Companies in Germany are generally subject to value-added tax (VAT). However, Section 4 of the German VAT Act (UStG) defines exemptions for certain activities and areas. In this article, you will learn how the VAT exemption under Section 4 of the UStG works and for which activities it is applicable. We also explain the effects of it on input tax deduction and the difference between a genuine and non-genuine VAT exemption. You will also find a comparison of the advantages and disadvantages of a VAT exemption and information on the relevance of Section 4 of the UStG for small businesses.

What’s in this article?

• How does the VAT exemption under Section 4 of the UStG work?
  
• Which activities are exempt from VAT under Section 4 of the UStG?
  
• What effects does a VAT exemption have on input tax deduction?
  
• What is the difference between genuine and non-genuine tax exemptions?
  
• What are the advantages and disadvantages of a VAT exemption?
  
• Is Section 4 of the UStG also valid for small businesses?
  

How does the VAT exemption under Section 4 of the UStG work?

The tax authority levies VAT in Germany on almost all goods sold and services provided. The general VAT obligation applies to companies, sole proprietorships, and freelancers—regardless of whether they operate a business or not. The tax authority requires businesses to add VAT to their sales prices, show it on invoices, and pay it to the tax office as part of their advance VAT return. The regular VAT rate is currently 19%, while the reduced rate is 7%. Germany introduced the latter for key everyday goods and services (see Section 12 of the UStG).

Still, some goods and services are subject to a zero-tax rate. Paragraph 4 of the UStG lists 29 exceptional cases to which this applies. They are subject to 0% VAT, i.e., VAT exemption. Consequently, the business might not record VAT for the product or service on a corresponding invoice. Further, the company needs to add a note to the invoice justifying the tax exemption with reference to the specific section and paragraph of the UStG.

In principle, companies can provide services both with and without VAT exemption. If you want to simplify tax collection in your business, get to know Stripe Tax. With a single integration, taxes are automatically calculated and collected for worldwide payments. Additionally, Stripe Tax provides access to all necessary tax documents and lets you apply for tax refunds quickly and easily.

Which activities are exempt from VAT under Section 4 of the UStG?

The primary aim of VAT exemption by Section 4 of the UStG is to promote certain social and economic areas. For example, medical, social, and charitable activities are exempt. The same applies to numerous activities in the education sector. What’s more, VAT exemption is intended to prevent double taxation in cross-border transactions. Below, you will find a selection of them that are exempt from VAT. However, you need to note that some of the activities listed in Section 4 of the UStG contain subcategories with additional regulations and exemptions:

• Outpatient and inpatient medical services and nursing services
  
• Supply of human organs, human blood, and human milk
  
• Volunteering
  
• Educational services at public or private schools and universities and other general education or vocational training institutions
  
• Cultural services provided by museums, orchestras, zoos, or archives, among others, as well as the organization of theater performances and concerts
  
• Financial and insurance services such as payment processing, the granting of loans, or the sale of insurance policies
  
• Renting and leasing of real estate
  
• Sales that fall under the German Real Estate Transfer Tax (RETT)
  
• Racing bets and lotteries
  
• Intracommunity supply of goods and products to companies in other European Union countries
  
• Cross-border transport of goods
  
• Air and sea shipping activities
  

What effects does a VAT exemption have on input tax deduction?

Input tax deduction is a central concept of the German VAT system. It enables companies to reclaim input tax, i.e., the VAT shown on invoices from the tax office from other companies, and thus deduct it from their tax liability. Input tax deduction means businesses can offset VAT collected on sales against it paid on purchases. This means that, unlike private individuals, companies only pay the net price for goods and services other companies provide, subject to VAT. Those businesses can then deduct input tax from their advance VAT return.

Suppose the company is exempt from VAT in accordance with Section 4 of the UStG. In that case, it can claim net amounts for operating expenses or reclaim the input tax via the advance VAT return if the company also provides services that are subject to VAT. If the company only offers VAT-exempt goods and services, reclaiming input tax is not possible. A distinction must also be made between genuine and non-genuine tax exemptions.

What is the difference between genuine and non-genuine tax exemptions?

Genuine and non-genuine tax exemptions differ in their ability to deduct input tax. The tax authority permits sales subject to genuine tax exemption per Section 4 of the UStG for an input tax deduction. This means that the companies concerned do not have to account for VAT themselves but still receive the input tax paid on input services back from the tax office. Sales that are subject to a non-genuine tax exemption, on the other hand, prevent a company from deducting input tax from their operating expenses.

Genuine tax exemptions

Some transactions that entitle you to deduct input tax are listed below:

• Export deliveries to countries outside the EU
  
• Intracommunity supply within the EU
  
• Transport services to countries outside the EU
  
• Specific financial services
  
• Air and sea freight transport
  

Non-genuine tax exemptions

Some transactions that do not entitle you to deduct input tax are listed below:

• Medical and healthcare services
  
• Sale, renting, and leasing of real estate
  
• School and educational services
  
• Cultural and artistic services
  
• Financial and insurance services
  
• Gambling winnings
  
• Turnover from statutory social security institutions, social welfare institutions, or institutions providing for war victims or welfare services
  

What are the advantages and disadvantages of a VAT exemption?

Advantages of a VAT exemption, Section 4 of the UStG

For companies that do not pay VAT, there is no obligation to prepare a full VAT return and submit an advance one to the tax office. This reduces bureaucracy and saves time. Invoicing is also simpler since it is unnecessary to take tax rates into account or calculate them.

A VAT exemption can also mean that companies have little or no need for advice on VAT-related issues. As a result, this can save on costs, such as for advice from tax consultants.

When VAT-exempt companies sell their goods and services at net prices, customers save money. They do not pay a tax surcharge, allowing them to buy at a lower cost. This is particularly advantageous for private individuals who, unlike companies, cannot reclaim paid input tax from the tax office.

Lower prices can positively impact customer demand and ultimately give VAT-exempt companies a competitive advantage. Moreover, VAT exemption under Section 4 of the UStG can increase international competitiveness if goods and services are sold abroad at a lower price—without the additional VAT amount.

Disadvantages of a VAT exemption, Section 4 of the UStG

Companies affected by a non-genuine tax exemption cannot reclaim the input tax they pay on incoming invoices, provided they only offer VAT-exempt services as described above. This means that the VAT paid on business expenses represents a final cost burden and increases operating costs.

VAT-exempt goods and services could be less attractive for business customers if they want to use the input tax deduction because taxable purchases reduce tax burdens.

If companies generally do not report and account for VAT, they can benefit from simplified accounting. Despite that, it is also possible for them to generate both taxable and tax-exempt sales. This increases the administrative workload, and you might want to pay close attention to invoicing, for example.

Without input tax deduction, larger investments become more expensive for companies—or not any cheaper, due to a VAT refund. In individual cases, this can mean that companies forgo investments, slowing down their development.

Pros and cons of a VAT exemption, Section 4 of the UStG

Is Section 4 of the UStG also valid for small businesses?

Selected professional groups will find the VAT exemption under Section 4 of the UStG relevant to their interests. However, regardless of profession, companies and freelancers in Germany can apply for one as small businesses. According to Section 19 of the UStG, entrepreneurs can voluntarily accept small business status if their annual turnover does not exceed €22,000 in the previous year and €50,000 in the current year. Small businesses generally do not pay VAT and cannot claim input tax deductions in return.

The small business regulation based on Section 19 of the UStG and tax exemption in line with Section 4 of the UStG are, therefore, different regulations that lead to the same result. Section 4 of the UStG is less relevant for companies that apply for VAT exemption and operate as small businesses. As they do not pay VAT anyway, they do not have to check, for example, whether their activities fall under the genuine or non-genuine VAT exemption.