To estimate future costs, a company must know the difference between direct and indirect taxes. Tax is a mandatory charge imposed by the government or other organizations to collect tax revenue to provide the public with services and infrastructure. The taxes collected by the government are used for different social programs in the country.
In general, there are two types of taxes. A direct tax is paid directly to the government by the taxpayers and can’t be shifted toward anyone. At the same time, an indirect tax can be shifted or passed on by the taxpayers.
Businesses can reclaim the tax they’ve paid through their customers by paying low incomes to their workers and low dividends to the company’s shareholders. Here are the main differences between a direct and indirect tax.
What is Direct & Indirect Tax
Understanding direct and indirect tax differences can help a company ensure compliance with the country’s laws. They can also know their future costs and the money they owe. Compliance with tax laws also ensures the company doesn’t face fines or penalties. Here are the main differences between a direct and indirect tax.
| Direct Tax | Indirect Tax |
| Collected from individuals and companies | Imposed on goods and services |
| It is a progressive tax | It is a regressive tax |
| It’s proportional to the income or assets of the taxpayer | Indirect tax is charged according to the value of a good or service |
| It is not transferable, and the taxpayer endures it | It is transferable and paid by the consumers in customs duty excise duty. |
| Some examples are corporate tax, income tax, and property tax | Examples are custom duty, VAT, GST, and tariffs |
Difference Between Direct Tax and Indirect Tax with Examples
Let us look at the direct tax and indirect tax in detail.
Direct Tax
Direct tax is the one that is imposed directly on an entity and individuals and can not be transferred to another individual or organization. It is the legal responsibility of the taxpayer to pay their tax, and it is collected directly by the government authority.
Direct tax is complex, so most taxpayers get help from direct tax software. This process can be complex if a firm has multiple branch offices in different cities. Also, the companies must consider the time and accuracy of documents. Hence, it is necessary to use sturdy tax software to automatically and speedily finalize a company’s financial statements.
Direct tax is dynamic, which means the tax will likely increase with income. Individuals with low income will likely have a small tax load, while someone with a high income will pay a relatively large amount of tax.
Examples of Direct Tax
There are five examples of direct tax, which are given below,
- Business income tax
- Personal income tax
- Real estate tax
- Property tax
- Capital gains tax
-
Business Income Tax
The government imposes Income tax on the income earned by a business and individuals in a financial year under their authority. This tax is charged at different rates related to the income type.
Businesses need to know how to calculate and understand the income tax; these corporations are called c corporations. Certain corporations pass their taxes to owners, such as LLCs, sole proprietorships, and partnerships, called S corporations.
-
Personal Income Tax
Personal income tax is also known as individual income tax. This tax is applied to a person’s salary, investment, or income.
In the UAE, the government doesn’t impose any kind of income taxes on individuals. However, the citizens pay 5% VAT to purchase goods and services. This exemption is for both citizens and foreigners living in the UAE.
-
Real Estate Tax
The state or federal authorities levy an estate tax on assets inherited by individuals at their death, whose value increases by a certain amount. Before the distribution of assets to the inheritors, the estate pays the tax.
-
Property Tax
It is a tax levied on residential and commercial properties like land and buildings. It is an annual amount the property owner pays to the local authorities.
Like income tax, property tax is also an important source of revenue for government authorities as it helps build schools, hospitals, roads, police departments, and other public services.
-
Capital Gains Tax
Capital gains tax is a tax on the profit earned when you sell an asset whose value has increased, such as real estate or stocks. Capital tax rates can be different, and this difference depends on two elements, income level and the period of keeping an asset.
Suppose a company purchased 200 “Company A” stock shares for $20,000 in 2015. After three years, the company sold those shares for $40,000. The long-term capital gain will be $20,000. This capital gain is liable to federal capital gains tax or state tax.
What is Indirect Tax?
Indirect tax is a form of tax imposed on goods and services. Indirect tax is a tax that can be transferred to an individual or an entity. The taxpayer pays the tax to the government through a mediator; hence, the government is paid indirectly. The company passes the tax to the consumer through sales tax, who ultimately pays the tax.
The tax rate is flat, so the tax burden is regressive. It means the tax is applied to all individuals equally, irrespective of their incomes. Consequently, individuals with low incomes will pay an unreasonable amount of tax, and people with higher salaries will pay a lower amount.
Indirect tax is constantly changing; therefore, navigating the term indirect tax is necessary. No matter the size and location of a company, understanding the critical concept of indirect tax and finding the latest software is mandatory.
Examples of Indirect Tax
Indirect tax can be divided into four main types,
- Value Added Tax
- Sales Tax
- Excise Tax
- Turnover Tax
-
Value Added Tax
A value-added tax (VAT) is a consumption tax on goods and services imposed at every stage of the supply network where value has been added. As a result, a value-added tax is added from the initial point of production of the goods and services to the selling point. Ultimately, VAT is paid by the consumer of the product and services.
For example, if a product costs $30 and has 10% VAT, the customer will pay $35 to the seller. The seller keeps $30 and pays the remaining $5 to the government.
-
Sales Tax
Sales tax is the tax imposed on the lease or sale of goods and services. The sales tax is controlled and handled by the state governments only. Sellers must collect sales tax from customers and remit it back to the government, acting as the tax collector.
Tax authorities can only collect tax revenue from sales made to consumers. Sales taxes vary in different states, which makes them difficult to understand.
-
Excise Tax
Excise tax is imposed and collected on specific goods like tobacco, fuel, alcohol, etc. The companies mostly pay excise taxes, passing the costs on to the consumers. An excise tax is also a hidden tax, as it is not specifically mentioned on the client’s receipt. These taxes need to be visible, which makes it quite hard to calculate.
-
Turnover Tax
A turnover tax, also known as a gross receipts tax, is imposed on a company’s gross sales without any deductions for a company’s business costs, like the value of goods sold and other compensations. When gross receipts tax is imposed on a business, its costs are often passed on to the customer.
Endnote
As discussed above, the difference between direct and indirect tax is that a direct tax can not be shifted and reminded of the responsibility of the one it was imposed on. While an indirect tax is the opposite, meaning it can be moved to another individual or group. Undoubtedly, both taxes have their complexities and significance, but they help improve the economy.
Consult Al-Riyady for all your business and tax-related problems. Make sure to comply with the tax regulations on time by getting guidance from our expert team. We also provide Accounting Services, Bookkeeping, Business Feasibility Studies, and more.
