Are digital products subject to VAT?

More than 80 countries around the world apply VAT to digital goods and services sold by nonresident businesses, including software and SaaS subscriptions. Typically, sales made by nonresident companies are subject to special VAT rules, separate from the requirements for local businesses. VAT rules can also vary based on the type of transaction, with sellers only responsible for collecting VAT on B2C transactions in many cases.

However, the specific requirements for VAT compliance are unique to each country, and changes are frequent in 2024. Make sure you consult a tax professional and consider an automated solution for global tax compliance to avoid any penalties or fees.

Determining if your digital product is subject to VAT

To determine whether VAT applies to the sale of your digital product or service, there are three main factors to consider:

1. Customer's location: You need to identify the location of your customer, as VAT regulations vary by country. Common pieces of evidence for customer location determination include billing address, customer account address, and credit card country.
   
   
2. Taxability of your product: Your digital product or service needs to qualify as a digital good or service for VAT purposes. This typically means that it is delivered electronically over the Internet or an electronic network, is automated, relies on technology, and is not a physical good.
   
   
3. Customer’s VAT registration status: If you sell to other businesses located in VAT countries, you should collect and validate their VAT registration numbers (VAT IDs). In many countries, sellers are not responsible for VAT on B2B transactions with the proper documentation, and the responsibility of accounting for VAT is transferred to the buyer through a reverse charge mechanism.

Getting VAT compliant

To ensure compliance with VAT regulations, here are the general steps that a US-based company selling software or other digital products should take:

1. Collect customer addresses and VAT IDs: Even if you are not registered for VAT, collecting customer VAT IDs can save you expenses in the future. This step can be taken right away for customers outside the US.
   
   
2. Understand your VAT obligations: Determine where you have VAT obligations by cross-checking customer locations and the product taxability and registration thresholds in each country. Each country has its own registration threshold, which triggers the requirement to register for VAT. In some cases, you may be required to register after your first sale in a country.
   
   
3. Monitor VAT exposure and register in exposed jurisdictions: If your sales reach the registration threshold in a specific country, you are required to register for VAT in that jurisdiction. While each country has its own processes for registration, these procedures are simplified in the European Union through the One-Stop Shop (OSS) process, where you can register with one member state on behalf of the entire EU.
   
   
4. Apply VAT where necessary: Identify transactions that require VAT collection and apply the correct VAT rates to those invoices. If the country utilizes the reverse charge mechanism for B2B transactions, you should still validate VAT IDs for B2B transactions to confirm the customer’s status, but charge VAT if a valid VAT ID is not provided.
   
   
5. File VAT returns, make payments, and keep records: Periodically file VAT returns with the jurisdictions in which you sell, reporting the VAT collected and remitted. Be prepared for foreign exchange conversions and cross-border payments in various currencies. Many countries also have a legal requirement to keep VAT records for a certain period of time.

Risks of delaying compliance

Delaying VAT compliance can expose your business to various risks:

1. Audits: As VAT legislation for digital goods is relatively new, audits for international sellers are increasing. Facing an audit for which you are not prepared can result in fees and penalties that can significantly impact your business.
   
   
2. Paying out of pocket: Regardless of whether your customers pay VAT, you are responsible for the VAT on the sales you make. If you are audited or register late, you may have to pay the VAT out of pocket, along with penalties and fees.
   
   
3. Reputational risk: When expanding internationally, your compliance with VAT rules may be questioned by potential business partners or customers. Failure to comply with VAT regulations can harm your reputation and even lead to blocked business opportunities.

Understanding VAT and its implications for companies selling software or other digital products is crucial for those with global ambitions. With VAT applying to digital goods and services in around 100 countries worldwide, being VAT compliant can unlock a larger market for your digital product. By following the necessary steps to ensure compliance, such as collecting customer information, understanding your obligations, and registering and filing VAT returns, you can avoid potential audit risks, out-of-pocket expenses, and reputational harm.