Value added tax is a business tax levied by the government on sales of goods and services. All businesses which have an annual turnover of more than the current VAT threshold (currently £85,000) must register for VAT and complete a quarterly VAT return.
How VAT works
Once your business is VAT-registered you must do three things: you must charge VAT – currently 20% – on the goods or services you sell to customers and other businesses, you must pay VAT on the goods and services you buy from other businesses, and you must file a VAT return every quarter to HMRC.
The idea is that the VAT you charge and the VAT you pay roughly balances – any difference is sorted out via your VAT tax return, with you either paying HMRC the amount you owe them or receiving a refund for the amount they owe you.
The practicalities of Value Added Tax
- You must register for VAT either if your turnover for the previous 12 months exceeded the threshold – currently £85,000 – or if you think that your turnover will soon go over this amount.
- When adding it on to invoices you should show the VAT amount separately, listing the cost of the goods or services before VAT, the cost of VAT and what rate it was charged at, and the total sum owed.
- There are three different rates of VAT that can be charged – standard rate (currently 20%), reduced rate (currently 5%) and zero rate (0%). Some goods and services are also exempt from VAT, such as antiques and education services.
- There are also specific VAT rules that apply to certain trades and industries – the motor trade for example.
- You can pay VAT online.
- The VAT threshold may change once a year when the government announces the Budget for the coming year – usually in March or April – so ensure you are always charging the correct amount.
- You must charge VAT on the full sale price, even if you accept goods in part exchange or barter instead of money.
Things to consider
If you are selling to other VAT-registered businesses then adding VAT to your invoice will be straightforward as they will be able to reclaim the VAT they have paid. However, if you have been selling to individual customers for some time before becoming VAT-registered, then adding on effectively amounts to increasing the price they must pay by 20% as they will not be able to claim the VAT back.
If you feel you are not able to start charging VAT without affecting the sales you can make, then you may need to review your pricing or accept taking a hit on your profit margins to cover some or all of the VAT amount due. In addition to standard Value added tax accounting there are three schemes designed to simplify the process for small businesses.
1. Flat rate VAT scheme
If your business has a turnover of less than £150,000 you can opt to pay VAT under the Flat Rate Scheme. The big advantage of this it is means you don’t have to keep a record of the VAT you charge on every sale or pay on every purchase. Instead, you can calculate your VAT payments as a percentage of your total VAT-inclusive turnover, which makes it easier and quicker to do your VAT return.
You don’t have to spend time working out how much VAT you spend buying stuff either, as under this scheme you cannot reclaim VAT on any purchases you make. Instead, the percentage rate you apply, typically between 9% and 14% depending on industry sector – is designed to take account of this.
2. Cash accounting scheme
If you use standard VAT accounting, you have to pay HMRC the VAT you charged on your sales whether or not your customer has paid you. If you use cash accounting, you only pay VAT when your client pays you. However, you can only reclaim VAT once you’ve paid your suppliers.
You can use cash accounting if you estimate that your turnover during the next tax year will be no more than £1.35 million.
3. Annual accounting scheme
If you use standard VAT accounting, you’ll have to complete a VAT Return and pay any VAT due, or get any refunds, quarterly. You can reduce your paperwork and make it easier to manage your cash flow by using the Annual Accounting Scheme (additionally your generally required to record VAT alongside your sales in your accounting software on an ongoing basis).
If you use the scheme, then you make nine monthly, or three quarterly, interim payments during the year, only need to complete one return at the end of the year, and then either make a balancing payment or receive a balancing refund at the end of the year. You can use annual accounting if you estimate that your turnover during the next tax year will be no more than £1.35 million.
You can choose to register for VAT even if your business turnover is below the £85,000 threshold if you feel that it will benefit your business to do so. In particular, it might be useful not to make it quite so obvious about how small your business is.
If you do not charge for VAT then customers will immediately know that your firm has a turnover below £85,000 – if you do charge, your business could be any size. To work out when to pay your VAT click here to access HMRC VAT payment deadline calculator
When Tarek Nseir started his own business creating websites and brochure for businesses while still at university, he forgot one vital thing – to charge VAT on his invoices and then pass on the payment to HMRC. So one day he awoke to find a £13,500 VAT demand had arrived in the post, and he had no money to pay it. The enormous bill could have spelt the end for his fledgeling business.
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Fortunately for Nseir, the taxman agreed he could pay in instalments and so his venture survived. When Nseir graduated, he used the experience he had gained in business to start his current business, a design agency called Think which employs more than 100 staff and has a turnover of £11 million.