Sales tax: why it is never the business's money

When a shop rings up a sale, the amount in the till is often more than the shelf price. Part of it is sales tax, a charge added to the selling price and collected from the customer. Because the money passes through the business’s bank account, it is tempting to treat it as extra takings.

It is not. Sales tax never becomes the business’s money, however long it sits in the account. Seeing why is the key to recording it correctly.

Money that passes through, not money that stays

The business stands between its customers and the tax authority. When a customer buys goods, the business adds sales tax to the price and collects it.

The tax was not earned by trading. The customer paid it because the law requires it to be collected.

The business holds it temporarily, like a cloakroom holding a coat, until it passes the money to the authority. It acts as a collector, and the money is in transit.

Two flows in opposite directions

Two streams of sales tax run through a trading business. On its sales, the business collects tax from customers and owes it to the authority. On its purchases, the business is the customer, so its suppliers charge it sales tax.

A registered business can reclaim the tax it paid on purchases from the same authority. So one stream is tax gathered for the government, and the other is tax the government will refund. The money settles between the customers and the tax authority, never as the business’s own.

Why sales are recorded without the tax

Tax charged on a sale was never income, so it stays out of the sales figure. If a customer pays RM1,060 for goods priced at RM1,000, only RM1,000 is recorded as sales.

The RM60 is set aside as tax owed to the authority. Revenue measures what the business earned by trading, and it earned RM1,000.

Including the tax in sales would inflate revenue with money that was only passing through.

Why purchases and expenses are recorded net too

The same logic applies to purchases. The business buys RM500 of goods and is charged RM30 of sales tax.

It records a purchase of RM500. The RM30 is tax it expects to reclaim, so it is set aside as an amount the authority owes back.

Recording RM530 as the purchase would overstate costs and understate profit, charging the business for something it will get back. For a registered business, sales, purchases and expenses are all recorded at their tax-free amounts.

The single account that keeps the score

The tax goes into an account of its own. Tax charged on sales is added to what the business owes the authority. Tax paid on purchases is set against it.

The account shows the difference between what has been collected and what has been paid. That balance is the business’s real position with the tax authority. It sits on the statement of financial position, not the income statement, because it shows who owes whom, not how well the business traded.

A liability most of the time, an asset sometimes

Most trading businesses sell more than they buy, so they collect more tax than they pay. The account then shows a balance owed to the authority. That is a liability, like an unpaid supplier.

Occasionally the picture flips. A business that bought heavily but sold little may have paid more tax on purchases than it collected.

Then the authority owes the business, and the account becomes an asset, a receivable awaiting refund. Either way, it is a debt in one direction or the other, never income or expense.

What settling up actually does

When the business pays over the tax it collected, its bank balance falls and the amount it owed the authority falls with it. Profit does not move.

No expense appears, because no value was used up in trading. The payment clears a liability, like paying a supplier. If settling the tax reduced profit, the business would be losing money that was never its own.

The idea worth carrying away

The business is a collector of sales tax, not an owner. Money charged on sales belongs to the government from the moment it is added to the price. Money paid on purchases is owed back by the same government.

That is why sales tax appears on the statement of financial position as a debt one way or the other. It never appears on the income statement as income or expense.

If your child keeps treating sales tax as part of a sale, one of our teachers can walk through one transaction from the till to the tax authority. That makes clear which figures belong to the business. Book a trial class to try it.