VAT, or Value Added Tax, can be complicated to understand and an area of concern for small and medium-sized businesses. If you are reading this then it is safe to assume that you are looking for some clear answers.
With the UK government reducing the VAT rate for certain businesses due to the economic downturn caused by COVID-19, there is more confusion than ever.
In our beginner’s guide to VAT, we will gently guide you through the essentials and simply explain common terms you will encounter when running your business in 2021.
What is VAT?
A brief history of VAT
Introduced to the UK on April 1, 1973, VAT is a tax added to most non-essential products and services by the companies that provide them. It replaced a consumption tax called Purchase Tax, which was levied at different rates depending on goods’ luxuriousness.
The adoption of VAT was a consequence of the UK joining the European Economic Community at the start of 1973. The Conservative Chancellor Lord Barber, at the time, set a single VAT rate (10%) on most goods and services.
How much revenue does VAT generate?
The Office for Budget Responsibility forecast VAT payments to raise £136.6 billion in 2019-20, which averages out at around £4,800 per household a year. It is the third-highest source of tax for HM Revenue and Customs (HMRC), just behind income tax and National Insurance contributions, although it is close to overtaking the latter.
VAT is not a cost to businesses themselves since the customer pays it. Your business, if VAT registered, will collect and pay it on behalf of the government, effectively making you an unpaid tax collector.
How does VAT work?
VAT can only be charged by a Taxable Person who is VAT registered with HMRC—this includes any individual, partnership, company, club, association or charity.
It is charged on any goods or services sold or hired out, any commission earned, and applies to business goods used for personal reasons. It is also charged on various non-sale activities like bartering, part-exchanges and gifts. These are collectively referred to as a ‘Taxable Supply’.
Should you register your business for VAT?
You must register your business within 30 days for VAT if during a rolling 12-month period:
– Your taxable turnover exceeds the VAT threshold of more than £85,000
– You receive goods from the EU to the UK worth more than £85,000
Taxable turnover is the total value of everything a Taxable Person sells within over 12 months that isn’t exempt. It does not include capital assets, such as buildings or vehicles—a full 2021 list can be found on the HMRC website.
Even if your company is not VAT registered, it doesn’t automatically mean that your sales are exempt from VAT.
Reasons for VAT registration, even if you don’t need to?
Registering early can offer some advantages, such as giving the outward impression that your sales are over the threshold, but it will also immediately make your product or service more expensive with VAT added to the price. In addition, some businesses only deal with VAT-registered suppliers.
Talk with your accountant to calculate your profit margins as a VAT-registered entity to understand if it is worth going the voluntary route and how it will affect your bottom line. You don’t want to suddenly lose your profitability.
It can be financially beneficial to register early if you are selling to businesses that are VAT registered because your sales would be no more expensive than if you weren’t VAT registered.
Your business expenses will become cheaper because you can reclaim any VAT paid on business-related goods or services, such as computer equipment, office supplies and even accountant bills.
Note: You can even reclaim the VAT on certain purchases bought up to four years prior to registering, which another reason to register for VAT and save every business-related receipt.
What are the different VAT rates?
The UK has three different rates of VAT and you must ensure that you charge the right amount.
Here is an overview of the UK VAT rate for 2021:
|% of VAT||What the rate applies to|
|Standard rate||20%||Most goods and services|
|Reduced rate||5%||Some goods and services, e.g. children’s car seats and home energy|
|Zero rate||0%||Zero-rated goods and services, e.g. most food and children’s clothes|
Since January 2011, the UK’s standard rate of VAT has been 20%.
It applies to most goods and services, ranging from chocolate and alcoholic drinks to shoes and taxi fares.
In response to the coronavirus pandemic, the government has introduced a temporary 5% reduced rate of VAT for certain suppliers of hospitality and tourism. It will be in effect until March 31, 2021.
A reduced rate of 5% applies to purchases of home energy, as well as goods like children’s car seats, maternity pads and mobility aids for people over 60.
Zero rate is used for food, books, newspapers and children’s clothing, for example.
Zero-rated means that the goods and services are still subject to VAT but are charged at 0%. This means that you must record them in your VAT accounts and report them on your VAT Return.
How does VAT apply to EU exports?
The zero rate is applicable to most goods you export to EU and non-EU countries.
You must be VAT registered if you export goods to the EU and you will also need the customer’s VAT ID on all paperwork. The invoice should be marked 0%, plus mention ‘reverse charge’.
Reverse VAT means that the buyer is responsible for the sale’s VAT declaration and then deducts the amount when self-assessing in their VAT Return.
It is also the way VAT is collected in the building and construction industry.
Items exempt from VAT include postal services, membership subscriptions, insurance and medical treatment.
Sellers of exempt goods and services are not entitled to reclaim VAT on business purchases.
How to file a VAT Return
If you’re a VAT-registered business, you must report to HMRC the amount of VAT you’ve charged and the amount of VAT you’ve paid. This is done through your VAT Return, which is due every three months from the date your company was registered.
Note: With the Annual Accounting Scheme, a business can submit one VAT Return a year.
Virtually all VAT-registered businesses are required by law to submit their returns online and pay VAT online electronically.
Thankfully, most VAT commercial software is compatible with the HMRC site.
How to calculate your 2021 VAT Return
HMRC states that you must account for VAT on the full value of what you sell, even if you:
- receive goods or services instead of money
- haven’t charged any VAT to the customer
Here’s an example of how to calculate your VAT:
During a three-month period, you collect £1,000 worth VAT from sales and pay £100 worth of VAT on goods you buy. The £1,000 you collected is referred to as Output VAT, and the £100 of VAT you paid is known as Input VAT.
As a VAT-registered business, you only pay HMRC the Output VAT minus the Input VAT. In this example it’s £900 (the £1,000 minus the £900), so you can keep the £100 difference.
However, if you receive more VAT from sales than you pay on purchases, then you’ll need to pay HMRC the VAT Due.
Note: You must keep all records of your income and expenditure for at least six years.
Calculating your VAT return can be complicated, but here is an online VAT Calculator to help you.
What is the Flat Rate Scheme?
The Flat Rate Scheme allows you to pay a fixed rate of VAT to HMRC. However, you cannot reclaim the VAT on your purchases – except for certain capital assets over £2,000.
To be eligible, your VAT turnover must be £150,000 or less (excluding VAT).
The flat rates are set by HMRC and vary depending on the industry sector, from 4% to 14.5%.
Do not use this if you usually receive VAT repayments, have an income that is not VATable, or you are involved in exports or EU imports.
We hope that our beginner’s guide has simplified some of the complex aspects of VAT and you are feeling a little more confident. If you have any further questions, please get in touch and we can help you!