We've all come across VAT, or IVA as it's known across the border in Spain. The tax applies across the European Union so, if Gibraltar is a member, why don't we pay it here? Do we benefit from being outside the VAT zone and should we exploit the fact?

Essentially, VAT is a European form of consumption tax. There are other systems around the world; anyone who has been to the US will have noticed shelf prices suddenly "marked up" at the till by around 7% on average – invariably resulting in a new price involving lots of small change. Most countries impose some sort of sales tax – although the systems vary widely. I shall concentrate on the European version.

In Europe, VAT is more than a simple sales tax charged at the till when purchasing something in a shop. As the name implies, VAT is imposed at every stage where value is seen to be added. The clue is in the name and that is the same in all European languages – for example Spain calls it Impuesto sobre el valor añadido or IVA, and the French know it as the Taxe à la valeur ajoutêe, or TVA. In whatever language, however, it's still a tax.

When acceding to the European Union, new member states also sign up to the VAT rules. They do this by joining the Customs Union, which is one of the main benefits of EU membership. And herein lies the answer as to why there is no VAT in Gibraltar. Although we joined what was then the EEC in 1973, alongside the UK, we did not join the Customs Union. Hence there is no VAT and, because our government duty is also so much lower, some things in Gibraltar such as alcohol, cigarettes, luxury goods and fuel also cost less – one of the reasons why tourists flock here.

For Gibraltar to impose European-style VAT would mean that all this changes too – so it's not likely to happen. Gibraltar could impose a unilateral sales tax in theory but I'll leave that one to the politicians! An interesting consequence is that when one flies from Gibraltar to the UK, one should exit through the "green channel" – not the blue "arrivals from the European Union" lane – even though we are in the EU.

Why do the rates vary across the European Union? As with most other EU laws, the rules come in the form of a Directive. This has been amended over the years but for VAT issues, the EU is currently bound by Directive 2006/112/EC (as I'm sure you knew!) under which EU governments are permitted to set their own rates – to suit their own economic circumstances. The minimum EU-wide VAT rate is set at 15% – and, where a reduced rate is allowed on certain goods, this must be at least 5%. At present, the maximum rate charged is 25%; currently paid by the unfortunate residents of Denmark, Sweden and Hungary. The UK rate was increased in January to 20% – the highest ever in Britain. In 2010, Spain increased VAT to 18% – still less that many of her European neighbours.

How does VAT work in practice? Imagine a manufactured item; say a wooden table. It might start out as a chunk of wood sold by the forest owner in Finland to a timber company in France. The wood is sawn into the requisite sizes – "refined" if you will – and then sold to a furniture maker in Germany. Finally the finished table is sold to a family in Spain. At every stage in this process, value will have been added. And VAT will be accounted for at every stage. But hang on. If the tax were around 20% each time, wouldn't that make the final price impossibly high? This is where it gets complicated. Provided that each company paying the tax – or at least accounting for it – at every stage as the raw material is transformed into a table is VAT-registered, then the tax will only finally be paid at the end of the process.

In the case above, it's our Spanish family who will end up paying the full VAT (at 18% in Spain as we saw above) on the total value of the table. This is because they are the final consumers. Therefore, VAT is considered an indirect, consumption tax – the more one consumes, the more VAT one pays.

The whole idea is that the tax is effectively accounted for throughout the process while the reclaim system along the way avoids the possibility of double taxation. Consumers – what one might call "end users" – pay the tax if they are in the VAT zone of course. VAT is generally charged in the place the goods are supplied. VAT on services is generally charged where the recipient is based.

For example, anyone going to the theatre in Spain cannot reclaim the VAT on the ticket price for they have "consumed" the ticket in Spain. But we can reclaim the IVA we have paid on goods bought in Spain if they are brought across the border into Gibraltar. It's a bit of a hassle, but for bigger ticket items it is well worth doing. Bear in mind that anything one brings into Gibraltar must be declared. With certain exceptions, import duty will be payable, so the IVA reclaim becomes even more important; otherwise one is being taxed twice.

As always real life is often more complicated than my simple example above but this is broadly how it works. For companies the costs in man hours involved in registering for VAT and subsequently compiling regular returns can be prohibitive. Sadly, VAT fraud has also become big business. One of the most common scams is known as Missing Trader Intra-Community – or "Carousel" – fraud. It's nothing to do with fairgrounds but the analogy is a good one. Round and round it goes with the fraudster claiming the VAT refund without ever paying the VAT itself. Mysteriously then going out of business, he disappears with the VAT reclaim monies. In the UK alone, the cost of "carousel" fraud to the exchequer in 2009 was said to be some £2bn.

Clearly, Gibraltar is in a competitive position vis-à-vis the EU by not imposing VAT. Consider non-EU members with whom Gibraltar competes in other areas, such as the Channel Islands and the Isle of Man. In Guernsey, like Gibraltar, there is no sales tax, while Jersey imposes a sales tax – known as GST – which is increasing from 3% to 5% in June as a result of the island's budgetary requirements. In the Isle of Man, however, VAT applies at UK rates. Hence it was raised to 20% following the UK government's decision to use increased VAT receipts as a key component of the British budget deficit reduction plan.

Last month I wrote about the new Gibraltar corporate tax rate of 10%. Expanding my thoughts, I looked at other reasons why individuals and firms might be attracted to Gibraltar when considering where to set up shop. Under certain circumstances the absence of VAT could be another significant advantage. As mentioned earlier, VAT for services is generally charged where the recipient of the service is based. This means that, for as long as Gibraltar remains outside the Customs Union, a Gibraltar company receiving services from elsewhere in the EU will not suffer VAT. This has led to many enquiries over the last few years for companies wanting to establish a base in Gibraltar, which is good news for all of us.

As always, good, sound advice should be sought at the earliest opportunity. Not only relating to the tax itself but also whether it might be cost effective to employ an independent specialist firm to take control of registering for VAT – and compiling those regular returns. The dangers of non-compliance are high.

I ended last month's column by explaining why business owners should consider setting up new ventures in our jurisdiction. Gibraltar's combined offering of EU membership, very low corporation tax rates– and the absence of VAT – starts to look irresistible.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.