Destination vs origin principle in Value Added Tax

The issue with cross-border transactions, obviously, is to develop universal rules of tax jurisdiction to prevent double taxation or double non-taxation of a certain supply of a good or service. Treaties regarding the prevention of double taxation do not cover indirect tax and are focused exclusively on direct taxes.

The concept of double taxation for direct taxes (such as corporate income tax) is also different from the one applicable to indirect taxes (such as VAT). In the case of direct taxes, the focus is on the same tax subject being taxed more than once, whereas under consumption taxes, the concern is with the same tax object being taxed by more than one jurisdiction.

Most countries apply the territoriality principle, which limits the capacity of a state to tax transactions taking place within its borders or within its national territory, regardless of whether the supplier is a domestic or foreign business. Consequently, foreign transactions are outside a state’s jurisdiction, even when performed by a domestic firm.

This principle provides a guideline for the allocation of tax jurisdiction, but there are instances where a transaction can be allocated to more than one jurisdiction.

For VAT, to prevent double taxation or non-taxation of cross-border transactions the choice is between taxing the supply of a good or service either in the country of production (origin principle) or in the country of consumption (destination principle).

Applying the origin principle may lead to economic distortions in case of tax rate differences between countries. If country A charges 10 per cent VAT and country B charges 20 per cent, a manufacturer in country A has an advantage when he exports to country B compared to a local competitor. If both sell comparable products at similar cost price that the tax difference leads to a price difference. Assume the product price is 100. A can export to country B for a price of 100 + 10 (tax) = 110.

However, its local competition must charge 100+20 = 120 for the same product. Manufacturer B cannot successfully penetrate the market of country B as his price of 120 cannot compete with the local price of 110.

Under WTO rules, a choice is made for the destination principle, including the possibility of rebates of indirect taxes paid in the country of origin. This may put countries that rely more on direct taxes than indirect taxes for government funding at a competitive disadvantage when engaging in international trade, because direct taxes such as corporate income tax cannot be refunded and, thus, increase the cost price of the product.

Under the destination principle, imports of goods and services must be taxed, and exports must be relieved from tax. As a consequence, border tax adjustments are required. Exports zero-rated, and imports are taxed.

To use our previous example, manufacturer A exports to country B at a price of 100 (as he receives a refund of the 10 paid in tax to country A) and upon importation he pays the VAT of country B, 20, which is the same as local manufacturers pay in country B. Now VAT is neutral from a perspective of competition.

The principle of economic neutrality requires that imported goods and services are taxed at the same rate as similar goods and services produced domestically because the purpose is to create a level playing field and not to protect the domestic market.

This can be realised by applying the destination principle instead of the origin principle.

Dr Robert F van Brederode is of counsel to Horwath Mak Ghazali in Oman. He is a tax lawyer, practitioner and scholar with over 30 years of experience in global VAT.

He served Crowe Horwath International as the global indirect tax leader, and was the national practice leader of the US member firm. Robert is the author of dozens of academic journal articles and 8 books. He can be reached at Robert.brederode@crowehorwath.om. are