What expense category is Value Added Taxes?

As businesses increasingly operate globally, accountants and SMB owners frequently encounter Value Added Tax (VAT) – also known as Goods and Services Tax (GST) in countries like Canada and Australia. This consumption tax is applied to goods and services in many countries outside the U.S. Unlike U.S. sales tax, VAT can often be reclaimed by businesses under certain conditions.

Understanding how to properly account for VAT is crucial. Is it an expense? An asset? Part of the cost of goods? This guide clarifies how to categorize VAT for accurate financial reporting and U.S. tax purposes.

Value Added Taxes: Expense Category or Not?

Here’s the key takeaway: Value Added Tax (VAT) is generally NOT treated as a distinct expense category on your income statement. Its accounting treatment depends entirely on whether the VAT paid is reclaimable by your business.

1. Reclaimable VAT (Input VAT)

• If your business is registered for VAT in the country where the purchase occurred and meets the requirements to reclaim the VAT paid (often called "input VAT"), that VAT amount should not be recorded as an expense.
• Instead, it should be tracked as an asset on your balance sheet, typically in an account like "VAT Receivable" or "VAT Recoverable."
• This receivable represents the amount you expect to recover from the foreign tax authority. It does not impact your profit and loss statement.

2. Non-Reclaimable VAT

If the VAT paid cannot be reclaimed (perhaps because your business isn't registered in that country, the specific item doesn't qualify for reclaim, or you lack the required documentation), then the VAT amount is treated as part of the cost of the underlying good or service purchased.

In this case, the expense category for the VAT is the same category as the item itself. For example:

• Non-reclaimable VAT paid on a software subscription becomes part of your "Software Expense."
• Non-reclaimable VAT on business travel (like hotels or meals abroad) becomes part of your "Travel Expense."
• Non-reclaimable VAT on equipment purchased abroad is added to the equipment's cost basis and depreciated along with the asset.

This treatment is analogous to how U.S. sales tax is handled per IRS guidance (Pub 334, Pub 535), where the tax becomes part of the cost of the service or property.   

Some Important Considerations While Classifying Value Added Tax Expenses

Effectively managing VAT requires attention to these details:

• Reclaimability is Key: Determining whether VAT is reclaimable dictates its accounting treatment. This often depends on VAT registration status in the specific country and the nature of the expense.
• Country-Specific Rules: VAT laws, rates, registration thresholds, reclaim eligibility, and invoicing requirements vary significantly from country to country. You must understand the rules of the specific jurisdiction where the VAT was incurred.
• Documentation (VAT Invoices): To reclaim VAT, you typically need a valid VAT invoice from the supplier that meets strict requirements (often including supplier's VAT number, your business details, a clear VAT breakdown, etc.). Standard receipts are often insufficient. Keep meticulous records.
• Underlying Expense Deductibility: Even when non-reclaimable VAT is added to the cost of an item, the underlying expense must still be an ordinary and necessary business expense to be deductible for U.S. income tax purposes.

Examples of Value Added Taxes

U.S. businesses commonly encounter VAT or GST in situations like:

• International Travel: On hotel stays, meals, conference fees, car rentals, and other expenses incurred while traveling for business in VAT-levying countries.
• Foreign Goods: On purchases of inventory or equipment from suppliers located in VAT countries.
• Digital Services: On subscriptions to software, cloud services, or online publications from foreign providers.
• Professional Services: On fees paid to consultants, lawyers, or other service providers based in VAT countries.

(Note: Common names include VAT, GST (Goods and Services Tax), HST (Harmonized Sales Tax in some Canadian provinces), IVA, TVA, etc., depending on the country.)

Tax Implications of Value Added Tax Expenses

From a U.S. federal income tax standpoint:

• Reclaimable VAT: Since it's treated as a receivable (an asset to be recovered), it is not a deductible expense. The expected refund offsets the initial cash outlay.
• Non-Reclaimable VAT: This becomes part of the cost of the item acquired.
  
  • If the item is a currently deductible business expense (like travel or subscriptions), the non-reclaimable VAT is deducted along with that expense.   
  • If the item is a capital asset (like machinery), the non-reclaimable VAT is added to the asset's basis and recovered through depreciation.
• Foreign Tax Credit: VAT is a consumption tax, not an income tax. Therefore, VAT payments are generally not eligiblefor the U.S. Foreign Tax Credit, which is designed for foreign income taxes. It's also not typically deducted directly as a "foreign tax" but rather handled as part of the related expense or asset cost.

How Fyle Can Automate Expense Tracking

Managing VAT requires careful attention to detail, especially documentation. Fyle can help simplify the process:

• Capture Total Cost: Fyle captures the full transaction amount paid via company cards through its real-time feeds. Employees can submit receipts showing the full cost via SMS, email, or the app.
• Categorize Underlying Expense: Fyle helps correctly categorize the underlying business expense (Travel, Software, etc.). For non-reclaimable VAT, this means the total cost (item + non-reclaimable VAT) is allocated correctly for U.S. tax deduction purposes.
• Support Reclaim Process: While Fyle may not manage the VAT reclaim filing itself, it provides the organized documentation (the stored VAT invoice linked to the transaction) needed for internal accounting teams or third-party VAT reclaim services to identify eligible amounts and process the reclaim.
• Accounting Integration: Fyle syncs the categorized expense data (including the gross amount for non-reclaimable VAT) to integrated accounting systems like QuickBooks, Xero, NetSuite, and Sage Intacct, ensuring accurate cost recording in the general ledger.