If calculated correctly, VAT doesn’t make goods more expensive

By MUNGAI KIHANYA

The Sunday Nation

Nairobi,

25 May 2008

Joe Mutinda says he is confused by all the taxes that he is required to pay to the Kenya Revenue Authority. He writes; “You did an analysis of the new turnover tax a few months ago and I was wondering if you could do the same for VAT. I am a small trader but some of my customers have started asking for VAT (ETR) receipts. I fear that if I register for VAT, my prices will be higher and I might lose business as a result”

Joe, I hope you are aware that if your turnover is below five million shillings, you do not have to register for Value Added Tax – that is, you can opt to remain unregistered without breaking the law. In addition, if you are this category, you can choose to sign-up for the new turnover tax instead of the normal income tax. Again, this is optional.

Your fear that your goods will be more expensive if you register for VAT probably arises from the assumption that you simply add 16 percent to the current charges. This is not entirely correct. If you pay VAT to your suppliers, then you won’t have to increase your prices at all! This is the reason why:

Suppose you buy a product for Sh100 plus VAT. The total cost comes to Sh116. Now if you add a profit margin of, say 25 percent to this, you would sell it at Sh145. This is the price you would charge your customers without collecting VAT.

If you register for VAT, your calculation is slightly different. Adding 16 percent to the Sh145 would bring you selling price to Sh168 and this would probably make you uncompetitive. But that would be the wrong way to work it out. Here is the correct method:

You are buying the product at Sh100 (before VAT), so you add your 25 percent profit margin to this figure to get Sh125 (before VAT). Adding 16percent VAT to this amount yields a final price of Sh145 – same as before registering for VAT!

So where is the catch? When you buy the product, you will pay Sh16 as VAT (bringing the total purchase price to Sh116). When you sell it, you collect Sh20 tax from your customer (this is what increases the selling price from Sh125 to Sh145). Therefore, when you make your VAT returns, you will only pay four shillings to KRA (Sh20 minus Sh16).

However, even though your profit margin remains at 25 percent, the income per item sold is slightly less. Before VAT registration it was Sh29 each (Sh145 minus Sh116) but afterwards it goes down to Sh25 (Sh145 minus Sh116 minus Sh4).

On the other hand, you are likely to lose some customers if you don’t register for VAT. In addition, being registered gives your business a little more credibility thus you might actually attract a few more (larger) customers and therefore make higher sales.