Companies engaged in the global trade of tangible goods crossing physical borders must navigate a complex indirect tax environment. A critical aspect of managing global trade transactions is understanding customs duties and Value Added Taxes or Goods and Services Taxes (VAT/GST) that apply in each jurisdiction. These indirect tax obligations can create significant cost and cash flow challenges for businesses and their customers. Proactive inclusion of these taxes at the planning stage is essential to anticipate potential financial burdens and reduce the chance of overlooking opportunities to avoid or recover such taxes.

The interplay between customs duties and VAT/GST arises at the point of importation, affecting both cross-border purchases and sales. Although often governed by different agencies and subject to distinct compliance requirements, customs and VAT/GST are interconnected in their trigger at importation, application, legal entity considerations, valuation/classification, and supply chain management, among others.

Understanding Customs Duties and VAT/GST

Customs duties are levied on goods when they enter a country, with rates determined by each jurisdiction based on the type of product and the country of origin of the goods, among other factors. Customs duties are generally the responsibility of the importer and are usually calculated as a percentage of the total value of the goods (“ad valorem”). Customs duties may also be based on a specific rate such as an amount per kilogram or other unit of measure.

VAT/GST is a consumption tax charged by over 160 countries worldwide on the supply of goods (and services) at each stage of the supply chain beginning with the importation of the goods and culminating in the final consumer bearing the cost. Unlike sales tax in the U.S., which is levied only on the final transaction with the customer and does not involve reporting obligations, VAT is levied on the value added at each stage of the supply chain. Businesses are responsible for the administration of VAT/GST—collecting the tax on behalf of the government at each stage of the product’s journey to market and offsetting the VAT/GST incurred on purchases and imports against the VAT/GST collected. VAT/GST rules and rates can vary widely from country to country.

The Convergence of Customs and VAT/GST

Customs and VAT/GST obligations arise at the time of importation of goods. While subject to diverse laws and regulations, common considerations exist when planning for both types of indirect taxes:

Legal Entity Considerations

Establishing or identifying the appropriate importing and/or exporting entity is critical for cross-border transactions, as that entity will have compliance and payment obligations related to customs and VAT/GST. In some jurisdictions, an entity can register as an importer without registering for VAT/GST. In those cases, VAT/GST incurred at importation may be recoverable depending on the jurisdiction. Further, sometimes an agent can act as the importer, which will facilitate customs clearance but also trap VAT/GST, which in most jurisdictions may only be recovered by the importer that owns the goods at the time of importation or will take title following importation.

From an export perspective, customs duties paid at importation when those exported goods reach their destination may be refunded. However, obtaining such refunds is complicated if the importing and exporting entities differ. In contrast, from a VAT/GST perspective, the recovery of import VAT/GST is driven by the intended transactions involving the imported goods. Each jurisdiction has its own rules on who is permitted to import or export and under what conditions. Planning for these risk and cash flow implications should be undertaken before engaging in cross-border purchases and sales.

Incoterms and Transfer of Title

Incoterms are widely used in international trade as they define the responsibilities of the seller and buyer for the delivery of goods under sales contracts and how costs and risks are allocated between the parties involved, and thus, corresponding customs and VAT/GST obligations. Determining the appropriate Incoterms and specifying them in transaction documentation and commercial agreements is critical to planning for and managing indirect tax risks and costs.

Incoterms do not dictate when title to the merchandise is transferred from one party to another; this issue is normally addressed in sales/purchase agreements. To whom and when the title is transferred will have an impact on eligibility to legally act as an importer or exporter, which ultimately drives compliance obligations and eligibility for certain cost reduction or refund programs.

The impact is also visible from a VAT/GST compliance obligation standpoint. Overseas vendors may inadvertently agree to Incoterms where they act as the importer (if the jurisdiction at hand allows nonresident importers in the first case; many countries do not), which can give rise to a VAT/GST registration obligation in the country of import as their sale of the merchandise may be deemed to be a domestic transaction in that country. Title transfer terms should always be clearly defined in commercial agreements between buyers and sellers, reflect commercial reality, and be accurately reflected in the customs documents.

Valuation and Classification

The value and tariff classification of imported goods are key components in determining the correct amount of customs duties and VAT/GST. The value and classification of imported goods often serves as the basis for VAT/GST calculations. Misclassification or incorrect valuation can lead to underpayment or overpayment of duties, taxes, and fees, resulting in penalties and/or unnecessary costs. The valuation and classification of merchandise may impact eligibility for certain VAT/GST relief or refund opportunities or eligibility for customs duty reductions such as favorable provisions in free trade agreements, among others. Customs valuation laws across jurisdictions can also capture additional payments related to imported goods such as transfer pricing adjustments, license fees/royalties, and tooling costs that may have VAT/GST implications. The value and tariff classification of merchandise must be determined prior to shipment.

Supply Chain Planning and Optimization

When planning for the design or transformation of global supply chain flows, customs and VAT/GST should always be considered before any changes are implemented as they have a direct impact on “landed cost” (the total cost of the product from its source to the buyer’s location). Minor changes to global supply chains can have a considerable impact on VAT/GST, possibly resulting in VAT/GST registration obligations that substantially increase operating costs due to managing VAT/GST compliance obligations in multiple jurisdictions. Commercial decisions about where to locate manufacturing hubs, distribution centers, and sales operations (e.g., drop shipping, e-commerce fulfillment) can affect the overall tax burden. For example, when selecting manufacturing locations, customs duties should be considered for international procurement and outbound sales. If the manufacturing location is a jurisdiction that applies high duty charges on the importation of raw materials, that raises the cost of goods sold. If the jurisdiction does not have many free trade agreements with other countries, that will impact the competitiveness of the products in global markets. For VAT/GST, in principle, companies will generally avoid or recover costs as the tax is passed on to the end consumer. However, certain jurisdictions have burdensome processes for reporting or recovering VAT/GST especially with respect to recordkeeping, which increases operational costs and impacts cash flow.

Role of Technology and Expertise

Increasingly, customs and tax authorities are shifting to digital methods for transaction processing and reporting, and to obtain advanced analytics for monitoring compliance and collections. Digitization facilitates compliance and reporting obligations for customs and VAT/GST purposes (once systems have been implemented), but it also better equips governments to analyze diverse datasets to identify noncompliance or irregularities.

To keep current with evolving laws and regulations, companies should invest in digital tools and technology solutions that make it easier to manage compliance, maintain accurate records, and provide real-time analytics to inform their decision-making. While technology has improved dramatically in recent years, leveraging expertise from tax professionals who specialize in customs duties and VAT/GST is still key to mastering the regulatory landscape and implementing effective tax strategies.

Written by Matt Wills, Mathew Mermigousis and Tyler Potter. Copyright © 2024 BDO USA, P.C. All rights reserved. www.bdo.com