Tax Basics: How does VAT work?
posted 5th January 2022
Value-added tax (VAT) is a consumption tax that's levied on goods that have had value added at each stage of the supply chain.
Most businesses with annual sales of £85,000 or more have to register for VAT. And even if your sales are below that level, you can register on a voluntary basis. VAT can be confusing, though, with different rates, options and, in some cases, quite complex rules to consider.
So, is your business likely to be required to pay and collect VAT? And why do we have VAT in the first place?
1. The key requirements for a VAT-registered business
In essence, VAT should be a simple form of taxation. As a VAT-registered business, you must:
- Charge VAT to your customers
- Deduct VAT you have been charged by your suppliers
- Pay the difference over to HMRC (or claim it back if there's a refund).
In basic terms, your business is acting as an unpaid tax-collector, and the actual burden of the tax is on unregistered businesses and individuals who are charged VAT but can't claim it back.
2. A short history of VAT
When VAT was first introduced in 1973 there was a single rate of 10% which applied to most goods and services. This kept things simple and straightforward across the board.
The first indication that the basic simplicity wouldn't last came in July the following year, when a rate of 12.5% was introduced on petrol and luxury goods, and that 'luxury' rate was then doubled to 25% four months later. The luxury rate was abolished in 1979.
A reduced rate of 8% was introduced in April 1994 and applied to domestic fuel and power, which was previously 0%. The reduced rate now stands at 5%.
Without covering all aspects of the tax, here are some common queries.
3. When do I have to register?
As we've mentioned, it's not mandatory to register for VAT until you reach the current VAT threshold of £85,000. But what should you do when this looks imminent?
If you believe your VAT taxable turnover will exceed £85,000 during the next 30 days, you need to register by the end of that month and start charging VAT from the 1st of the next month.
Where you have a VAT taxable turnover of over £85,000 in the immediately preceding 12 months, you have to register by the end of the next month - and start charging by the 1st day of the second month after you went over the limit. This is a rolling 12-month period, not a calendar, tax or business year, so if you think you may be close to that point you should check each month.
4. When should I consider registering on a voluntary basis?
Even if you're below the threshold for compulsory registration, you may want to register on a voluntary basis. There are two main reasons that businesses do this:
- Sometimes people believe that, cosmetically speaking, they appear bigger or more successful if they're VAT registered, and that alone is enough to persuade some people.
- Secondly, if most of your customers are themselves VAT-registered, then the VAT you charge isn't a real cost to them, and you can benefit from reclaiming VAT incurred on your own purchases. Because of this, you can make more profit as a VAT-registered business that otherwise would be lost to tax.
5. What's the difference between the invoice basis and the cash basis?
VAT is accounted for on either a quarterly or (less common) monthly basis. There are two different ways that you can account for the VAT:
- On an invoice basis, you include VAT on sales based on your invoice dates, and deduct VAT charged by your suppliers based on their invoice dates.
- On the cash basis, the relevant dates are when your customer pays you, and when you pay your supplier.
If your customers pay immediately, but you purchase on credit, then the cash basis would suit you well. From a timing viewpoint, you would be reclaiming VAT on your purchases earlier. If, on the other hand, your customers typically take a while to pay, while you settle your supplier invoices quickly, then the invoice basis may be better.
6. What rates should I charge?
There are currently 3 VAT rates to choose from:
- The standard rate of 20% applies to most goods and services.
- The reduced rate of 5% applies to domestic gas and electricity, and to supplies in the construction industry, such as certain building renovations and alterations. It also applies to some energy-saving materials installed in residential properties, to child car seats and some mobility aids. The reduced rate has been temporarily extended to some aspects of the hospitality industry over the course of the pandemic.
- Zero-rate (0%) applies mainly to everyday items, like basic foods, children's clothing, books and newspapers etc.
- There is another category, which is called 'exempt'. This is where no VAT is charged, but the business supplying it cannot reclaim any VAT they incur in respect of such supplies. This includes items such as postal services and health services.
7. What VAT can I reclaim?
Presuming that you don't make exempt supplies, then you can reclaim all VAT you incur in respect of your purchases.
- Goods, services and materials to be incorporated into things you sell
- Expenses such as stationery and telephone charges
- Most capital purchases, such as computer equipment and commercial vehicles.
The main exception is if you buy company cars, where the VAT is not reclaimable, or items with mixed business and personal use where part or all of the VAT may be blocked.
8. What are these VAT schemes I've read about?
There are a number of VAT schemes which are available to businesses.
Some, such as the second-hand margin schemes, apply to specific industries such as used motor vehicles, art and antiques. Others, such as the flat-rate scheme and the annual accounting scheme, aim to simplify the workings of the VAT system.
9. What impact will VAT have on your business?
Where you register for VAT, apart from handling the administration, there is no net VAT 'cost'.
When paying the quarterly VAT bill, it's simply tax you've added on to your charges to your customers, less any additional amounts you've paid to your suppliers.
Where VAT can have a significant financial cost, though, is where you don't follow what are increasingly complicated rules. So, for example, being prevented from claiming back costs on your purchases because you didn't check that your suppliers' invoices are valid, or charging the wrong rate - or not charging at all - to your customers.
Talk to us about giving your VAT the once-over
This overview is a basic primer to VAT but there are lots of detailed industry-specific rules that apply in various circumstances. So getting professional advice is always a good idea.
As tax specialists, we can help you:
- Decide whether or not you should register voluntarily
- Run a 'health-check' of your systems if you're already VAT-registered
- Make sure you've considered any of the applicable special VAT schemes.
Get in touch to talk about your VAT needs.