How does VAT work? A guide for new business owners

So you're asking yourself how does VAT work? We know it can be a complicated subject. Most people are familiar with the basic concept of VAT - at least, as consumers, it isn't usually lost on us that VAT bumps up the cost of most of our purchases. If you're running a business, however, you need to understand much more, as correctly handling VAT within your business is one of the vital ways to ensure that your business is operating legally.

If you are starting a new business venture for the first time, you'll need to get your head around all things VAT. Here is a guide to help you get to grips with what VAT is, how it works, and what your obligations are as a business owner.

What is VAT?

Value-added tax, or VAT, is a consumption tax that is added to the cost of goods and services. It was originally introduced to the UK in 1973. Generally speaking, the areas that can be subject to VAT include:

• The sale of a good or service - including exchanges

• The hire or loan costs of goods

• The sale of business assets

• Commissions

VAT does not apply to all product or service sales, however, as some are either outside of the scope or exempt from VAT. For example, health care, education, insurance, and postage stamps are exempt, while donations to charities are outside the scope of VAT. In addition, any statutory fees, goods, or services purchased and used outside of the UK are also outside of the scope of VAT.

Related: How to avoid VAT when buying a van for business

Who pays VAT?

VAT is a tax paid by consumers. While it is businesses that pay the VAT to HMRC (Her Majesty's Revenue and Customs), the cost has already been covered by the business's paying customers. Essentially, companies are obligated to charge and collect VAT on behalf of HMRC and report it fully.

What is the current rate of VAT?

There are three VAT rates that are chargeable in the UK depending on the goods or services that are being provided.

Currently, the UK's VAT rates are:

What is the VAT threshold?

The VAT threshold is the amount of money your business can turnover before you are required to register for VAT.

The current VAT threshold in the UK is £85,000. Once you start turning over £85,000 or more, you are legally required to register your business for VAT.

Once you are registered for VAT, you will need to charge VAT on all goods and services that your business sells. Registering for VAT also means that you are legally allowed to reclaim any VAT expenses that your business incurs on any goods or services it purchases.

It's important to note that you are not legally allowed to charge (or claim for) VAT unless you are registered. While you aren't legally obligated to register for VAT while your business turnover is under the threshold, you can still register if you so choose. This is known as voluntary registration.

In determining whether your business has reached the VAT threshold, it's important to remember that it is measured on any rolling 12-month period as opposed to a tax year or calendar year. In other words, as soon as your business has reached a turnover of £85,000 in any consecutive 12-month period, it's time to register.

How to register for VAT

In most cases, you can register for VAT online. When registering online, you create a VAT online account (otherwise known as a 'Government Gateway Account').

Once registered, you should receive your VAT registration certificate approximately two to four weeks from the date of submission. This certificate will include your business's VAT number.

If you would prefer, your accountant or tax agent can register your business for VAT on your behalf.

It's important to note that you must also register for VAT if you expect your business turnover to exceed the threshold within the next 30 days or take over a VAT-registered going concern.

What is my VAT number?

VAT-registered businesses are assigned a VAT number. This is the number that you will need to include on your invoices. It's important to note that you are not legally permitted to charge or otherwise show any VAT on your invoices until you receive your VAT number.

What is exempt from VAT?

The rate of VAT applicable depends on the nature of the item being purchased. Some goods and services are 100% exempt from VAT. Some examples of this include:

• Charitable fundraising/donations

• Insurance and financial services

• Education and training

• Letting or selling commercial properties

• Postage stamps

To check what VAT rate applies to any type of good or service in the UK, you can refer to the government's guide.

What is the difference between ‘VAT exempt' and ‘zero rate’ VAT?

Goods and services charged at zero rate VAT are still technically registered for VAT but are not obligated to apply VAT to their sales. This still allows them to recover VAT costs on any of their business's overheads and expenses. Essentially, they still 'charge' VAT, but at 0%.

On the other hand, if a business only offers VAT-exempt goods or services, they are not required to register for VAT.

Related: VAT in the food industry

Your VAT responsibilities as a registered business

Once you become a VAT-registered company, you have a duty to charge VAT on all goods and services you offer. You can then also recover any VAT you have expensed via business-related costs.

The VAT that your business charges must be calculated on the total sales price of whatever you are selling. You must also apply it to all sales, including any exchange or part-exchange sales. Should you charge a customer without including VAT, the total sales price will still be considered inclusive of VAT when it comes to reporting it to HMRC. If you accidentally charge a customer too much VAT, you must still pay it in full to HMRC.

You will have to complete a VAT return, usually quarterly (once every three months). Once you are registered, you will need to complete this return regularly, whether or not you have collected or expensed VAT for the period. In addition, as of April 2019, most VAT-registered businesses must now follow new rules regarding Making Tax Digital (MTD). Under these new rules, businesses must file their VAT returns via the HMRC digital gateway.

Once your report is completed and submitted, it will be reconciled by HMRC. If you have spent more in VAT than you have charged to your customers, you can reclaim the difference from HMRC.

Input and Output Tax

A registered business must charge the applicable VAT rate on all taxable sales, which is known as 'Output Tax.' The customers pay this VAT, but the business must collect it, report it, and pay it to HMRC.

When it comes to reclaiming VAT on business-related purchases, it is known as 'Input Tax.' Some items, however, are not eligible for VAT reclaim, as outlined below.

How to calculate VAT

To calculate VAT-inclusive prices that are subject to the standard VAT rate of 20%, you can simply multiply the price excluding VAT by 1.2 - thereby adding 20% to the sales price. For the reduced (5%) rate, multiply the price excluding VAT by 1.05.

To calculate VAT-exclusive prices, divide the total price that includes VAT by either 1.2 or 1.05, depending on the rate to which it has been taxed.

When it comes to pricing your goods and services, it might be prudent to consider that adding VAT may make your prices less competitive. You will need to decide whether to set your prices in line with any non-VAT-registered competitors.

VAT invoicing

A VAT invoice must include the following:

• the seller's trading name and address

• the seller's VAT registration number

• an invoice number

• the date of the invoice

• the tax point (the sale date as treated by the HMRC) if different to the invoice date

• the customer's name/trading name and address

• a description of the services or goods supplied

Each item type that you sell must include a breakdown of:

• the unit price or rate excluding VAT

• the quantity of goods or extent of services provided

• the VAT rate applicable to each item sold

• the total amount payable, excluding VAT

• the total amount of VAT as charged

• any applicable cash discount rate offered

VAT penalties

Given that VAT registration is a legal obligation, any business that fails to adhere to the rules can be charged VAT penalties. In severe cases, custodial sentences can even apply.

Any penalties charged by HMRC for late VAT registration are calculated as a percentage of the VAT due from the date the business should have registered, to the date the HMRC becomes aware that you have failed to register.

HMRC can also charge extra penalties for not receiving your VAT return or full VAT payment by the applicable deadlines. As you can see, it is imperative to running your business legally that you take your VAT obligations seriously.

What VAT can be reclaimed?

As a registered business, you can reclaim VAT back on any goods and services used specifically for your company operations.

You can claim the VAT back on items such as:

• Vehicles used solely for business

• Fuel and maintenance of company vehicles

• Staff travel

• Mobile service costs relating to business activity

• Utility bill for home-based businesses (as a percentage of business usage)

Some examples of items that cannot be reclaimed include any expenses that are solely for personal use and any business entertainment costs.

Get advice

The concept of VAT may not be difficult to understand, but the process of reporting and especially reclaiming VAT can be tricky. The rules around reclaiming VAT include many exceptions and exemptions that must be taken into account.

It is recommended that businesses consult with qualified accountants when reconciling their VAT accounts and lodging their returns. To get in touch with our experienced tax accountants, reach us on 0207 043 4000 or info@accountsandlegal.co.uk, or get an instant accounting quote here.