Exemptions for Value Added Taxes Often Overlooked

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The purpose of this article is simple — to provide a basic understanding of value added tax (VAT) and help stakeholders complete sound exemption processes for the Defense Department’s international efforts in foreign countries.

The VAT exemption process, if appropriately implemented and executed, can produce enormous cost savings for the United States. Common knowledge and information are essential since there are numerous stakeholders involved. They include military service members, civilian personnel, industry partners, various U.S. government entities, and various foreign government entities.

VAT is not a new phenomenon as it has existed for decades. It is merely a consumption-based tax charged by foreign countries that serves as a revenue source. The concept is similar to sales taxes charged on purchases of products and services made within the United States. For instance, as of 2019, Hungary’s standard VAT rate is 27 percent and the United Arab Emirates’ standard VAT rate is 5 percent. Value added tax applies to most purchases made within a foreign country, such as those for equipment, materials, facilities and services. Some foreign countries may also impose the tax on items that entities transport into that foreign country from an outside source.

Understanding the importance of VAT and instances where an exemption is applicable is critical for success. It is increasingly significant as the Defense Department continues and expands efforts with allied nations around the world. The National Security Strategy and the National Defense Strategy repeatedly specify the need for strengthened alliances and increased partnerships to provide for the common defense. Further, total foreign military sales for fiscal year 2018 tallied $55.7 billion — a 33 percent increase from total sales for fiscal year 2017.

As a result, it is reasonable to believe the department’s international efforts with foreign countries will continuously increase for years to come. Increased activities will directly impact the amount of U.S. funding spent within foreign countries.

In most cases, the Defense Department and its industry partners can be exempt from paying VAT. Exemption may apply whenever substantive spending occurs on defense-related purchases within a foreign country or when the department or its partners transport items into a foreign country.

Types of efforts can include international deployments, international armaments cooperation, FMS programs and other types of U.S. security assistance. Specific examples are the defense cooperation efforts in Afghanistan, the Navy’s Aegis Ashore sites in Europe, Camp Humphreys in South Korea, and the F-35 joint strike fighter.

VAT exemption can allow international efforts to have reduced installation expenditures, reduced total lifecycle costs, and prevent excessive and unnecessary funding from flowing into foreign countries for which U.S. taxpayers reap little or no benefit. For these reasons, defense entities and industry partners must pursue every opportunity possible to receive VAT exemption on qualifying purchases, which is only possible if the Defense Department receives authority from a foreign country’s government.

Authority is usually documented within country-to-country agreements — treaties, status of forces agreements, memorandums of agreements, memorandums of understanding, a contract, or FMS letters of offer and acceptance. Although administrative in nature, exemption processes can differ widely per effort and per country. Most processes generally require signatures, seals of approval, and forms in both English and the foreign country’s primary language.

There generally are two options to receive VAT exemption approval: time of sale and reimbursement. Time of sale allows the purchaser to complete a purchase free of VAT (approval or authority for exemption is granted at the time of purchase). For example, a time of sale VAT-exempt purchase of $1 million in Hungary would allow the purchaser to avoid paying $270,000 in VAT associated with the purchase.

For the other option, reimbursement allows the purchaser to complete a purchase inclusive of the tax and obtain reimbursement from the foreign country after the purchase.

Using the prior example, a purchaser would pay $1.27 million at the time of purchase and later be reimbursed the $270,000 VAT assuming all requirements were fulfilled.

Each stakeholder has specific exemption-related responsibilities, but all must work together and in sequence for successful outcomes. The stakeholders can be broadly separated by U.S. entities and non-U.S. entities. The primary U.S. entities consist of the Department of State, the Defense Security Cooperation Agency, defense programs and industry partners.

The State Department creates and maintains U.S. agreements with foreign countries where VAT exemption authority is included. It also manages all facets of U.S. security cooperation programs including FMS cases. The DSCA supports U.S. national security interests and leads cooperative efforts with foreign countries through training, educating and advising.

Defense Department programs, which may consist of military service members and civilian staff, execute international efforts and are responsible for managing the associated VAT exemption processes. Personnel involved can include those in program management, contracting, financial management, engineering and logistics. These personnel complete the day-to-day activities, working upstream with the foreign country entities and downstream with all industry partners and other U.S. government entities involved.

Industry partners, whether prime contractors or subcontractors, work with the Defense Department programs and execute purchases for products or services related to international efforts. VAT exemption is of specific importance to industry partners since they submit invoices to the department’s programs to collect payments for work completed.

The primary non-U.S. entities consist of the foreign country’s foreign ministry, ministry of defense, tax or duty office, and merchants where U.S. entities make purchases. The foreign ministry negotiates agreements with State. The ministry of defense maintains authorization to permit VAT exemption on purchases related to defense efforts. The tax or duty office manages the country’s collections and oversees the VAT exemption activities. Lastly, merchants support the foreign country’s agreements by allowing U.S. entities to complete VAT-exempt transactions on qualifying purchases.

It is typical for exemption processes to vary for each effort based on the foreign country involved. Although there is not a universal VAT exemption process, there are some specific actions and initiatives that can make them more effective and efficient.

Successful VAT exemption processes require effective communication. Otherwise, teams will encounter significant challenges executing the process over the effort’s life.

Defense Department personnel responsible for managing the exemption should initiate communication with all appropriate stakeholders — both U.S. and non-U.S. entities identified above — immediately after effort initiation. Early and consistent communication will not only allow for universal understanding of responsibilities, procedures and required forms, but also result in “buy-in” from entities involved.

With international efforts come different countries, cultures, currencies, time zones, and more. Since VAT exemption processes are meticulous, they should not be any more convoluted or challenging than needed. Sound communication will help teams overcome barriers and achieve success.

If international efforts have anything in common, it is that personnel changes happen regularly. To mitigate the loss of personnel with institutional knowledge who complete critical parts of the VAT exemption process, it is necessary that entities responsible for managing the process create and regularly administer training for appropriate stakeholders. VAT-related training is not typically a priority when entities initiate international efforts; however, it is a valuable investment that can prevent large administrative burdens such as misunderstanding of required procedures or unnecessary backlogs that take months or years to recover.

It also serves as an effective mechanism to share information, promote standard operating procedures, secure the maximum amount of savings, and establish credibility with a foreign country’s government. Training events should particularly highlight the importance of documentation requirements since they are a necessity of any process within any country.

Meanwhile, most countries default to the reimbursement option for VAT exemption. However, some countries also allow exemption through the time-of-sale option. The Defense Department and its industry partners should always attempt to utilize the time-of-sale option, if available, since there are multiple advantages. First, the purchaser is not required to pay the tax. This results in immediate cost savings or avoidances during purchases of products or services. 

Second, the purchaser does not have to complete the reimbursement process to recapture VAT from a foreign country. Recapturing the tax from foreign countries can potentially take as long as several years and usually requires purchasers to establish a VAT-exempt account within the nation. There is also the risk that some nations may be reluctant to complete timely reimbursement action, as such action is dependent on each country’s financial situation.

The reimbursement process is unique to each country, but is generally cumbersome, lengthy, and requires extensive documentation and authoritative signatures. Some nations may also permit exemption on entire contracts between the Defense Department and its industry partners that span several years. The department and industry partners shall pursue these opportunities if foreign countries are willing to provide such “umbrella” permission.

This can further alleviate administrative burdens during the exemption process by shifting exemption approval per purchase to U.S. organizations instead of the foreign country organizations so long as the purchases fall within the scope of a contract.

Contract clauses are also very important on contracts where VAT exemption may apply. Contracting officials must properly plan for and incorporate unique clauses per effort pertaining to exemption. These actions will ensure business efforts support country-to-country agreements and motivate industry partners to complete exemption efforts. The Federal Acquisition Regulation and Defense Federal Acquisition Regulation Supplement provide guidance and clauses for defense programs to consider incorporating into contracts. An example of a basic clause is: “Invoices submitted in accordance with the terms and conditions of this contract shall be exclusive of all taxes or duties for which relief is available.”

In addition, DSCA policy requires any country receiving U.S. assistance to provide VAT exemption for any articles, equipment, materials or commodities. If appropriate clauses are not present or sound exemption processes are not in place on international efforts, the department risks encountering requests for equitable adjustments or contract claims from its industry partners.

The defense community should have a common understanding of VAT to capitalize on the opportunities to ensure maximum exemption. The Defense Acquisition University has resources to assist with VAT exemption on international efforts. It has an online tool (www.dau.mil) that defense programs and industry partners can use to calculate the exemption. The university also expects to have an exemption online training course created by the end of 2019. 

Stephen Speciale (stephen.speciale@dau.mil) is a professor of financial management at the Defense Acquisition University. Matthew Lawrence (matthew.lawrence@mda.mil) is a program manager for the Missile Defense Agency. Both have experience managing value added tax exemption activities for the Defense Department overseas.

Topics: Defense Contracting, Contracting