VAT (Value added tax) is an administrative headache for a lot of people. It’s charged by businesses on goods or services at the point of sale, and as it’s a consumption tax, it’s paid by the end customer, rather than the company selling the goods.
It can be fiddly, complex and time-consuming, and you can incur some heavy costs if you get it wrong.
In the UK, whether a business must legally register for VAT or not depends on its annual turnover and the type of goods it sells. Companies without a legal obligation to register can also choose to register.
There are several different rates of VAT applicable to different types of products, in different circumstances. While there are some exceptions, VAT applies to almost every single transaction for a vast number of businesses.
This guide will take you through the ins and out’s of VAT.
What is VAT?
In the UK VAT, or 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 (£85,000 in 20/21) must register for VAT and complete a VAT return.
VAT is a consumption tax, collected when you assign value to a product. In other words, it’s a tax charged on products/services that people and businesses buy. It’s an indirect tax, meaning that businesses collect it on behalf of the government: companies add a VAT charge on their goods and services, then paying the VAT collected on to HMRC.
While VAT registered businesses charge their customers VAT on the products and services they sell, they also pay VAT on the products and services they buy, such as raw materials, professional services or stock.
However, VAT registered businesses (barring flat rate registered businesses making sub £2,000 non-capital purchases) can claim back the VAT that they pay on business expenses, provided they are VAT registered. They therefore only pay HMRC the difference between the amount they have collected and the amount they have paid. If they have more VAT expenditure than they receive from customers, HMRC will pay them the difference.
VAT is charged on most goods and services, such as:
- business sales
- loaning goods
- selling business assets
- items sold to staff, such as hot meals in the canteen
- business goods used for personal reasons
- ‘non-sales’, such as gifts and part-exchange.
All these items for which VAT applies are known as ‘taxable supplies’. VAT can appear on top of the price for business-to-business sales, with many prices showing ‘ex VAT’. For direct to consumer sales, the price includes VAT.
Any business with an annual turnover of more than £85,000 must register for VAT. If your company has a yearly turnover under this threshold, you can choose to register voluntarily. If you register for VAT, you will have to charge your customers VAT. If your customers are other VAT registered businesses, they can reclaim the VAT that you have charged them. You may also recover the VAT you pay, reducing your costs.
When you’ve registered for VAT with HMRC, you will need to start keeping VAT records. These records should include details of all the VAT you have charged your customers, and all the VAT you have been charged. You can find more details on this later.
How does VAT work?
VAT applies to the majority of goods and services. VAT-registered businesses are effectively unpaid tax collectors, charging VAT on the products they sell and paying the consumer tax on to HMRC. This doesn’t come without any remuneration, however. Many VAT-registered businesses save money by being registered, and the process is becoming simpler and simpler with new legislation.
Businesses are liable not only to collect tax but to pay it on any of the purchases they make. Instead of transferring collected VAT on to HMRC every time a transaction happens, companies submit a VAT return indicating the total they’ve collected and the total they’ve paid out within the tax quarter or year, depending on the scheme they adopt.
VAT paid and VAT collected is differentiated as input tax and output tax. Input tax refers to the VAT your business has paid its suppliers, for business equipment, materials or expenses. This includes purchasing professional services, such as consultancy fees or accountancy services, as well as business phone calls or any items you buy to re-sell.
Output tax refers to the tax you charge on the goods and services that your business supplies. You charge the output tax and collect it from your customers.
You will then have to measure your input tax against your output tax: whether you have to pay money to HMRC or not will depend on how much VAT you have charged, and how much you have paid.
For example, you might charge all of your individual customers VAT, but pay VAT on all the goods you purchase from your suppliers. In most cases if you collect more VAT from your customers than you pay out to suppliers and service providers, then you will owe the surplus VAT money to HMRC. If you pay out more in input tax than you collect in output tax, you can fill in a form and reclaim the money from HMRC.
Current VAT rates
First and foremost, you must be aware of the right VAT rate for your goods and services, so that you can charge it correctly and reclaim any VAT on purchases made by your company.
There are currently three rates of VAT. The rate that applies to your business will depend on the goods or services you provide. You will add this VAT to the price of your products and services when you sell them to customers, whether they are business or non-business customers.
The current standard rate of VAT in the UK is 20% which is applied to the majority of goods, services and purchases. Anything deemed a luxury item falls in this category too, which is why food products such as ice cream and confectionery use the standard rate.
A reduced rate VAT applies to specific products. This reduced rate tends to be 5% and applies to goods such as children’s car seats, domestic fuel or power.
The final category of VAT is the zero rate, which is a nominal VAT rate applying to most food products, books, newspapers and children’s clothes. Anything the UK government deems ‘essential’ typically falls into this category.
It’s also worth noting that most goods that you supply to non-EU countries and any goods you provide to VAT-registered EU businesses are also zero-rated. Although the rate does not add any charge to the products, companies must still record transactions involving these goods and services and report them on their VAT return.
If you trade exclusively in zero-rated goods or services, you may be exempt from VAT registration. However, you will need to apply for an exemption directly to HMRC. If you are exempt from registration, you won’t be able to reclaim any VAT on any business purchases or expenses.
Exempt goods and services
No VAT is charged on exempt supplies, which covers services in sectors such as medicine, dentistry, education, finance and insurance. Other exempt items include postage stamps and property transactions.
While the zero rate, while nominal, still applies and therefore requires records, exempt items do not need to be accounted for in your taxable turnover. Similarly, if you purchase exempt items, there is no VAT to reclaim from HMRC on those goods.
HMRC includes the following goods and services as VAT exempt:
- insurance, finance, credit
- training and education
- fundraising events by charitable organisations
- subscriptions to membership organisations
- selling, leasing and letting of commercial land or buildings.
If you only trade in goods and services which are exempt from VAT, your business, too, will be exempt from VAT. This means that you won’t be able to register for VAT, even if your annual turnover is over £85,000. You will also be unable to reclaim any VAT on business expenses.
The Jaffa Cake VAT debacle
While food and drink items are usually zero-rated, there are some types of product which are always standard-rated, including catering, confectionery, crisps and savoury snacks and ice cream. This throws up a bit of a dilemma for some food companies. Take Jaffa Cake, for example. In 1991, Jaffa Cake became the subject of a VAT-related controversy, claiming that their chocolate-covered biscuits were, in fact, cakes. Why?
While cakes and plain biscuits are zero-rated items, a chocolate-covered biscuit falls under the category of confectionary, thus becoming standard-rated. By insisting that Jaffa Cakes are in fact cakes, rather than chocolatey biscuits, McVitie’s were lobbying for the zero-rate VAT. However, HMRC challenged this classification in 1991. The case attracted widespread media attention and ended up in a VAT tribunal, where the jury was posed the crucial question: cake or biscuit?
The court ruled in favour of McVitie’s, officially classifying the product a cake. Lucky for Jaffa Cake fans, who didn’t face the VAT price increase – something which might have prevented Jaffa Cakes becoming the best-selling cake (or biscuit) in the United Kingdom in 2012.
How to charge VAT
Once you’re clear on the rate of VAT to charge on each of your products and services, you can apply the charge. Be sure to follow these steps when charging output VAT to your customers:
- charge the right rate of VAT
- work out the VAT if a single price is shown that includes or excludes VAT
- show the VAT details on your invoice
- show the transaction in your VAT account
- show the amount on your VAT return.
HMRC denotes any sales invoices including VAT as ‘VAT invoices’. VAT invoices must be compliant with HMRC by fulfilling specific requirements.
VAT invoice requirements
There are three types of VAT invoices. HMRC stipulates different requirements for each kind of invoice, which you can find below. For a full list of HMRC requirements, you can visit the HMRC website.
Full VAT invoices
A full VAT invoice is used for most transactions. Full VAT invoices must show:
- the supplier’s name, address and VAT registration number
- the name and address of the person receiving the supplied goods
- a unique identification number
- the date of issue
- the date of supply of the goods or services (in some cases the same as the date of issue)
- a description of the supplied goods or services, including the quantity of each item
- the price per item, excluding VAT
- the rate of VAT charged per item
- rate of discount per item
- total amount excluding VAT
- total amount of VAT.
Modified VAT invoices
Currently for retail supplies over £250, you must use a modified invoice. It must include all the information listed above as well as the total amount, including VAT.
Simplified VAT invoices
Currently for any retail supplies totalling less than £250, you can use a simplified VAT invoice. Simplified invoices must only show:
- the supplier’s name, address and VAT registration number
- a unique identification number
- the time of supply of the goods or services
- a description of the supplied goods or services
- the rate of VAT charged per item
- the total amount including VAT.
You must use an entirely unique number for every single invoice you issue. The number should be sequential – you may use a different sequence per customer, so long as the series of invoices is unique. Some companies choose to use customer prefixes on the invoices. If you decide to use customer prefixes, ensure that each customer has a unique prefix.
What about invoices using foreign currencies?
If you are invoicing for transactions in foreign currencies, you must show the total payable VAT in pounds sterling on your invoice. For any invoices written in a foreign language, you must retain an English translation of the invoice. HMRC may request an English translation, and you must be able to provide one within 30 days.
When you convert the total payable VAT into sterling from a foreign currency, you must use one of the methods given by HMRC:
- the market selling rate at the time of supply
- the rate used by the European Central Bank
- HMRC’s period rates of exchange.
If you want to use an accounting method for foreign invoices which is not listed above, you will need to contact HMRC for permission.
Claiming back VAT
As a business, you are generally able to claim back the VAT you have paid on purchases of goods and services for your business. This is known as a VAT refund. If you have purchased items which also serve a private use, you may only claim part of the VAT back. Say you have a mobile phone that you use for both your professional calls and private calls: if 60% of your calls are business-related, you may reclaim 60% of the VAT on your mobile phone plan.
You may only claim back the VAT that applies to purchases for VAT taxable business purposes. This excludes things like business entertaining – many companies will take clients out for lunch, for example, which comes under this category. The VAT you pay on a restaurant meal for a client would not come under reclaimable input tax. There are other instances where you may not be able to reclaim VAT, such as for:
- goods and services used by your business to make VAT-exempt supplies
- items purchased from an EU country
- business assets transferred to you as a going concern
- goods and services for private use.
To claim back you need a VAT receipt
To claim back VAT from a purchase, you must have a valid VAT receipt from your supplier. This serves as proof of the purchase and shows that you have paid your input VAT on that transaction. Without a valid VAT receipt, you cannot claim any tax back.
Many suppliers provide VAT receipts which are invalid, missing crucial information. Delivery notes, email confirmations or letters do not qualify as valid VAT receipts. Just like VAT invoices, valid VAT receipts must include:
- A unique invoice number
- The name and address of the seller
- The seller’s VAT registration number
- The date of the invoice
- The date of supply, otherwise known as the tax point
- Your name and address
- A description of the goods or services supplied to you.
VAT invoices and receipts serve as your proof for your input and output tax figures. Once you’ve got these, you can claim back your VAT. These invoices and receipts can be stored in an electronic format.
How to claim back VAT
Reclaiming your VAT is straightforward. When you submit your VAT return, enter the total amount of VAT charged, and the total amount of VAT paid. If you are owed money from HMRC, this amount is shown. Then, provide your account details on your VAT online account. If HMRC owes you any money in tax, you will receive your VAT refund usually within 30 days of submitting your return (if HMRC does not have your bank details, they may send you a cheque, known as a payable order).
Be sure that your suppliers provide you with a valid VAT invoice, and don’t try to claim back VAT on any invoices that may not be valid. If in doubt, it is worth seeking the advice of an accountant before claiming, to save you from any surprises from the tax inspector.
Interest on errors made by HMRC
If an error on the part of HMRC results in your business paying too much VAT, underclaiming VAT or prevents you from recovering VAT at the correct time, your business can claim interest. This interest is claimable on the duration of time you have been unable to use the money. Claims must be by made in writing, addressed to the VAT Written Enquiries team, who will consider each case. If your business has a nominated contact in HMRC, then you should direct the claim to them.
Does my business need to register for VAT?
The VAT threshold is currently £85,000. This means that as soon as your business reaches a turnover of more than £85,000 in the last 12 months, or if its turnover is going to reach the threshold within the next 30 days, you must register for VAT with HMRC.
What if my business turnover falls below the threshold after registering?
If your company is VAT-registered and its annual turnover drops significantly, you may deregister your company. The deregistration threshold is £83,000. If your turnover falls below this amount, you can ask HMRC to cancel your company’s VAT registration or deregister your company.
VAT exemption can apply to organisations as well as goods and services. Some businesses cannot register for VAT. If your company only sells goods and services that are VAT exempt, the company itself is, too, exempt from VAT. This exemption applies even if the business turnover is over the threshold of £85,000.
For businesses that sell only or predominantly zero-rated items, you can avoid the paperwork of VAT registration for this nominal charge by applying directly to HMRC for VAT exemption. However, if HMRC grants you a certificate of exemption, this means you cannot reclaim any VAT, either.
Like unregistered businesses, VAT-exempt companies may not charge VAT on any sales and may not reclaim VAT on any business expenses. Equally, they do not need to keep VAT records or submit VAT Returns.
Partially VAT exempt businesses
Businesses may sell a mixture of goods and services, some of which are taxable and some of which are VAT-exempt. In this case, the company is partially exempt from VAT. Partially exempt businesses may reclaim the VAT they have paid only on purchases involved in producing or acquiring the VAT-rated goods. If this applies to your business, you must first and foremost keep a separate record of exempt sales, as well as detailed records of how you have calculated how much VAT to reclaim.
VAT is often a daunting topic for partially exempt VAT companies. The crucial takeaway is that partially exempt businesses must only apply output VAT to their taxable supplies and apply none to their exempt supplies. This distinction is important for two reasons: so that the customer is not paying VAT when they shouldn’t be, and for working out how much input VAT the business can reclaim.
Generally, you cannot reclaim exempt input tax. That said, if the amount of exempt input tax is relatively low, you may be able to recover it. You can, however currently recover input tax that relates to any of the following:
- taxable supplies that you make
- supplies that you make outside the UK that would be taxable if made in the UK (these are known as ‘foreign’ supplies)
- certain exempt supplies (known as ‘specified’ supplies).
These types of supplies are known as supplies with the ‘right to deduct’ input tax. You cannot usually recover exempt input tax, which refers to the following:
- exempt supplies
- supplies made outside the UK that would be exempt if made within the UK.
The problem arises when a business incurs input tax on purchases relating to both the taxable and exempt supplies. In these cases, you can only recover the input tax for the portion used to make taxable supplies. Calculating this portion involves a multistep process.
Partial exemption standard method
First of all, the business needs to use a process of direct attribution. This involves categorising a business’ VAT into the following three categories:
- 100% Exempt Input VAT: VAT which relates to the making of fully exempt supplies
- 100% fully taxable input VAT: VAT which relates to the making of fully taxable supplies
- Residual input VAT: VAT associated with the making of both the taxable and exempt supplies. (Your total value of input tax, minus the tax directly attributed in steps 1 & 2.)
This process shows how much of your input tax is directly attributable to your taxable supplies and exempt supplies, and therefore allows a business to separate the ambiguous VAT. The first figure cannot be recovered. The second figure, however, can be fully recovered. The third figure, the residual tax, is the grey area – the leftover VAT which doesn’t fit neatly into either of the preceding categories. This is the figure we are interested in when using the method below.
Working out how much of your residual input tax is attributable to taxable supplies can be challenging. One method is the Partial Exemption Standard Method which is suitable for most smaller businesses. As this method is specified in the law, companies must use this method unless HMRC gives your business express approval to use what’s called a special method. The standard method works as follows:
[Value of taxable supplies in the period (excluding VAT) / Total value of supplies in the period (excluding VAT)]x 100 = Recoverable percentage of residual input tax.
You then apply this percentage to your calculated residual input tax. The resulting value is the amount of your residual input tax that you can recover. To work out your total recoverable taxable input tax, add this value to the directly attributable taxable input tax from step 1.
To work out your total exempt input tax, add together your directly attributable exempt input tax from step 2 with the amount of residual tax that was not attributed to taxable supplies. You can use this total exempt input tax figure to calculate whether or not the de minimis rule is applicable for your business.
An example of partial exemption standard method
It’s helpful to see the standard method in practice. By directly attributing its VAT, a business works out that:
- Its input tax relating exclusively to taxable supplies is £10,000
- Its input tax relating solely to exempt supplies is £6,000
- The input tax from business entertainment is £500
- Its residual input tax is £7,500
- Value of all taxable supplies ex VAT = £120,000
- Value of exempt supplies = £60,000
Using the standard method, we take the value of taxable supplies in the period and divide by the total value of supplies in the period, and multiply by 100. In this example, this calculation appears as follows:
[120,000 / (120,000 + 60,000)] x 100 = 66.67%, which should be rounded up to 67%. This figure represents the recoverable percentage of residual input tax.
The recoverable amount of residual input tax is therefore £7,500 x 67% = £5,025.
A special method is an option for businesses who consider that the standard method does not yield a fair recovery of input tax. While the standard method will achieve this for the majority of smaller-sized companies, some larger businesses may wish to seek approval of using a special method. To do this, you will have to apply to HMRC in writing.
Using a special method means that partially exempt businesses can determine the amount of input tax it can deduct. Potential special methods include transaction-based and staff-number apportionments.
The de minimis rule
In theory, you cannot recover VAT relating to any exempt supplies. However, there is a rule in place where it may be possible, provided the VAT is below certain limits, known as the de minimis rule. If the total value of the exempt input tax is insignificant, namely less than a prescribed value, you may treat it as though it were taxable. Insignificant, or de minimis, exempt input tax amounts are typically anything less than:
- £625 per month on average over the tax period, or longer (or £1,875 per quarter)
- half of your total input tax (excludes blocked input tax) during the relevant period.
The amount must meet both these conditions to pass the de minimis test. To calculate your total value of exempt input tax, you must add the total VAT directly attributable to exempt supplies (the resultant figure from step 1 above) and add it to the proportion of residual input tax that is attributable to exempt supplies. This latter figure is the total amount of residual input tax, less the recoverable amount.
There are two other, more straightforward ways to figure out whether your input tax is de minimis. You can use these simple tests first, to check whether or not you have reached the de minimis limit before using the more complicated method above.
Simple de minimis test 1
To pass this test, check that the total input VAT incurred does not exceed £625 per month on average, and the value of exempt supplies is no more than 50% of the value of all supplies.
Simple de minimis test 2
The total input VAT incurred, minus input VAT directly attributable to taxable supplies, is no more than £625 per month on average and the value of exempt supplies is no more than 50% of the value of all supplies.
If the exempt input VAT is below the de minimis limit, businesses can recover all of their input VAT incurred. Any partly exempt business which completes a VAT return every month or every quarter must do a partial exemption working for each period. At the end of the VAT year, you must then carry out an annual calculation to verify whether the de minimis limit has been breached in the yearly figures. This calculation can affect the business’ VAT recovery.
If the annual calculations show that the de minimis threshold has not been breached, then all input VAT incurred can be recovered, including the input VAT attributable to exempt supplies. This means that if any of the input VAT was previously restricted in any of the monthly or quarterly periods where the de minimis limit was exceeded, this input VAT becomes recoverable through annual adjustment. Businesses can make an annual adjustment through the VAT return, on either the final return of the year or the first return of the following year.
On the other hand, should the annual calculation show that the de minimis limit has been breached, the business would have to repay any input VAT attributable to exempt supplies recovered in a particular period to HMRC through the annual adjustment.
Annual adjustment serves two purposes. One, to check the exempt input tax under the de minimis rules, as we have seen above. Secondly, it’s helpful to consider the use of goods and services over the longer period. A business’ partial exemption year concludes either in March, April or May, depending on its VAT return quarters, which is when the annual adjustment takes place.
New partly exempt businesses
For new businesses in the early stages of trading, the standard method may not produce a fair and reasonable result, even if it likely will once the company has established itself. In this case, these new businesses may use an alternative calculation method to calculate its recoverable input tax, without seeking express permission from HMRC. This saves the new company the hassle of seeking approval of a special method for what is likely to be a limited time. A new partly exempt business may use this calculation during:
- its registration period – from the date the company first registered for VAT until the day before the start of its first tax year
- its first tax year (usually referring to the first period of 12 months beginning 1 April, 1 May or 1 June, following the end of the registration period) provided that the business did not incur any input tax relating to exempt supplies during its registration period
- any tax year, provided the company did not incur input tax relating to exempt supplies in its previous tax year.
Once any of these periods expire, the business must revert to the usual standard method of calculation, based on the value of supplies. This option for new companies is merely an option: newly partially exempt businesses may still operate with the standard method, or seek approval of a special method if they prefer.
This alternative calculates recovery of input tax based on use. When using this method, businesses must look at their primary sources of expenditure and determine to what extent they relate to taxable supplies. Most new companies will have a solid business plan in which they will have carefully considered their costs, which usually serves as an ideal basis for a fair recovery of input tax.
To remain consistent, any business which adopts the basis of use method to calculate its input tax must also calculate a use-based annual adjustment. If a company does not recover input tax based on use but was entitled to, the business may still choose to work out its annual adjustment based on use. This option offers maximum flexibility to new partly exempt firms, to ensure they recover a fair amount of input tax.
In these cases, there’s no need to inform HMRC when using the use-based method. HMRC will be able to tell that a business has opted for the recovery based on use option if it doesn’t use the usual values-based calculation. Similarly, if a company recovers input tax using the standard values-based calculation, HMRC will assume it’s chosen not to recover on the basis of use.
Should my business voluntarily register for VAT?
Some businesses choose to register for VAT voluntarily, even though their annual turnover is below the £85,000 annual threshold. For some companies, it can be more profitable to register for VAT.
The major downside of registering for VAT is that you have to charge your customers VAT, increasing their prices. However, if your business sells to other VAT registered companies, your customers will be able to reclaim their VAT, meaning this price increase is unlikely to affect your sales. You’re then able to reclaim VAT on your business expenses, boosting your profits and minimising your costs.
If you sell to individuals, adding VAT unnecessarily can add a considerable cost that might reduce your number of sales. In this case, it’s worth reviewing whether the amount you would save in reclaimed VAT on expenses such as materials and manufacturing costs would outweigh the money lost in sales.
Another considerable disadvantage of registering for VAT is the extra accounting involved. Being VAT registered means you have to keep track of the VAT on your expenses and income, in the way of receipts and invoices, and submit a VAT return every quarter. The VAT rules are complex, and if you sell to clients in different countries, you may have to charge different VAT prices. Upgrading computer systems and ecommerce sites to incorporate these price variations can be costly and involve significant admin.
VAT businesses have a better reputation
Many companies are more likely to accept contracts with VAT registered businesses. Registering for VAT can add a level of credibility to your business, giving it the appearance of being a larger, more stable company.
A significant benefit of registering for VAT is that you can claim back VAT on transactions made before you registered. Currently you can reclaim the VAT on items you bought before your registration date in your first VAT return, provided you still own the items. This rule applies to any goods you purchased within the four years prior to your VAT registration.
How to report VAT: Choosing a VAT scheme
Each business needs to opt for a particular system to inform the government how much VAT they’ve charged, and how much VAT they’ve paid. There are several methods for doing this. The main differences are in the manner in which you report to HMRC.
Standard VAT accounting method
This process is the most common method of VAT calculation and submission. The standard method simply involves keeping a VAT record of all purchases and sales. You can do this manually, or use accounting software to capture VAT data automatically. You then use this information to complete your quarterly VAT return, four times a year. You will have to pay any VAT you owe quarterly, and any VAT refunds owed to you will be repaid quarterly, too.
Annual Accounting Scheme
This alternative to the standard VAT accounting method is only an option for businesses with an annual turnover of £1.35 million or less. It works on the same principle as the standard VAT accounting method, but instead of filing quarterly returns, you are only required to report VAT once a year.
Under the scheme, you have to make advance VAT payments towards your VAT bill but need only submit a tax return once a year. You must then make nine monthly, or three quarterly, interim payments during the year, before settling the outstanding balance at the end of the year. These advance payments are based on your last return. At the end of the year, you submit your VAT return and settle the balance, which is the outstanding balance of your VAT bill, less your advance payments. If you have overpaid, you can apply for a VAT refund, and HMRC will return the overpaid funds.
You can use annual accounting if you estimate that your VAT taxable turnover, that is to say, everything you have sold which is not VAT exempt, during the next tax year will be no more than £1.35 million.
Flat rate scheme
Usually, businesses pay or reclaim the difference in VAT between the output VAT charged to customers and the input VAT they have paid. Instead of keeping track of all the VAT they charge and collect, businesses under the flat rate scheme pay a fixed rate of VAT, which represents a percentage of their turnover. The flat rate you pay depends on the industry in which you operate.
You will still have to charge VAT on your invoices, but you won’t have to document the VAT details of every transaction. You also won’t be able to reclaim the VAT on your purchases. This scheme is only open to smaller businesses with a VAT turnover of up to £150,000, excluding VAT.
Cash Accounting scheme
Under the scheme, instead of accounting for VAT based on invoices issued, you will only account for VAT on payments made and received. So you will pay VAT on your sales only when customers have paid you, and you can reclaim VAT on your purchases only once you have paid your supplier. This scheme is helpful for businesses who invoice their customers with extended payment terms or for companies struggling to maintain healthy cash flow.
Companies must meet several requirements to be eligible to use the cash accounting scheme, as stipulated on the government website. Notably, the value of the business’ taxable supplies in the next year must be £1.35 million or less. The company must also not have any VAT returns outstanding or owe HMRC any money without an agreed repayment plan in place. On top of this, a business will not be eligible if HMRC has already written to them, denying them access to the scheme.
VAT margin schemes
Under the VAT margin schemes, tax is only applied to the difference between what you paid for an item and what you sold it for, rather than the full selling the price. The VAT applied to the difference is 16.67%.
You can opt for the margin scheme if you sell second-hand goods, works of art, antiques, or collectors’ items. For example, if you sell a painting for £2,000 and sell it on for £3,000, under the margin scheme you will pay 16.67% VAT on the £1,000 difference, totalling £166.70.
Support with keeping on top of VAT
Businesses can incur considerable fines if they fail to account for VAT correctly. On top of accounting failures, companies can be heavily penalised for late filing, late payment or supplying incorrect information. VAT is complicated and time-consuming, and it’s not worth risking a hefty fine. To help you stay on top of your VAT and accounting, you should consider hiring an accountant to keep your tax returns compliant. Alternatively, automated software can be a huge time saver. Accounting software can automate data capture and reporting, which can significantly cut down your time and margin for error. A combination of accountant and accounting software though is almost always the best option/needed.
How to register for VAT
Whether you’re required by law to register for VAT or you want to do so voluntarily, you can do so by registering online with HM Revenue & Customs. HMRC have an online VAT service that you can use, sometimes known as a Government Gateway account. After you’ve become VAT registered, you will have to submit all your VAT returns to HMRC. As with annual accounts filings, many businesses choose to appoint an agent, such as an accountant, to communicate with HMRC and file their VAT returns on the business’ behalf.
Applying for a registration exception or exemption
Registering for VAT works slightly differently for companies seeking registration exemption or exception. This may be the case for companies trading in exclusively zero-rated VAT items or for businesses who expect to exceed the turnover threshold only temporarily. In these cases, currently it is necessary to apply for exception via post, using form VAT1.
It’s important to note the difference between having an exemption from registering from VAT and having an exception to being registered. For example, if your business exceeds the VAT threshold unexpectedly due to a temporary blip in sales, you would need to notify HMRC within 30 days, explaining why the expected taxable sales are unlikely to exceed the deregistration threshold of £83,000 in the next 12 months. If HMRC accepts your reasoning, your business will enjoy an exception to being registered for the time being.
An exemption is different. An exemption is a possibility for unregistered businesses whose annual turnover exceeds the registration threshold, but whose sales relate solely, or mainly, to zero-rated goods. The basis for the exemption comes from the assumption that the business’ input tax will exceed output tax. Again, the company must submit a request within 30 days of exceeding the threshold.
Retrospective exemption and exception
In practice, it can be hard to adhere to the 30-day rule for requesting exemption or exception. Such is often the case for individual labourers, for example, who may exceed the registration owing to a big one-off job. Say a builder has a one-off job in the 12-month period up to 31 March 2019. It may not be until they bring in their self-assessment tax return the following January 2020, that their accountant realises the temporary threshold breach from the previous tax year.
In these cases, despite there being almost ten months since the threshold-breach, the builder can still request an exception to being VAT registered. Instead of basing the request on the actual turnover figures achieved since March 2019, the trick in this hypothetical case would be to base the claim on the known facts on 31 March 2019 as to why the builder knew that their sales in the 12 months to 31 March 2020 would be less than £83,000. The difference here is slight but significant. Getting it wrong could mean that HMRC backdates the builder’s registration to 1 May 2019, so it’s worth looking at the guidance on retrospective applications published by HMRC.
Applying by post
In addition to companies seeking registration exception, you must also apply by post if you’re registering business units of a corporation under separate VAT numbers. A postal registration is also necessary for farmers wishing to apply for the Agricultural Flat Rate Scheme, a scheme providing a flat rate addition of 4% to farmers. Accountants submitting a VAT registration on behalf of a client will also send the relevant application by post.
There are several postal forms available on the government website for different applicants.
- Use VAT1A if you are an EU business ‘distance selling’ to the UK
- Use VAT1B if you acquire goods worth more than £85,000 from an EU country
- Use VAT1C if you are disposing of assets on which 8th or 13th Directive refunds have been claimed.
Details to provide
Whether applying online or by post, you will have to provide the following information:
- details about the status of the business
- National Insurance (NI) number or unique taxpayer’s reference
- incorporation details, if applicable
- details of all associated businesses within the last two years
- the company’s contact details
- the company’s business activities
- the business’ bank details
- the reason you are registering for VAT
- details of the applicant (the person registering the business for VAT).
Effective date of registration
The date you register is known as your ‘effective date of registration’. This means that you will have to pay HMRC any VAT due from this date onwards. However, you may reclaim any input VAT paid before this date if you still own the items on which you paid the VAT.
Registering for VAT Online Services
Whether you apply online or by post, VAT paperwork now takes place online. HMRC has been paperless since 2012 (largely), which means that after applying, all newly registered businesses must submit their VAT returns electronically. If you owe money to HMRC, you must also make your VAT payments online.
Once you’ve completed your online or postal application, you should receive a VAT certificate of registration, known as a VAT4, within 30 working days. You will then need to register for VAT Online Services with HMRC, to set up your account where you can submit your VAT return and make payments. To set up an account, you will need the following information:
- Your VAT registration number
- The postcode of your place of business
- Your effective date of registration for VAT
- The final month of the last VAT return you submitted
- The figure from ‘Box 5’ in the last VAT return you submitted (this box may change as the form changes, make sure to double check this).
Your VAT registration number and date of registration will appear on your VAT4. The last two details are only relevant to companies who have already registered for VAT. For newly VAT-registered companies, you will typically need to write ‘N/A’ for the ‘final month of last VAT return submitted’ and 0.00 for the ‘Box 5’ figure (this box may change as the form changes, make sure to double check this).
Reclaiming historic VAT
It is possible to claim for VAT that you have paid before your VAT registration date. However, there are independent limits that apply to goods and services, respectively. In both cases, you are required to have VAT invoices. The VAT element you try to recover must represent the amount shown on the invoices, and not the current rate of VAT.
You may reclaim VAT on any goods that you purchased within the four years prior to your VAT registration if all the following conditions apply:
- The items were bought by your company, now VAT-registered
- The items are for your VAT taxable business purposes
- You still hold the items, or they were used to make other goods that you still hold.
Make a particular note of the second condition. If the items are used in part of the business which is VAT exempt, you may not reclaim VAT. HMRC recommends that companies take a stock-check at the point of VAT registration, and keep details of the expiration of purchased goods.
For services, you may backdate only six months. The following conditions must be true of the services you paid for in this six-month period:
- The services were bought by your company, now VAT-registered
- The services were for your VAT taxable business purposes.
Services for which you can reclaim VAT may include accountancy fees or fees for legal advice, which is often the case for new businesses.
How to submit a VAT return
A VAT return requires meticulous records, as with any tax submission to HMRC. You will need to keep a careful record of all receipts of purchase as well as invoices your company has sent, which include VAT. Relevant documents include bank statements, receipts, bills and separated business transactions. You must also keep a record of all the supplies you acquire and make.
When supplying your VAT Return, you will have to provide a summary for the accounting period, including information such as:
- your total sales and purchases
- the amount of VAT you owe (input tax)
- the amount of VAT you can reclaim (output tax)
- what your VAT refund from HMRC is (your input tax less your output tax).
Even if you have no VAT to pay or reclaim, that is to say, that you have paid the exact amount of VAT that you have collected, you must still submit a VAT return to HMRC. Records need to be up to date and kept somewhere safe. Tax inspectors may visit at any time and ask to see any VAT records from the last six years.
The process is time-consuming and complex, requiring a significant amount of paperwork. If you fail to keep records or submit false information, you may be liable to hefty fines or other kinds of penalties. To free up valuable time and ensure the returns are filed correctly, many businesses choose to delegate to an accountant to take care of the VAT returns.
How to keep VAT records
You can keep VAT records on paper, electronically or on a software program. The records you need for your VAT return must be digital. If you lose any VAT invoices, or if they’re unreadable due to damage, you can ask your supplier for a duplicate, but make sure it is marked as such.
Working out VAT prices
You must account for VAT on the full value of any items you sell. This requirement applies even in cases where you received goods or services instead of money, in the case of part-exchange. It applies, too, if you haven’t explicitly charged VAT to your customers – the price is assumed to include VAT.
If you sell goods, you must work out how much VAT to record. You may also need to work out how much VAT you have paid on items. First of all, determine whether a price includes or excludes VAT.
VAT inclusive prices
To work out a price which includes the current standard rate of 20% of VAT, multiply the price excluding VAT by 1.2. So if you are purchasing a batch of mobile phones for £2,000 excluding VAT, the price including VAT would be 2,000 x 1.2 = £2,400 including VAT.
To calculate a price which includes the reduced rate of 5% VAT, multiply the price excluding VAT by 1.05. So for a batch of children’s car seats with a price of £1,000 excluding VAT, the price including VAT would be 1,000 x 1.05 = £1,050.
VAT exclusive prices
To calculate a price without VAT, charged at the standard rate of 20%, divide the price including VAT by 1.2. Say you purchased a batch of mobile phone chargers for £12,000 and want to work out how much it was without VAT. The price excluding VAT would be 12,000 / 1.2 = £10,000. This means that the VAT you paid for this item was £2,000 (12,000 – 10,000).
For a batch of children’s seats charged with a reduced rate of 5% VAT, to work out the price excluding VAT, you would take the total cost and divide by 1.05. For a price of £10,000, the price without VAT would be 1,000 / 1.05 = £952.38. In this case, the VAT paid on this transaction was 1,000 – 952.38 = £47.62.
If you want to double-check your calculations or save yourself some time, you can use an online VAT calculator to do the work for you (it’s also worth double checking calculations by yourself and checking with your accountant to ensure correct math).
VAT retail schemes
VAT retail schemes simplify your VAT calculations. Instead of working out how much VAT applies to each sale you make, you can do it just once per VAT return. There are three VAT retail schemes:
- Point of Sale scheme, where you identify and record the VAT at the point of sale
- Apportionment scheme, where you buy goods for resale
- Direct Calculation scheme, where you make a small number of sales using one VAT rate, and the majority using another rate.
Point of Sale Scheme
The Point of Sale scheme is applicable for retailers who can identify the VAT rate of goods sold at the time of sale. If you have an electronic till, for example, it can automate this process for you. Simply add together all the sales for each VAT rate. For standard 20% rated goods, divide the sales amount by 6, and for reduced rate goods charged at 5%, divide the sales amount by 21.
If you buy goods for resale, you may use the apportionment scheme. Your turnover must not exceed £1 million per year, excluding VAT. Under this scheme, add up the total value of goods that your company has purchased for resale for each VAT rate. Divide the purchase total for each VAT rate by the total for all purchases, and multiply the outcome by your total sales, divided by 6 for standard 20% rated goods and divided by 21 for products charged at the 5% reduced rate.
Let’s take an example. Say you purchase £20,000 of goods at the standard rate of 20%, £10,000 of goods at the reduced rate of 5% and £10,000 of zero-rated goods. Your total purchases equal £40,000. Say your total sales is £50,000.
The VAT on the standard rated goods would be: (£20,000/ £40,000) x £50,000 / 6 = £4,166.67. The VAT on the reduced rated goods would be: (£10,000 / £40,000) x £50,000 / 21 = £595.24. The total VAT for the period therefore equates to £4,761.91.
Direct Calculation scheme
This scheme may be useful for businesses that make a small number of sales at one VAT rate, but the majority at another rate. To be eligible for this scheme, you cannot have a turnover which exceeds £1 million a year, excluding VAT.
For this scheme, you must total up the expected selling prices (ESPs) for either your minority or majority goods. Then, calculate the ESP for the VAT period. If your goods are rated at the 20% standard rate, divide the total ESP by 6. If they’re zero-rated, deduct the total ESP from your total sales to give your sales at 20%, which you can then divide by 6.
If you have reduced-rate goods, deduct the ESP of your reduced rate goods from your sales before calculating the VAT at 20%. Next, calculate the VAT due on your reduced-rate goods by dividing the ESP for said goods by 21. Add this figure to the 20% VAT to give the total VAT due.
Let’s look at an example. Say your total sales are £20,000. Deduct the ESP of zero-rated goods of £2,000 and the ESP of reduced-rate goods of £100 from the total, giving you the sales of goods at the 20% VAT rate: £20,000 – £2,000 – £100 = £17,900. Divide by 6 to calculate the VAT due on the 20% goods: £17,900 / 6 = £2983.33.
Now, divide the ESP of reduced-rate goods by 21 to calculate their VAT: £100 / 21 = £4.76. The total VAT due is therefore £2,983.33 + £4.76 = £2,988.09.
Bespoke retail scheme
For retailers with a turnover of over £130 million, excluding VAT, you must come to a tailored agreement with HMRC under their bespoke retail scheme. Companies who are ineligible to use the above retail schemes or who are unable to use standard accounting must use a bespoke retail scheme.
All of these retail schemes can be used in conjunction with the Cash Accounting scheme as well as the Annual Accounting scheme, but may not be used with the Flat Rate scheme.
VAT fraud refers to instances where a business doesn’t charge VAT when they should, or when they charge VAT but don’t pay the money to HMRC. A company might commit VAT fraud by:
- asking you to pay in cash to avoid paying VAT on some work
- asking you to make the payment to someone other than the business
- not being registered for VAT when their turnover exceeds the threshold
- falsely claiming to have applied for a VAT number
- using a VAT number belonging to somebody else.
VAT fraud is a form of tax evasion and taken extremely seriously by HMRC, whether accidental or not.
Reporting cash in hand pay
Businesses must declare all forms of income, including ‘cash in hand’ payments for work. If your employer or another business pays workers ‘cash in hand’ without paying Income Tax or National Insurance, you need to contact the HMRC fraud hotline, as it may be a case of tax evasion.
It’s important to note, too, that employees risk losing their employment rights, among other benefits, should they accept cash in hand payments. In these cases, employees may have to make the tax and National Insurance contributions themselves.
VAT visits and inspections
You may get a visit from a VAT officer to inspect your VAT records at any time. During the visit, the VAT inspector will check your VAT records to ensure that you are paying or reclaiming the correct amount. You must keep detailed business records to supply accurate information in your tax returns to avoid any interest or penalties.
Usually, HMRC will write to your business and ask you to phone them back to discuss your records. They’ll ask you some questions about your files and business activities to determine whether you’re keeping sufficient documentation to meet your legal obligations. This call usually takes no longer than 15 minutes. Using the information you provide, the HMRC officer will assess whether you’re likely to be able to submit an accurate tax return from the records you’re keeping and either:
- inform you if no further action is required, which they will confirm in writing
- advise you on the call that you need additional support with your tax return, and provide a helpful link
- decide you’re at risk of keeping inadequate records and inform you that you need an in-person visit
- pass your details on to the visiting booking team, who will contact you with a suitable date and time for the visit, which they will confirm in writing after the call.
HMRC may also visit without an appointment at any time, however they will usually give you seven days’ notice of a visit by letter. When arranging an inspection, they will let you know which documents and records they want to see, the expected duration of the visit and whether or not they wish to inspect your premises. For smaller businesses, visits usually take several hours, but for a more complex or larger business, it can last several days. You are permitted to request that they delay the inspection.
During the visit, the VAT officer will:
- discuss various aspects of the business with you
- give you an indication of how long the inspection will take
- examine the records you keep of the business
- advise you of any overpayments or underpayments.
After an inspection, HMRC will write to you with details of the visit, including anything you need to improve in the way of recording your VAT, any corrections you may need to make to your account and any penalties you may be obliged to pay. If the officer finds an error, you have the right to request a review of their decision by a different officer who has no previous involvement. If you’re still not happy with the outcome, you can appeal a penalty to an independent tribunal, so long as you do it within 30 days of the visit.
How to pay your VAT
Payment for VAT must be made online within the deadline shown on your VAT return. If you are unsure of your VAT payment deadline, you can use the deadline calculator on the government’s website. There are different deadlines if you use either the Annual Accounting Scheme or payments on account to pay.
HMRC currently accepts VAT payments in the following formats:
- On the phone or online via Faster Payments
- Using CHAPS
- Direct debit
- Standing order
- Debit or credit card
- Through your bank or building society.
To check that your payment has gone through, you can log in to your VAT online account, which should update within 48 hours of receipt of payment.
Payments on account
If your business owes more than £2.3 million in VAT in a 12-month period, you are obliged to make payments on account. Payments on account are advance payments towards your VAT bill, made at the end of the second and third months of each VAT quarter. You must then make a balancing payment for the quarter with the VAT return, which is the quarterly liability less the payments on account made.
HMRC works out your advance payments based on your company’s annual VAT liability in the period you exceed the VAT threshold. Typically, you will be required to pay instalments equal to your company’s yearly VAT liability, divided by 24.
How to deregister for VAT
If you’re no longer eligible for VAT registration for any reason, you may/must deregister. This may be the case if your business ceases to trade, or if you join a VAT group, where two or more corporations join together to account for their VAT under a single registration number.
You can also voluntarily cancel your registration if your annual turnover drops below the deregistration threshold, which is currently £83,000. You can deregister for VAT by logging into your online VAT account, otherwise known as your Government Gateway account. You can also do this by post, by completing and returning the VAT7 form.
HMRC will typically confirm the cancellation of your VAT registration within three weeks. With this confirmation, they will provide you with your official deregistration date, from which you won’t be liable for VAT, and you must stop charging. Remember to keep your VAT records for six years after deregistering, as HMRC may still ask for them within this period.
Can I transfer VAT registration?
It is possible to transfer VAT registration from one business to another. Both the person buying the company and the person selling the business must notify HMRC that they would like to transfer the VAT registration. A transfer application can be made online through your VAT online account, or by post using the VAT68. HMRC typically takes three weeks to respond.
International trade and VAT
If you trade with overseas companies, some of your sales may come outside of the scope of UK VAT. This means that UK VAT will not apply to your services. In these cases, you do not charge VAT on sales you make outside the UK, and you don’t include these figures in your VAT returns.
If you buy goods from another EU country, the supplier will not charge VAT. Instead, you must account for the tax in your VAT return.
If you buy goods from a non-EU country, you will pay VAT when the goods enter the UK, which will be part of your input VAT. If the goods remain outside of the EU, they will be out of scope.
If you sell goods to a VAT registered business within the EU, the sale will be zero-rated. You still need to record these sales in your return.
How has the VAT rate changed?
VAT succeeded the Purchase Tax in 1973. While the zero rate has existed since VAT’s introduction, the standard rate of VAT has fluctuated over the past 50 years, reflecting both political moves and the state of the economy. The lowest ever rate of Value Added Tax was 8% from 1974-1979, and the current rate of 20% is the highest VAT has ever been.
VAT for builders
For most work carried out by builders, the standard rate of 20% VAT applies. The same goes for the work of similar tradespeople, such as plumbers, carpenters and plasterers. There are, however, some exceptions.
If you are building a new house or flat, you may not have to charge VAT. This condition applies if the home is new, self-contained (not internally linked to other houses or flats), can be used independently of any other property, can be sold on its own and has proper planning permission. If these conditions apply, you may charge zero-rate VAT on the work.
For example, if you were to build an annexe onto an existing house, you would not be able to charge the zero-rate VAT on the work, as you cannot sell the annexe without the house. However, the zero-rate would apply to a flat built above a shop, even though the building has a mixed-use. Only work on the residential portion of the property would qualify for zero-rate.
Zero-rate VAT may also apply for work you carry out for disabled people in their home. Work may include alterations such as building a ramp, widening doorways or hallways or installing a bathroom to fit the person’s needs. Gov.uk also lists work related to the installation, reparation or adaptation of any equipment designed to assist disabled people in their home, such as adjustable beds, hoists and stairlifts, as zero-rated.
Reduced rate VAT
For some types of work, builders can charge the reduced rate of 5% VAT. To qualify for the reduced rate, currently the work must come under one of the following:
- installation of energy-saving products
- converting a building into a house or flat
- renovating an empty home
- home improvements on the Isle of Man.
Some types of building are also excluded from VAT, such as construction on charitable buildings or repair work on protected buildings. Communal residential buildings such as children’s home, nursing homes, student accommodation and school boarding houses are also currently exempt from VAT.
What if I am building my own home?
If you’re building your own home, you may be eligible to claim a VAT refund on building materials and services you have used. This situation applies if you are constructing a new home, converting a property into a home or building a property for a charity. Your building work and materials must qualify under HMRC’s standards, and you must send an application to HMRC within three months after completion of the work.
VAT for motor dealers
Car dealers may reclaim the VAT from vehicle purchases if they are buying the vehicle to then sell on. In the case of cars, you must intend to sell them on within 12 months, if you want to claim VAT. You must keep detailed records when you purchase a vehicle so that you can charge the correct amount of VAT when you sell it on.
In the case of imported vehicles, you currently need to use a Notification of Vehicle Arrivals (NOVA). You must complete this within 14 days of importing a vehicle to the UK. To do this, log in to the NOVA online service using your Government Gateway user ID and password. HRMC will process your NOVA form and then confirm the amount of VAT due. On your next VAT Return, account for vehicles as acquisitions, provided you imported them from the EU. If you have imported a vehicle from outside the EU, you will have to pay VAT through customs and reclaim it on your next VAT Return.
Vehicles you don’t sell
You can also reclaim VAT on vehicles you don’t sell, if you use them for daily rentals to customers, for test drives or as courtesy cars for your business. If a vehicle is also used for personal use by an employee, you will have to pay VAT back to HMRC.
What about VAT for charities?
Charities can qualify for the reduced rate or zero rates of VAT when purchasing certain goods and services. The reduced rate of 5% applies for fuel and power, provided they are used for:
- residential accommodation (such as in a care home or children’s home)
- charitable non-business activities
- small-scale use (up to 1,000 kilowatt-hours of electricity per month).
Charities may also pay the zero rate VAT for other goods and services, including:
- aids for disabled people
- construction services
- medicine or drugs
- lifeboats and fuel
- goods for disabled people
- rescue equipment.
These are just some of the examples of goods to which the zero rate applies to charities. However, for each of these goods, you must satisfy specific requirements, which can be found in detail on the government website.
VAT number checks
It’s always a good idea to know a bit about who you’re going into business with. Quick research can help you suss out a business’ credibility, offering reviews and other crucial information. One of the most important things to do is to verify the VAT number of any registered company you choose to deal with.
All companies receive a unique code when they register for VAT. This code is known as a VAT number or VAT registration number and indicates they have officially registered for VAT with HMRC, a legal requirement if they’ve got a turnover over the current threshold. These numbers are nine digits long, usually beginning with ‘GB’.
It’s essential to check a company’s VAT number for several reasons. Firstly, if you enter an invalid VAT number on your VAT return, you could invalidate your invoice, meaning HMRC may reject your tax input claim. Not only will you be liable to pay the VAT, but you could face a lot of paperwork and even a penalty.
While the majority of cases of invalid VAT numbers comes from simple human error, rarely but occasionally somebody may try to use somebody else’s VAT number fraudulently. Either of these cases has significant implications for you, so it’s well worth it to perform a quick VAT registration check. There are two ways you can do this:
- Call directly with HMRC, calling them on their VAT helpline.
- Use a website which provides an online VAT checker
If in doubt…
VAT can be a headache for many businesses. For many, it can seem like an administrative nightmare and can be costly if it’s done wrong. Remember that VAT registration is a legal obligation for many businesses, so it’s not something to put off.
That said, even with all the information, working out the right rates to apply and how much you can reclaim can get confusing for any business, particularly if you sell a combination of exempt and taxable goods. Fortunately, there are several ways to help you keep informed. This guide sheds light on the main concerns faced by businesses when it comes to VAT. Beyond this, save yourself the trouble by considering hiring an accountant or using accounting software. Finally, if in doubt, seek advice from HMRC, and be safe in the knowledge that you’re VAT compliant.