Understanding what VAT is and how it works is crucial whether you are planning to set up a business or have been self-employed for a while because it is most likely an extra cost that you are paying for but could potentially be avoided in the right circumstances.
If questions about VAT have been lurking in the back of your mind, then this guide is going to be perfect for you! I put together this overview to help you understand the rules of VAT, how it works across different industries and answer some FAQs that will hopefully stop some of those nagging thoughts.
Table of Contents
- 1. How VAT Works
- 2. Registering for VAT
- 3. Charging VAT
- 4. Reclaiming VAT
- 5. VAT Returns
- 6. Paying Your VAT Bill
- 7. VAT Penalties
- 8. Exporting
- 9. Industry Specific Advice
- 10. Coronavirus Support
- 11. FAQs
I’ve updated this guide on 12 December 2020 for changes in the latest legislation
1. How VAT Works
Firstly let’s get to grips with some VAT basics to help you understand what VAT is, that way you’ll be able to see how it affects your business.
1.1 What is VAT?
Value Added Tax, often shortened to ‘VAT’, is a tax added to the price most goods and services consumers buy. So when you go shopping and get a receipt you will most likely see a line for VAT.
VAT was originally called ‘purchase tax’ which was introduced during the second world war to raise money at 33%. In 1973 purchase tax was replaced with value added tax of 10% when Britain joined the EU.
Most items we buy have VAT added at 20% although some like domestic power has the 5% VAT rate added and other essential items like children’s clothes and food have no VAT added to their price.
The UK Government uses businesses with a taxable turnover of more than £85,000 to collect this on their behalf and not pay VAT since they are not an end consumer. The way that they do this is to allow registered businesses to claim back all the VAT they pay, but require them to charge VAT on everything they sell. Here’s an example of how VAT works to explain more:
An Etsy seller is registered for VAT and buys wood to make a table for £200 + VAT, £240. Once complete they then sell the table to an individual for £400 plus VAT, £480. The Etsy seller will need to declare the VAT element of this sale to HMRC using a VAT return form declaring the VAT they collected of £80 and the VAT they paid of £40. They will then be required to pay over the difference of £40.
1.2 Do I Have to Pay VAT if I’m Self-Employed?
A VAT registration is a separate registration to self-employment. If you are not registered for VAT you will have to pay VAT as though you are a consumer. Only VAT registered businesses have the ability can claim back any VAT they have paid because they have access to relevant forms.
2. Registering for VAT
Businesses with a taxable turnover of £85,000 or more MUST register for VAT, which is why it represents a major milestone in your business. The VAT rules are the same for business regardless of their business structure. So whether you are a Limited Company, self-employed or in a partnership you’ll be subject to the same HMRC registration, VAT thresholds and rules.
2.1 VAT Registrations Thresholds
You need to stay aware of the VAT registration thresholds, constantly monitoring whether you have crossed the limits both looking back 12 months and looking forward 30 days. Here are the applicable thresholds for 2020/2021:
|Cash and annual accounting scheme turnover limit||£1.35m||£1.35m|
|Cash or annual accounting deregistration|
|Flat rate schemes turnover limit||£150,000||£150,000|
|Flat rate schemes deregistration turnover limit||£230,000||£230,000|
2.2 Voluntary VAT Registration
Even if your taxable turnover is below the vat limit of £85,000, you can choose to register for VAT voluntarily. There are many businesses out there choosing to do this because it does bring advantages means they can reclaim VAT that they pay and they hide their turnover despite the extra administration. But there are some disadvantages of a voluntary VAT registration, so you should think carefully before you choose to do it.
2.3 How to Register for VAT Online
The easiest way to register for VAT is to go online and apply on the .GOV website. You’ll need to provide information about your business or company if you have chosen to set up a Limited Company, pick your registration date and let HMRC know if you want to use a VAT scheme.
2.4 VAT Schemes
HMRC has launched many different VAT schemes and, although it can make things confusing when it comes to choosing the right one for you, they are designed to help with cash flow and reducing administration. Here are the main VAT schemes available:
- Cash Accounting – only pay VAT to HMRC once your customers have paid you;
- Annual Accounting – only submit one VAT return a year;
- Flat Rate Scheme – pay VAT at a reduced rate to HMRC and avoid deducting for VAT that you pay;
- Global Accounting – lets certain businesses pay 1/6th of the difference between the number of items sold in a quarter and the amount you spent on new purchases;
- VAT MOSS – a VAT scheme requiring businesses supplying digital products and services in the EU to register for VAT;
- Second-Hand Margin Scheme – saves money for second-hand businesses that sell to the general public;
- VAT Reverse Charge – simplifies the VAT process where services are supplied between the UK and other EU countries.
3. Charging VAT
Once you are registered for VAT, you must charge VAT on your sales. There are different VAT rates that you need to apply when you invoice your customers depending on what you are supplying them. And on the flip side, depending on what you buy in your business, you may pay different rates of VAT.
3.1 VAT Rates
Here is a summary of the current VAT rates and examples of products and services that they apply to:
|Standard||20%||Most goods and services such as adult clothes, furniture, alcoholic drinks|
|Reduced||5%||Female sanitary items, children’s car seats and some energy-saving materials in the home|
|Zero||0%||Most food, coffee and children’s clothes|
|Exempt||n/a||Interest, bank charges, education, insurance, postal services, residential property rent|
Remember you can only charge VAT if your business is registered for VAT otherwise you’ll have no way to pay the VAT you have collected over to HMRC. If you have concerns that someone has charged you VAT but are not actually registered, you can check the validity of a VAT number online. Check before you pay the invoice because HMRC won’t refund you even if you are the victim of fraud.
3.2 VAT Invoices
A VAT invoice is different from a normal sales invoices because it contains additional information in relation to the taxable supply including VAT added to the price of the goods or service being provided, the rate and VAT registration number. Use this VAT invoice template to check that you are including the right information on your sales invoices, including choosing the right tax point.
3.3 How to Add VAT To a Price
VAT is added to the net price of a service or product, at the applicable rate. For the purpose of this example, I’ll assume that is 20% even though other rates exist. So if you sell a product for £100, you add 20% for VAT and charge the total. In other words, £100 + £20 = £120 or £100 x 1.2.
This is how I think about it visually:
I’ve put together a VAT calculator that you can use to add and remove VAT from figures quickly.
4. Reclaiming VAT
Claiming back VAT reduces your VAT bill, but you can’t claim back VAT on everything you pay for or in full, even if it is for business reasons.
In the main, you’ll be able to claim back VAT on most of the things you pay for such as rent, stationery or computer equipment. But there are some expenses that have restrictions such as cars and fuels, mileage and entertainment. If you want to check what you can and can’t claim VAT back on, then read this guide on How to Claim VAT Back on Expenses.
Don’t forget, you’ll also need to make sure you keep VAT receipts on record to support any expenses that you are claiming VAT back on.
5. VAT Returns
You’ll need to submit your VAT return to HMRC, normally quarterly, to pay over the VAT you owe or claim a repayment.
A VAT return is the form you need to fill out, normally quarterly, to let HMRC know how much VAT you have collected from your customers and paid to your suppliers. If you have paid more than you have collected then your return will show that a repayment is due and HMRC will send you a VAT refund.
Each return summarises your sales and purchases and VAT on them for a single VAT period and is made up of 9 different boxes:
Boxes 1 and 2 summarising VAT you have collected on your sales (or output tax) with any VAT on sales you made with other EC member states disclosed separately.
Box 4 relates to VAT on your total purchases (or input tax) that you want to reclaim.
Box 5 is the net amount you need to pay to HMRC or reclaim from them.
Box 6 contains your total sales excluding VAT for your VAT period.
Box 7 contains your total purchases excluding VAT for your VAT period.
Box 8 the value of exports to EC countries
Box 9 the value of purchases supplied from EC countries.
Almost all VAT registered businesses are now required to submit their VAT return and any VAT payments electronically, under the rules of Making Tax Digital.
5.2 Making Tax Digital
Making tax digital is the complete digitisation of the entire tax system, meaning mandatory quarterly tax reporting into HMRC along with regular tax payments by businesses and individuals via digital bookkeeping. These businesses must now maintain their books on a bookkeeping system submit their VAT returns using an HMRC compliant software, like Quickbooks.
6. Paying Your VAT Bill
It is your responsibility to make sure that your VAT payment reaches HMRC by the payment deadline and there are penalties for missing the deadline. There are a number of ways you can pay your VAT bill including bank transfer and BACS.
7. VAT Penalties
If you are late filing your VAT return or paying your VAT, HMRC can impose a variety of penalties, surcharges and interest. The consequences for missing your deadlines can be quite severe and in the most serious cases can lead to HMRC winding up your Company to get the money owed.
When UK businesses buy and sell from each other, things are straightforward – each one will charge and reclaim VAT, reporting these amounts on their individual VAT returns. But once a UK company starts to buy and sell from countries around the world and part of the EU, there are more rules that you need to follow such as:
- Reverse charge where businesses supplying services to other business within the EU can avoid charging each other VAT, reducing admin;
- VAT on Exports to Non-EU Countries where UK businesses don’t always need to charge any VAT on the goods they supply;
- Vat on Exports to EU Countries avoiding the charge of VAT on B2B product exports but not B2C;
- Distance Selling Thresholds Explained the level of sales a business can sell to EU countries before requiring individual VAT registrations in each country;
- VAT MOSS where a mandatory VAT registration is required in the UK and EU countries that it supplies digital goods to.
9. Industry Specific Advice
In addition to the guides I have mentioned throughout this article, I have produced a number of industry specific VAT guides to help people in very particular circumstances or industry types:
- VAT Advice for UK Amazon FBA Sellers
- VAT for Etsy Sellers
- Tax & VAT for Airbnb Hosts
- Tax & VAT for Shopify Store Owners
- Is there VAT on Rent Deposits
- VAT on Inter-Company Charges
10. Coronavirus Support
The Chancellor has announced various schemes to financially support businesses that have been adversely affected due to the Coronavirus pandemic including a VAT deferral scheme and a 5% VAT Cut for the Hospitality and Tourism Businesses.
Taxable turnover means the value of sales that would be relevant for charging the standard rate of VAT (20%), excluding any sales that would be exempt from VAT (such as insurance or some financial services).
It is your responsibility to monitor your turnover and register for VAT if required. HMRC does not automatically register you. You’ll need to continually review your turnover on a rolling basis and register for VAT once you know it will exceed the VAT registration limit in the next 30 days.
Failing to register for VAT can result in hefty HMRC penalties, so make sure you have a bookkeeping system in place that you update regularly that helps you monitor your turnover.
A VAT registration number is a unique 9 digit code issued to VAT registered businesses. You’ll find your VAT number on your VAT registration certificate stored online in your .GOV business tax account, once you have successfully registered with HMRC.
Input VAT is also referred to as VAT on purchases and refers to the amounts paid on things bought by a business. Output VAT is also referred to as sales tax and refers to the amounts a business charges to it’s customer on the products and services it sells.
VAT exempt supplies are outside the scope of VAT and include:
Betting, gaming, dutiable machine games and lotteries
Burial and cremation
Fundraising events by charities and other qualifying bodies
Health and welfare
Sport, sports competitions and physical education
Works of art
Even though zero rated supplies have a VAT rate of 0% they must still be included as part of the VAT return and marked on invoices as Zero Rated. Exempt supplies are outside the scope of VAT, such as bank charges, and as such do not need to be included on the VAT return.
If you sell VAT exempt supplies such as health and welfare supplies like care homes, then you cannot register for VAT and so won’t be able to claim back input VAT on purchases.
The complication comes for businesses that sell both vat-able and exempt supplies. In these cases, they must register for VAT if they cross the threshold and can only claim back VAT on part of their input tax.