We all pay VAT on most of the items or services we purchase. If you run a business, then you may also need to become involved in the VAT system as a collector.
It sounds confusing (to be honest it sometimes can be), so we’ll use this article to “bust the jargon” surrounding VAT. We’ll help you understand how it may affect your business, and how to deal with it.
What is VAT?
VAT stands for Value Added Tax. It’s a type of tax charged on the purchase of most goods and services in the UK. The charge is a percentage of the cost you pay for the goods or services, and it’s designed to be paid by the end consumer.
Most countries have their own version of VAT. You will normally pay VAT on items you purchase from abroad, usually via UK customs when the goods enter the UK.
If you send goods to an overseas buyer, they will normally pay their own country’s version of VAT before they take delivery.
How much is VAT?
The amount of VAT payable depends on the nature of the goods or services, but there are 3 rates:
- Standard rate: The majority of goods or services attract the standard rate, which is 20% of the purchase price.
- Reduced rate: Certain goods and services qualify for the reduced rate of 5%. These include items relating to health, energy, heating, and some protective items or services.
- Zero-rated: Some items or services involving health, food, children’s clothing, and publishing, qualify for the zero rate
Check the different VAT rates here.
Some goods and services are exempt from VAT. These include insurance, art, antiques, educational training, and subscriptions to membership organisations. A few items are “out of scope” of VAT, which means they are outside the VAT system. These include statutory fees such as tolls and fines.
Why is the difference between zero-rated and VAT exempt important?
Being VAT exempt is different to being zero-rated, and this is particularly important when you calculate your business’s taxable turnover.
Make a sale of something zero-rated, and the sale still counts towards working out your turnover. Sell something which is VAT-exempt, and the sale doesn’t count towards calculating your taxable turnover. Why does it matter?
Well, registering for VAT becomes compulsory once your taxable turnover reaches the registration threshold. If you sell VAT-exempt items, but only consider your total turnover, rather than your VAT taxable turnover, you might think you need to register for VAT when you actually don’t.
How is VAT charged and collected?
If a business registers for VAT, it must charge customers the appropriate rate of VAT on the sale. The invoice must also show the VAT amount.
The same business will usually also pay VAT on goods or services it purchases. If the business registers for VAT, it can claim back the VAT it pays out.
- When the amount of VAT a business charges to its customers is more than the amount it pays out to its suppliers, it will pay the difference to HMRC. It works the other way, too.
- If the business pays more VAT to its suppliers than it charges to its customers, it can reclaim the difference between those two amounts.
It’s compulsory for a business to register for VAT when its taxable turnover reaches £85,000 in a 12-month period. This is known as the VAT registration threshold. Failure to register a business that has exceeded the VAT threshold may result in a fine.
This is where the difference between “zero-rated” and “VAT exempt” goods or services becomes important. “Zero-rated” items are still taxable (although at 0%), so those sales are still included in the taxable turnover.
Exempt items are not included in the VAT threshold, so a business that sells mostly exempt goods or services may not need to register for VAT, regardless of its turnover. A business that only sells exempt goods or services is not allowed to register for VAT.
A business whose taxable turnover is less than £85,000 can voluntarily register. This may be an advantage if a business sells a mixture of exempt and taxable goods or services.
The business will be able to reclaim the VAT it pays, and will only have to charge VAT on taxable goods or services it sells. This might mean the business normally pays out more VAT than it charges on sales, so it will be able to reclaim the VAT.
How to register for VAT
Registering a business for VAT is free, straightforward, and where possible best done online.
All you need to register is:
- Your National Insurance (NI) number, or Unique Tax Reference (UTR) number.
- Details of any other businesses you’ve owned in the past 2 years.
- Your business bank account details.
- You’ll be asked to decide which VAT accounting scheme you wish to use.
Once you register, you’ll receive a VAT registration reference number, which you’ll need to show on your invoices.
VAT accounting schemes
There are different VAT accounting schemes, some of which have their own requirements.
Standard VAT accounting scheme
This is the accounting scheme that most businesses use. Under this scheme, you record VAT on every purchase and every sale, and make a VAT submission to HMRC every quarter.
Annual VAT accounting scheme
Some businesses can use an annual accounting scheme. In this case you only submit a VAT return to HMRC once a year. You still pay VAT quarterly, but this is based on the VAT due on the previous return or in some cases an estimate. Any under or overpayment is then reconciled at the next annual return.
Flat Rate Scheme
Rather than paying or reclaiming VAT based on every purchase and sale, your VAT bill will be a percentage of your annual turnover. The percentage rate is decided based on the industry you are in.
You’ll still charge VAT to your customers at the usual VAT rates, but you won’t be able to reclaim VAT on purchases. Instead, the flat rate used to work out your VAT bill is (usually) lower than what you would charge to customers, so you simply keep the difference. Learn more about the VAT Flat Rate Scheme.
VAT cash accounting
Rather than accounting for VAT using the date of the invoice, this scheme accounts for VAT when the cash actually changes hands. This can be useful because it means you won’t pay VAT to HMRC unless the customer actually pays you.
Under the standard accounting scheme there’s always a risk that you report your VAT to HMRC and pay your bill, only for the customer to never pay you. Fortunately, it is possible to claim the VAT back from HMRC if you ever need to write-off an invoice.
Making Tax Digital (MTD)
Most countries, including the UK, are moving towards accounting for and paying tax online. As part of the MTD initiative, from April 2022 any UK VAT-registered business must use an approved digital system for filing VAT returns and paying VAT. One like Pandle!
Keeping track of VAT can be a real headache. Learn more about Pandle’s time-saving bookkeeping features for MTD VAT, and create your free account.