and more, check out our guide on digital taxes around the world.

How you can comply with the reverse-charge mechanism

What you should do if you’re the seller

  • Verify the buyer’s location and tax registration number
  • 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 that the reverse-charge mechanism is being used
  • Declare both your purchase and the supplier’s sale on your tax return

Want to know exactly what should be included on every tax invoice you give and receive? Check out our post on the four receipts you must know in order to run a tax-compliant business.

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 the reverse-charge process 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 indicates that you’re using the reverse-charge mechanism. 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 the reverse-charge mechanism is definitely part of that.If you use Quaderno for automated invoices and tax calculation, then the following will be done automatically:

  • 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? Please sign up for our 7-day free trial and see what you think!

* 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 accountant.

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