VAT, or Value Added Tax, is a tax on most goods and services. Businesses collect VAT from customers and pass it to HMRC. Simply, the business acts as a middleman for the government.
When you buy something, the price usually includes VAT. Therefore, you often pay it without noticing. This makes VAT different from some other taxes, as it forms part of the final price.
How Does VAT Work?
VAT follows a simple cycle. Businesses charge it on sales and pay it on purchases. They then report the difference to HMRC.
Here’s how it works step by step:
- You charge tax when you sell goods or services
- You pay tax when you buy items for your business
- You submit a VAT return to HMRC
As a result, you either pay HMRC or receive a refund.
If you charge more tax than you pay, you send the difference to HMRC. However, if you pay more than you charge, HMRC usually refunds you. This ensures VAT only applies to the value added at each stage. This also means that businesses do not pay VAT on their full turnover.
What is the VAT Threshold?
You must register for VAT if your taxable turnover exceeds £90,000 in a rolling 12-month period.
Taxable turnover includes:
- Standard-rated sales
- Reduced-rated sales
- Zero-rated sales
However, it does not include VAT-exempt income.
You can still register voluntarily if your turnover stays below £90,000. Many businesses choose this option to reclaim VAT on expenses and improve their business image.
You should monitor your turnover regularly. If you expect to exceed the threshold within 30 days, you must register without delay.
What are the Tax Rates?
There are three primary VAT rates. The correct rate depends on the type of goods or services you supply.
| Standard Rate (20%) | Applies to most goods and services |
| Reduced Rate (5%) | Applies to items such as home energy and children’s car seats |
| Zero Rate (0%) | Applies to essentials such as most food and children’s clothing |
Additionally, some goods and services are exempt. These include areas such as education, insurance and healthcare.
However, there is a difference between zero-rated and exempt supplies. Zero-rated items remain within the VAT system, which means you can reclaim VAT on related costs. Conversely, exempt items fall outside of the system, so you cannot reclaim VAT on expenses.
What Registered Businesses Need to Do
Once you register for VAT, you take on several responsibilities. You must follow HMRC rules and keep accurate records.
These responsibilities include:
- Charging tax at the correct rate
- Including tax in your prices
- Keeping records of tax on purchases and sales
- Submitting VAT returns (usually every three months)
- Paying any tax owed to HMRC
You must also account for VAT on imports and certain non-sales transactions. Additionally, you should keep digital records under Making Tax Digital (MTD) rules.
Read more: Making Tax Digital for VAT
You can appoint an accountant or agent to manage this on your behalf, which can reduce errors and save you time.
What is a VAT Return?
A VAT return is a report you send to HMRC. It shows how much tax you charged and how much tax you paid.
The calculation follows this formula:
VAT charged – VAT Paid = Amount owed or reclaimed
For example: VAT charged is £4,000 and VAT paid is £2,000. This leaves £1,500 owed.
You usually submit VAT returns every three months. You must use compatible software under Making Tax Digital rules. Moreover, you should always submit your return on time. Late submissions can lead to penalties and interest charges.
What Can VAT Be Charged On?
VAT applies to most business activities. These activities are taxable supplies.
This can include:
- Selling goods and services
- Hiring or loaning goods
- Selling business assets
- Charging commission
- Providing items to staff
VAT may also apply to non-cash transactions such as bartering or gifts. Consequently, you must consider VAT even when no money changes hands.
Schemes for Businesses
Several schemes can help simplify reporting. However, these schemes do not change how much tax you charge.
Common schemes include:
| Flat Rate Scheme | Pay a fixed percentage of turnover |
| Cash Accounting Scheme | Pay VAT when customers pay you |
| Annual Accounting Scheme | Submit one return per year |
Each scheme has its own eligibility rules, so you should choose one that suits your business needs.
For example: Smaller business often benefit from the Flat Rate Scheme.
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This article is for general informational purposes only and does not constitute legal or financial advice. While we aim to keep our content up to date and accurate, UK tax laws and regulations are subject to change. Please speak to an accountant or tax professional for advice tailored to your individual circumstances. Pi Accountancy accepts no responsibility for any issues arising from reliance on the information provided.