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VAT - A Short Guide

William Simon

"The nation should have a tax system that looks like someone designed it on purpose."

A (Very) Short Guide to VAT

If you are completely new to VAT you might find the following overview helpful to understand the concept.

VAT was first introduced in 1973 when the UK joined the European Economic Community (EEC). It was the first tax in the UK to be based on European legislation. From January 1, 2021 the UK is no longer constrained by the EU VAT rules.

The notes below relate to the post-Brexit position from January 1, 2021.

By any other name, VAT is a sales tax although the way it is administered makes it more complicated than a flat rate tax.


Overview

VAT is charged on most goods and services although some are exempt, some are outside the scope of VAT and others are charged at a zero rate.

VAT is charged by all businesses - either individuals, partnerships or limited companies - which are VAT registered in the UK. It is an offence to charge VAT if your business is not VAT registered.

Also, VAT is charged on goods and some services that are imported from countries outside the UK.

A business which is registered for VAT can reclaim the VAT paid on any goods or services used in their business.

There are currently three rates of VAT, although these rates do change from time to time. The rates are:

     ➣  Standard - 20%

     ➣ Reduced - 5%

     ➣ Zero - 0%


It’s Not That Simple

Why is VAT so complicated?

Unlike direct taxes such as income tax or capital gains tax, VAT relates to each specific transaction. So a business may make a sale and charge VAT on that sale - but if the next sale has different circumstances it may not be VAT-able.

A good example of this are accountancy fees. Where Cambridge Tax Practice invoices a client within the UK we are obliged to charge VAT. However, if a similar client is based outside the UK then we do not charge VAT (due to the “place of supply" rules).

Further complications arise because of the arbitrary way in which some goods or services are deemed to be zero rated. A famous tribunal case had to decide whether Jaffa Cakes were a cake or a biscuit - because one definition would mean standard rating for VAT and the other definition would mean zero rating. Another classic is the ‘hot pies’ case - cold takeaway pies are zero rated but hot takeaway pies are standard rated.

There are many such tribunal decisions.

There is a more detailed overview of VAT at the link below :

https://www.gov.uk/guidance/vat-guide-notice-700


How it Works in Practice

A VAT registered business will add VAT to the price they charge when they provide goods or services to their customers.

The VAT registered business will -

     ➣ charge VAT on the goods or services provided

     ➣ reclaim the VAT paid on goods and services used in the business

If a business is not a VAT registered then it cannot charge VAT to its customers, nor can it reclaim VAT on the cost of goods or services used in the business.


VAT Returns

When a business is registered for VAT then HMRC will require quarterly VAT returns to be submitted. In each VAT return the business will disclose :

     ➣ output tax (the VAT charged to customers)

     ➣ input tax (VAT incurred by the business on goods or services)

The difference between these two figures will be the VAT paid to HMRC or repaid to the business.

HMRC recognise that small businesses can suffer late payment of invoices and therefore the VAT calculation can be made on a cash basis (cash received) rather than the strict basis which would be based on invoices issued.

VAT returns are currently filed under the Making Tax Digital regime.


Requirement to Register a Business for VAT

A business is obliged to register for VAT if :

     ➣ the turnover for the previous 12 months has gone over the VAT threshold

     ➣ there is an expectation that the turnover exceed this limit in the next 30 days

The VAT threshold is £85,000 (£90,000 from April 1, 2024).

It is important to understand that the registration threshold calculation is based on a rolling 12 month period - not your accounting period.

If it is beneficial to the business then registration can be on a voluntary basis even if the above limits have not been reached.

There is a guide to VAT registration at the link below :

https://www.gov.uk/register-for-vat


Rates of VAT

There are different VAT rates and the rate charged will depend on the goods or services that are being provided. Currently there are three rates:

     ➣ standard rate of 20%

     ➣ reduced rate of 5%

     ➣ zero rate - 0%

In normal circumstances the standard rate of VAT will be the default rate and this is the rate which most businesses will charge. However, if the VAT rules specify that a particular situation will be charged at a different rate or is exempt then that will overrule the standard rate.

The reduced rate applies in fairly limited circumstances, the main example being the supply of domestic fuel and power.

Many goods and services are currently zero rated. Examples might include -

     ➣ food - but not meals in restaurants or hot takeaways

     ➣ books and newspapers

     ➣ children's clothes and shoes

     ➣ public transport

Other items can be exempt or outside the scope of VAT, for example -

     ➣ insurance (exempt)

     ➣ education and training (exempt)

     ➣ most services provided by doctors and dentists (exempt)

     ➣ non-business activities like a hobby (outside the scope)

     ➣ statutory fees such as vehicle MoT tests (outside the scope)

As an additional complication, some goods or services may be zero rated depending upon the location of the customer. This is known as the "place of supply" rules.

A guide to the VAT rates for different goods and services is at the link below :

https://www.gov.uk/rates-of-vat-on-different-goods-and-services


Zero Rated or Exempt - What’s the Difference?

There is an important difference between exempt supplies and zero rated supplies.

For VAT calculations any zero rated supplies still count as taxable supplies, even though the business doesn't charge VAT. However exempt supplies do not count as taxable turnover.

In practice, if you are supplying goods or services which are mainly exempt (or outside the scope of VAT) then you are unlikely to be able to recover the VAT on your business costs. Making zero rated supplies allows full input VAT to be recovered.

Where a business supplies a mix of exempt supplies and zero or standard rated supplies then this is known as “partial exemption" and special rules are applied to decide how much VAT can be recovered on business costs. Details of how the partial exemption rules work is at the link below :

https://www.gov.uk/guidance/partial-exemption-vat-notice-706


VAT Records

There are specific rules for all VAT registered businesses which describe the records to be kept. HM Revenue & Customs have a full guide on record keeping at the link below :

https://www.gov.uk/guidance/record-keeping-for-vat-notice-70021


If you are considering accounting software, have a look at our Business Software page.

Need Help?


Do you need help with any of the issues discussed on this page?

If you need assistance with UK tax filing we can complete and file a return for you with all tax calculations taken care of.

We can agree a fixed fee in advance.


Contact us for details

VAT Schemes

There are a number of schemes available which can simplify VAT reporting.


VAT Cash Accounting Scheme

The normal basis to account for VAT is based on invoices issued to customers and purchase invoices received. Using this method you would have to pay the VAT element of sales invoices issued, even if you have not been paid by your customers.

Using the alternative Cash Accounting Scheme you only report VAT on the sales income received and the purchase invoices paid. So you only pay VAT on the sales invoices which have been paid by your customers.

If you use the cash basis you don't need to notify HMRC.

The Cash Accounting Scheme is only available for businesses with an annual turnover of less than £1.35m.

See https://www.gov.uk/vat-cash-accounting-scheme


VAT Flat Rate Scheme

The normal basis for accounting for VAT is based on -

     ➣ the VAT charged on sales

     ➣ the VAT incurred on costs

The difference between these two figures is the amount paid to HMRC or repaid to the business by HMRC.

As an alternative, a business can elect to use the flat rate scheme. With the flat rate scheme the business pays a fixed rate of VAT to HMRC, based on sales and the VAT element of costs is not reclaimed.

Different rates are applied depending on the nature of the business. A list of the rates is here.

The VAT you charge your customers is not affected by the flat rate scheme - your invoices should include the normal rates of VAT.

If your business spends a small amount on goods you will be classed as a ‘limited cost business’ and the flat rate of 16.5% will apply. The limited cost business rate applies if goods purchased cost less than either 2% of your turnover or £1,000 a year.

A common mistake is to overlook that the flat rate is applied to sales, plus VAT. So if your flat rate is 12% and your sales in a VAT period are £25,000, the VAT to pay under the flat rate scheme will be based on 12% of £30,000 (£25,000 plus VAT).

The flat rate scheme is only available to businesses with an annual turnover below £150,000. An application to HMRC must be made to join the scheme, using form VAT600AA/FRS.

See https://www.gov.uk/vat-flat-rate-scheme


Retail Schemes

For retailers, there are three VAT schemes to help make VAT accounting easier. They are -

     ➣ Point of Sale Scheme - you identify and record the VAT at the time of sale

     ➣ Apportionment Scheme - you buy goods for resale

     ➣ Direct Calculation Scheme - you make a small proportion of sales at one VAT rate and the majority at another rate

A retail scheme can be used together with the cash accounting scheme and the annual accounting acheme.


See https://www.gov.uk/vat-retail-schemes


Annual Accounting Scheme

Usually a businesses will submit VAT returns every three months. However, the business can apply to use the Annual Accounting Scheme.

With the annual accounting scheme only one VAT return is submitted each year, with a slightly longer deadline allowed for filing.

However, quarterly VAT payments are still required and are based on the previous VAT returns.

The annual accounting scheme is only available for businesses with an annual turnover of less than £1.35m.

Apart from a slightly easier admin burden, the scheme is advantageous if you need to make cash forecasts as the VAT quarterly payment is a fixed amount. For a growing business, the annual accounting scheme can give a cashflow advantage as the quarterly VAT payments are estimated, based on past VAT returns.


See https://www.gov.uk/vat-annual-accounting-scheme


VAT margin schemes

You can choose to use a margin scheme when you sell

     ➣ second-hand goods

     ➣ works of art

     ➣ antiques

collectors’ items

VAT margin schemes calculate the VAT to be paid based on the difference between what you pay for an item and what you sell it for. VAT is calculated at 16.67% on the difference.

There are different rules if your business sells

     ➣ second-hand vehicles

     ➣ horses and ponies

     ➣ houseboats and caravans

     ➣ items that have been pawned

     ➣ high volume, low price items - see the Global Accounting Scheme

There are also different rules for auctioneers, agents or if you buy and sell goods in Northern Ireland and the EU.

There are specific record keeping requirements for these schemes.


See https://www.gov.uk/vat-margin-schemes