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Where input VAT which has not been paid before that period’s tax filing, the taxpayers must still account for it. This concept is known as reverse charge mechanism (RCM). Under this, the taxpayer effectively uses the reverse charge as a payable amount on its tax return to account for an input tax amount that should have been but was not collected on a previous purchase.
When a VAT-registered business imports a taxable service, it applies the reverse charge mechanism. Imported services do not go through customs like imported goods, so VAT cannot be collected for imported services at an airport or a border. However, the buyer is still required to account for input VAT on the service using the reverse charge mechanism.
Let’s see an example:
An electronics store purchases a software subscription from a firm that is outside the purview of VAT for SAR 2,000. In this case, there is no physical delivery of goods. This is a case of service. Since the software is delivered electronically, there is no need for it to go through customs formalities and hence VAT cannot be collected upon its “import”. Therefore, in such cases the receiver must use the reverse charge mechanism to account for input VAT, in the following way:
- The value of the service of SAR 20,000 is recorded in the standard rate box.
- Its output tax of SAR 1,000 is recorded and SAR 2,000 input cost as an import subject to VAT through the reverse charge mechanism
Proportional deduction under RCM
Financial services lie outside the purview of VAT in KSA. Therefore, for organizations providing financial services, much of their output is VAT exempt. Suppose a financial service organization purchases a software subscription electronically, proportional deduction has to be applied to determine the taxable value on which tax has to be paid. Where only 30% of the financial service organization’s sales were taxable in the previous year and the other 70% was revenue from exempt financial services, the organization has to pay input VAT to GAZT connected to the 30% of output which is taxable.
So, in the above example, the financial service organization will actually owe input VAT to GAZT. This input VAT amount is determined by calculating 5% input VAT on input cost multiplied by the proportion of exempt sales from the previous year. In other words the organization should calculate the input tax on 70% of its purchases costs. In this case, the organization will have to pay an input tax of 70% of SAR 2,000 or SAR 1,400. Therefore, the input tax will be 5% of SAR 1,400 or SAR 70.
This input VAT adjustment value of SAR 1,400 is to be shown in the VAT return as an adjustment in the reverse charge for imports row. The deductible input VAT which has already been paid is the input cost multiplied by 0% since it is not liable to VAT from which the adjustment amount (SAR 1,400) multiplied by the standard rate of 5%, so SAR 70 has to be reduced.
Therefore, the formula for Deductible input VAT equals (Input cost x VAT rate) – (Adjustment x VAT rate)
The net VAT payable by the taxpayer equals the standard Output VAT – Input VAT.