Credit versus VAT and income tax – what do you need to know?

The words ‘VAT’ and ‘interest’ usually appear side by side in unpleasant circumstances related to the late settlement with the Tax Office. In reality, however, credit and VAT are linked, although these relationships are not always obvious. Understanding them can help you avoid costly mistakes and even increase your profits.

Credit and VAT

Credit and VAT

For those entrepreneurs who are not VAT payers, the matter is quite simple: VAT is simply part of the price. The entrepreneur does not have to worry about him, he is only interested in gross amounts.

VAT payers have a bit harder in this respect. When VAT payers talk about revenues, costs, or investments, they generally use net amounts. They are the basis for calculating profit, VAT is something that can be omitted. Of course, this tax can have a significant impact on liquidity, but profit as such is not affected.

When we add credit to this puzzle, stairs appear. With the use of net amounts in the blood, you can “calculate” the cost of credit based on the net amount, but it would be a mistake – after all, you credit the entire payment, not just its net portion.

In simplified terms, it can be said that in the case of a loan, you also pay interest on VAT (in simplified terms, because it really applies not only to interest but also to all other costs, which are expressed as a percentage of the loan amount, e.g. commission or insurance.) It is worth remembering when you combine loan costs with e.g. profitability.

Fortunately, taking into account the fact that loans are for gross amounts is very simple in such calculations: you simply “add” VAT to the cost of the loan. If you use the APRC in this case (and we hope it is so), then you add VAT to the APRC.

You are considering buying a product on credit

You are considering buying a product on credit

The net price of the purchased goods is 20 thousand. USD, the VAT rate is 23% and the APRC of the loan is 20%. Annual sales profitability is 25% (i.e. every zloty of working capital brings 25 groszy annually). Will it be profitable to use the loan?

Let’s see. Remembering that “we also pay interest on VAT” we add VAT to the interest rate (in our case – to APRC). We do it exactly the same as we would do by adding VAT to each net price:

It turns out that after taking into account the impact of VAT on the cost of credit, the cost of raising capital would be higher than its profitability – the loan is therefore unprofitable.

Your supplier offers a 30-day payment period or a 1.5% discount for cash payments. The goods are charged the basic (23%) VAT rate. You don’t have cash, so the only way to get a discount is to get a loan. You want to check the maximum interest rate (APRC) on a loan so that the rebate benefits are higher than the cost of the loan.

A 1.5% discount on cash payments means that the 30-day payment deadline actually means a loan that bears 18.3% per annum. This, in turn, means that if you were to finance a cash purchase with a loan, its cost (APRC) may not exceed 18.3% per annum, and – and this is important – we must remember that you will also finance VAT. The cost must, therefore, be correspondingly lower.

To calculate the maximum allowable cost, we ‘remove’ VAT from the APRC by doing the following:

Therefore, it will be worthwhile to use a loan for a cash purchase if we find a loan whose APRC is lower than 14.9% (the lower the interest rate, the greater the additional profit we will generate thanks to the discount).

Using a loan whose APRC is higher than 14.9% will mean losses. So if you do not find one, it is more profitable to use a trade credit: give up the discount and pay for the goods after 30 days.

Credit and income tax

Credit and income tax

However, the relationship between credit and taxes goes beyond VAT: interest on credit is, after all, a cost. In addition, as a rule, they are also tax costs, in contrast to the cost of equity, which from an accounting point of view is not even a cost.

The fact that loan costs are tax costs is one of the reasons why foreign capital is usually cheaper than equity.

External financing allows not only to increase the rate of return on equity but also to improve tax efficiency. The cost of invested equity is not a tax cost. There are also some legal restrictions related to the withdrawal of these measures. Even if it is possible, we must make sure that such a withdrawal does not require tax settlement.

In turn, external financing allows for the inclusion of costs incurred in the tax account. However, you must remember about the so-called thin capitalization – i.e. rules limiting the recognition of interest on liabilities exceeding equity capitals. These provisions will probably change from January 1, 2018.

Leave Comment

Your email address will not be published. Required fields are marked *