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to reimbursement (including the grant of warranties, insurance, 17 and similar items) and making of a covenant not to compete (or a similar agreement to refrain from doing something).

Because property would be defined to include only tangible property, it is unclear whether the bill would treat the licensing of intangible property to be the taxable performance of a service. Other VAT systems would subject the licensing of intangibles to tax, either by providing a broad definition of taxable services or by specifically including the licensing of intangibles as a taxable service. 18

d. Definition of business

A noncorporate person would be subject to the VAT only if that person sells or leases real property, imports property, or sells property or performs services in connection with a business. Business would be broadly defined to include a trade or activity regularly carried on for profit. Thus, it appears that activities that constitute a trade or business (under Code sec. 162) or that encompass expenses for the production of income (under Code sec. 212) would qualify as a business under the bill. However, an activity that is regularly carried on without a profit motive (for example, a hobby) would not be subject to the VAT. Other VAT systems often define business in greater detail or include all activities regularly carried on as taxable, irrespective of the profit motive.19

e. Treatment of employees

For purposes of the bill, an employee would not be treated as a taxable person with respect to activities engaged in as an employee. These services would be incorporated into the value of the goods or services sold by the employer to customers and would be subject to the VAT upon sale. Since services provided by nonemployees would be subject to the VAT, the distinction between an employee and an independent contractor would be significant. The bill would utilize the payroll tax definition of employee utilized in present law for the payroll tax.

An employer's services for an employee would not be treated as the performance of a taxable service under the bill unless the services are a type that are included in the gross income of the employee. Thus, fringe benefits provided to employees that are excluded from Federal taxable income also would be excluded from the VAT. Some have argued that all fringe benefits provided to employees should be subject to the VAT on the theory that if the employee had been paid in cash (rather than with the fringe benefit) and had used the cash to purchase the fringe benefit, a VAT would be collected on the subsequent purchase. The desire to adhere to such a theory must be weighed against the administrative difficulties in creating two separate tax regimes (VAT and income) for the same fringe benefit.

17 See pp. 25-28 for a discussion of the special rules relating to insurance.

18 See, Duignan, James "Technical Features of the Value-Added Tax in Europe," prepared for the International Monetary Fund, Fiscal Affairs Department, 1970, at pp. 19-22.

19 See, New Zealand Stat. 1985 No. 141, sec. 8(1) (New Zealand Goods and Services Tax Act) and sec. 4003 of the American Bar Association's Model VAT Statute, both of which would subject hobby transactions that are regularly carried on to the VAT.

f. Treatment of business gifts

The gift of business property or services would be a taxable transaction in the amount of the fair market value of the gift. The term "gift" would include property or services transferred in connection with business promotion activities. Thus, if a corporation donated inventory to a charitable organization and the inventory had a fair market value in excess of the corporation's cost, the donor corporation would be subject to a net VAT liability (after taking into account the VAT credit) on the amount of value the corporation had had added to the inventory. Other VAT systems either impose no tax when property or services are transferred at no cost or impose a tax based on the cost of the property or service. 20

Imposing a VAT liability on the fair market value of promotional transfers raises issues concerning sales of goods or services at less than fair market value (i.e., "loss leaders"). If a taxable person sold a new product at a deeply discounted price in order to create a market for such a good, it is unclear whether the VAT liability, as imposed under the bill, would be based on the undiscounted, fair market value of the good or the discounted purchase price. If the undiscounted, fair market price controls, the determination of such an amount may be difficult and potentially subject to dispute between the taxable person and tax authorities. In addition, even if the fair market price could be determined at the time of the sale, the seller would be required to charge a customer a VAT based on the higher fair market value or make up the shortfall itself.

If, on the other hand, VAT liability were based on the discounted purchase price of the goods or services when sold, but were based on the fair market value of the goods or services when a gift, there would be a strong incentive to structure business gifts in the form of purchases for nominal amounts.

g. Personal use by owners

The bill would treat the personal use of business property or services by an owner of the business as a taxable transaction subject to the VAT at the fair market value of the property or services. Such treatment is consistent with the treatment prescribed by the bill for taxable fringe benefits provided to employees and business gifts and with the present law income tax rules regarding the constructive distribution of property or services to shareholders. However, it has been suggested that this rule, as drafted, could technically tax farmers and fishermen on the personal use of their own produce. 21

2. Invoice requirement/credit mechanism

Under the bill, business purchasers would receive tax credits for VAT paid by domestic sellers of inputs or for VAT paid on imported inputs. Although tax would have to be paid by sellers on each

20 See, sec. 10(9) of the New Zealand VAT Act, supra, and art. 11A(1)(b) European Economic Community's Sixth Council Directive of May 17, 1977, "On the Harmonization of the Laws of the Member States Relating to Turnover Taxes-Common System of Value Added Tax: Uniform Assessment," Official Journal No. L145.

21 See, ABA Report, at p. 162.

transaction at every stage of production and distribution, credits would also be provided to all purchasers (except the final (nonbusiness) purchaser (the ultimate consumer)), so the net taxable amount at a particular stage of production or distribution represents the value added by that taxpayer at that stage of production or distribution. VAT credits prevent the imposition of multiple layers of tax with respect to the total final purchase price.22

The VAT credit would be used to reduce VAT liability. If VAT credits exceeded VAT liability, an amount equal to that excess is refunded to the taxpayer.

In order to receive a credit, a business purchaser would be required to possess an invoice from a seller that contains the name of the purchaser and indicates the amount of tax collected by the seller on the sale of the input to the purchaser. However, regulations could waive the invoice requirement where the amount of credit is de minimis, the taxpayer through no fault of his own does not posses a tax invoice, or the amount of credit can be reliably documented by sampling or some other method.

It is often argued that one advantage of the credit invoice method of collecting a VAT is that enforcement is enhanced because invoices are available for audit purposes.23 In addition, the VAT possesses a degree of self-enforcement since the tendency by sellers to underreport sales and reduce taxes will be offset by the incentive of purchasers to report sales at their full price in order to receive full tax credits. However, these enforcement mechanisms are useful only if there is a credible threat of audits. Also, at the retail level, there is no incentive for the final consumer to counter the sellers' incentive not to report sales since the final consumer does not receive a VAT credit.24

Credits should only be available to businesses when purchases are used for business purposes. If final consumers receive credits, no net tax is paid. For example, an automobile used for nonbusiness purposes would entirely escape tax if credits were allowed on the purchase for nonbusiness purposes. The bill would disallow credits for property not used for business purposes. This may, however, lead to administrative complexity, in that whether something is subject to the VAT depends on the use to which the item is put, not just the identity of the purchaser. Thus, there may be significant avoidance of the VAT with respect to purchases of business property that is used for nonbusiness purposes. Similarly, credits should not be allowed for inputs allocable to nontaxable transactions. If property or services are used partly for nonbusiness purposes or partly for nontaxable transactions, the amount of VAT credit allowable would only be that amount allocable to taxable business transactions.

22 For an example of how this operates, see Example 2 in C.3., pp. 15-16.

23 See, for example, Charles E. McLure, "Tax Restructuring Act of 1979: Time for an American Value-Added Tax?" Public Policy, Vol. 28, No. 3, p. 306.

24 See U.S. General Accounting Office, The Value-added Tax-What Else Should We Know About It?, PAD-81-60, March 3, 1981, pp. 32-34.

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3. Zero-rated items and exemptions from the VAT

a. In general

Exclusions from the VAT

Most VAT experts believe that the simplest and most efficient VAT would impose a uniform, flat rate of tax on a broad base of goods and services. However, economic, social, political, and administrative factors often dictate that certain goods and services are either excluded from the VAT or are subject to the VAT at a reduced rate. For example, a VAT that would impose a flat rate of tax on all consumption is considered by some to be regressive because consumption (as a percentage of income) falls as income rises. Therefore, in order to mitigate regressivity, almost all VAT systems adopted to date provide exclusionary relief for certain basic necessities such as food, clothing, shelter, or medicine. Certain enterprises (such as small businesses or farms) often are exempted from the VAT because both the compliance costs of the taxpayer and the administrative costs of the government are considered to outweigh the benefits of additional tax collections. Other goods or services often are eliminated from the VAT system because of the difficulty in accurately measuring the amount of value added (for example, financial services). Finally, exported goods generally are not subject to the VAT (this is generally accomplished by permitting the exporter to claim a credit for the VAT previously paid on the item being exported).

Goods, services, or enterprises may be taken out of a VAT system either by providing a zero rating or an exemption. There are significant differences in the two alternatives. If a sale is zero rated, the sale is still a taxable transaction, but the rate of tax is zero percent. Thus, sellers of zero-rated goods or services will not collect or remit any VAT on their sales. However, sellers of zero-rated goods or services may claim refunds for the VAT they paid with respect to purchased goods and services. Likewise, sellers that are exempt from VAT on their sales of goods or services will not collect any VAT on their sales. However, such sellers may not claim any refunds of the VAT they may have paid on their purchases.

Examples of zero rating and exemption

Whether a sale is zero rated or exempted from the VAT will have different effects upon the seller and the government, as shown in Examples 1-3 below.

Example 1. Assume a manufacturer purchases cotton from a supplier for $1000. The supplier has no purchases that are subject to the VAT. The manufacturer converts the cotton into clothing which is sold for $1200. The jurisdiction in question levies a VAT at a rate of 10 percent.

If the jurisdiction provides VAT relief for clothing but not cotton, either through exemption or through zero rating, the results would be as follows:

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In the example above, if cotton rather than clothing were the item to which relief was granted, either an exemption or a zero rating would produce the same result, as follows.

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The stage in production at which the VAT relief is granted may affect the amount of total taxes collected. A VAT system that zero rates sales at the final stage of production has the effect of refunding all VAT collected throughout the production of the item. A system that zero rates an intermediate step of production will result in the same amount of tax being collected as if no relief had been granted.

Example 2. Assume the same facts as in Example 1 above, except that the manufacturer sells the clothing to a retailer, who in turn sells the goods to consumers for $1500. The results of providing a zero rating at various stages of production are as follows.

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