Greetings in Chapter 5! The word “tax” can be scary, but generally speaking, in the business world, there are two distinct buckets it would typically fall into. It is vital to understand the difference between the two buckets because one will impact your profit, and one will impact your price. Let's differentiate Direct and Indirect taxes.
Every business interacts with the government in two ways: as a taxpayer and as a tax collector.
Direct taxes refer to the taxes that a business pays directly to the government. Corporate income tax is the most popular example. The tax percentage is calculated based on the profit earned. In case your corporation has a terrible year with zero profit, you would generally pay zero corporate income tax. The tax effectively lowers the Net Income, which was explained in Chapter 1.
Indirect taxes apply to goods and services, not to profit. Popular examples are Value Added Tax (VAT), Goods and Services Tax (GST), or Sales Tax.
The secret of indirect taxes is that they are neither your money nor your expense.
VAT is collected by the seller from the customer, which is to be paid to the government by the seller of goods or services.
Non-finance managers could risk treating that additional $10 as cash they're free to spend. It is cash trapped that will eventually be passed on to the tax authority.
Direct taxes diminish your profit, while indirect taxes are merely a pass-through, which you collect for the government. Do not mistake your sales tax collections for your operational cash! The next lesson will explore why the profit on your Income Statement isn't the figure that the government actually taxes. It's time for quick exercise.