VAT
One subject that is guaranteed to raise ire among small businesses is VAT. Essentially, the VAT system is operated by businesses acting as tax collectors for the government. As far as you the business person is concerned, you pay tax when you buy goods from someone else and charge the tax when you sell them on. Broadly speaking, you hand over to HM Revenue & Customs (HMRC)* the difference between the amount of tax you charge your customers and the amount of tax you have paid your suppliers.
What is in this chapter?
- How the VAT system works (see below).
- Who has to register? (p. 400).
- What rate of tax? (p. 403).
- Voluntary registration (p. 403).
- How is the tax worked out? (p. 405).
- The records you need (p. 406).
- Accounting for VAT (p. 408).
- Paying the tax (p. 410).
VAT is a complex tax, and this chapter can only outline the principles. The examples given are deliberately simplified. You are advised to ask for professional help with VAT.
This chapter was last updated in January 2019. There may have been changes that have taken place since that date. Updates are posted on www.pearson-books.com/businessstartup that should keep you abreast of important new information.
How the VAT system works
The principle of the system is that tax is paid on the value added at each stage of the business process.
Example 1
Jason King grows timber. He sells £1,000 of oak to A. J. Furniture, which will turn the oak into hand-crafted timber. He charges £1,000 for the timber and adds on 20 per cent to the invoice for VAT. The total A. J. Furniture pays to him is £1,000 plus £200 VAT, £1,200 in all. Jason pays the £200 tax collected (called output tax) to HMRC*.
A. J. Furniture makes the oak into ten tables. These are sold on to an online furniture retailer run by Doris Bates. Doris is charged £250 for each table plus VAT. On the invoice, this is shown as £2,500 plus £500 VAT. A. J. Furniture claims back the VAT charged by Jason King (called input tax), that is, £200, and hands over the VAT Doris pays to them, £500 (called output tax). This means a net payment of £500 − £200 = £300 to HMRC paid by A. J. Furniture.
Doris sells the tables online at a price of £500 plus VAT. She receives in total for the tables, £5,000 plus VAT of £1,000. When she makes her VAT return, she claims back the £500 VAT (called input tax) she paid to A. J. Furniture, while handing over the £1,000 VAT paid by the customers (called output tax), a net payment of £1,000 − £500 = £500.
The customers cannot claim back the VAT they have paid on the tables, but all the businesses are registered for VAT and can do so.
VAT is charged on what is called taxable supplies. In Example 1, Jason King makes taxable supplies (the timber) of £1,000, A. J. Furniture makes taxable supplies (the tables) of £2,500 and Doris makes taxable supplies of £5,000 (the tables). Not all goods supplied to businesses are taxable; some are known as exempt, and VAT is not charged on those (p. 402).
In VAT terms, the VAT that you charge on what you sell is called your ‘output tax’. If registered for VAT, the business to which you sell claims back the VAT that it pays you as its ‘input tax’. This is done when it makes its VAT return to HMRC.
Who has to register?
It is the person, not the business, who is registered for VAT. Each registration covers all the business activities of the registered person. For VAT purposes, a company is treated as a person. There are a number of reasons why you might not have to register. These include:
- your sales (strictly, the amount of your taxable supplies, see below) are too low, but you might still wish to register for VAT purposes and charge it on your sales (see below);
- your business operates outside the VAT area (see below);
- you make only exempt supplies (see p. 402);
- you carry out non-business activities (but you would still charge VAT on what counts as your business activities – see p. 402).
If you fail to register when you should do so – and you have 30 days’ grace – HMRC* can impose financial penalties. The penalty is 5 per cent of the tax due if registration is up to 9 months overdue, 10 per cent if registration is more than 9 but not more than 18 months overdue and 15 per cent if registration is more than 18 months late. The minimum penalty is £50.
Your level of sales
You must register your business for VAT if your sales are above a certain limit (strictly, the limit is for the value of your taxable supplies, see below, rather than sales). The limit increases each year in line with the rate of inflation. For the tax year 2019–20, you must register if:
- your sales in the previous 12 months were more than £85,000;
- you expect to go over the threshold in a single 30-day period.
But you may be excused registration if you can show that exceeding the VAT threshold is temporary and your sales in future will be less. If you are already registered, should your sales fall below the limit above, you can ask to have your registration cancelled. You would have to establish that your sales, excluding VAT, will be £83,000 or less for the next 12 months.
The area for VAT
VAT applies to England, Scotland, Wales, Northern Ireland and the Isle of Man. It does not apply to the Channel Islands. If you have customers or suppliers there, the goods you buy or sell will be treated as imports or exports.
What are taxable supplies and what are exempt?
Broadly speaking, if you supply goods and services in your business (including anything you take for your own use or sell to your staff), these will be taxable unless the government has specifically laid down that they are not. If they are not taxable, they are called exempt.
If all the goods or services that you supply are exempt, you cannot normally be registered for VAT. What this means for you is that you cannot claim back the VAT on any of the things you have bought for your business.
On the other hand, with a business composed of some taxable and some exempt supplies, you will still have to comply with the registration limits for the value of your taxable supplies. You will be able to claim back the VAT you have paid for the whole of your business if the value of your exempt input tax (that is, input tax relating wholly or partly to your exempt supplies) is below a certain amount.
Items that are exempt as far as VAT is concerned include, broadly speaking:
- some sales, leases and lettings of commercial land and buildings;
- providing credit;
- insurance;
- certain education and training;
- some healthcare;
- some postal services;
- most betting, gaming and lotteries.
What is business and what is non-business?
As far as the VAT system is concerned, business is supplying goods or services to someone else in return for something that could be regarded as payment; it does not need to be money. You must be supplying the goods on a continuing basis to be a business activity.
If you are carrying out only non-business activities, you cannot be registered for VAT; if you have some non-business activities, the VAT you can reclaim is reduced.
What rate of tax?
For taxable supplies, there are three rates of tax:
- the standard rate, which, at the time of writing, is 20 per cent;
- a special 5 per cent rate applying to domestic fuel, installation of energy-saving materials in homes and women’s sanitary products;
- the zero rate.
The standard rate is charged unless the government specifies otherwise.
These are the main supplies that are zero-rated at present:
- some food and drink;
- books and newspapers, but not digital versions;
- young children’s clothing and footwear;
- public transport, but not taxis or hire cars;
- exports;
- sales of, and the construction of, new domestic buildings only;
- dispensing prescriptions;
- mobile homes and houseboats, but not including static caravans typically used as holiday lets, on which the rate is 5 per cent.
Do not confuse exempt and zero-rated. The effect of the two categories is quite different. Neither charges VAT on what they sell, but the exempt category cannot claim VAT back on what they have paid, while the zero-rated category can. Costs for the exempt category are likely to be up to 20 per cent higher than the costs for the zero-rated category.
Voluntary registration
You can apply to register even if the value of your taxable supplies is below the limit. You have to satisfy HMRC* that you are making taxable supplies in your business. There are two reasons why you might apply to register even if your sales are likely to be below the limit (p. 401). In both cases, registration will mean lower costs.
The first instance would be if you sell to businesses that can claim back VAT, so charging the 20 per cent on your sales will not mean you lose business. If this is the case with you, consider applying to register. You may still decide not to if the administrative set-up is too difficult, for example if you sell a large number of low-value items. But if you register, your costs could be as much as 20 per cent lower than they otherwise would be. See Example 2 below.
Example 2
Susan Hammond runs a car hire service. Her main customers are businesses. She considers whether she should apply to register for VAT, although her present sales of £50,000 are below the limit. Her costs are £20,000 including VAT of £2,000 (she is not charged VAT on all the goods and services she purchases).
If she registers, she will have to charge VAT of £10,000 on her sales of £50,000, but her business customers can claim this back. She can claim back the £2,000 of VAT (input tax) she has paid on her purchases. The net result is that she receives £50,000 from her sales, claims back £2,000 VAT and pays £20,000 to her suppliers. Her profit goes up from £30,000, before registering, to £32,000, after registering.
An alternative would be to lower her prices as her costs are now lower, but this does not seem necessary as she is not losing sales because of the price she charges.
The second instance of registering being beneficial is if your sales are zero-rated but you are paying VAT on the goods you buy in. See Example 3 below.
Example 3
Barbara Croft runs a business making bibs and similar items for babies. Consumers cannot claim VAT back, but clothing for children is zero-rated, so she does not charge VAT. Her sales are £15,000 and her costs are £5,000, including VAT of £500. If she did not register, her profit would be £15,000 − £5,000 = £10,000. This would be increased by £500 to £10,500 if she can register voluntarily.
How is the tax worked out?
What do you charge VAT on?
You charge VAT on the taxable sales you make; this is known as output tax. The amount of VAT is worked out on the price for the goods or services you are supplying.
You cannot escape charging VAT if you decide to take other goods, for example, rather than money in full payment or in part exchange. In this case, you have to work out the VAT to add on the basis of the open-market value of the goods or services you are supplying.
Packaging is treated as part of what you are selling, so there will normally be no extra VAT to pay; and if the thing you are selling is zero-rated, that also applies to the packaging.
With delivery, if you charge extra for it, VAT is due on that extra amount. But if the delivery is included in the selling price, no extra VAT is due.
Exports of goods are normally zero-rated, and this also applies to many exports of services, although some are standard-rated.
What you can claim VAT back on
You can claim back VAT on the goods and services you use in your business. However, there are some supplies on which you cannot claim back the VAT. Broadly, these include:
- motor cars (but private taxi and self-drive hire firms and driving schools can recover the VAT they pay on cars purchased for their businesses);
- business entertainment expenses;
- if you are a builder, on certain things you install in buildings;
- on some imports if you do not wholly own them;
- on assets of a business transferred to you as a going concern (because you should not have been charged VAT if the going concern conditions have been met);
- on goods that are zero-rated or are exempt supplies (because you have not been charged VAT).
Working out the amount of input tax you have paid
Basically, if your business is very simple, you can work out the input tax like this:
- Get all your purchase invoices in date order.
- In your records (see below), you will have some way of showing the VAT you have paid on each invoice.
- You cannot claim back VAT on exempt or zero-rated supplies.
- Some invoices show the amount of VAT you are charged, so these are quite straightforward.
- Other invoices are not so detailed and you will have to work out the amount of VAT yourself. See Example 4 below for how to do this.
- Remember you can claim back only the proportion of VAT for goods that you use partially in your business. For example, if you run your business from your home, you could claim back the VAT only on the part of your telephone bill that was due to your business.
Example 4
Peter Taylor is working out what VAT he can claim back on some stationery he has purchased for his business. The amount of the VAT is not shown on the receipt he has from the shop. The stationery cost him £4.75. He needs to know the amount of the VAT and the net cost of the stationery.
He divides £4.75 by 1.2 or he does this sum: £4.75 × 1,000/1,200.
Both calculations give the same figure, £3.96, which is the net cost; the amount of VAT he can claim back is £4.75 − £3.96 = £0.79.
The records you need
These are the main additional records you need for VAT purposes, and these must be kept for six years:
- the tax invoice;
- a VAT account showing the results for each tax period;
- the returns to HMRC* showing the VAT payable or repayable.
If you fail to keep your records properly, you can be charged a financial penalty. VAT inspectors will come to see you every so often to check that your records are satisfactory. Although you are still required by law to keep your records for six years, in the normal way, HMRC can go back only three years to review the amount of VAT you should have paid. However, in cases of fraud, HMRC can go back 20 years.
There are special rules about petrol used for your private motoring – check with your VAT inspector. But, broadly speaking, you must keep detailed records of your business and private mileage to support claims that the cost of your private mileage is not included in the business accounts.
Tax invoice
When you supply goods, you should send a tax invoice and keep a copy of it. Your ordinary invoice will do, as long as it includes the following details:
- invoice number;
- tax point (see below);
- your name and address;
- your VAT registration number;
- your customer’s name and address;
- a description of the goods or services you have supplied. This should include the quantity supplied, the charge without VAT, the rate of VAT, the rate of any cash discount and the total VAT charged;
- the unit price of the goods or services.
A tax point is nothing more than the date on which you are liable to account for the VAT to HMRC; this is the date on which you provide the goods or services. However, if you issue a tax invoice or receive a payment earlier than this, the tax point is the date you issue the invoice or receive the payment, whichever happens first. If you issue a tax invoice up to 14 days after supplying the goods or services, and no earlier tax point has been created by a previous invoice or payment (as above), the date when you issue the invoice becomes the tax point. Finally, if you want to invoice monthly, you can use a monthly tax point, but you must have written approval from HMRC first.
Accounting for VAT
At the end of each VAT period, normally every three months, you need to make a VAT return to HMRC; although if you are constantly claiming a repayment, for example because you are zero-rated, you can arrange monthly returns. In the return, you show the information you put in your VAT account; see above. You also enter any bad debts you may have. As a check for HMRC, you have to enter the figures for your total purchases and total sales for the period.
You have to file your VAT returns online and pay the VAT due electronically. You need to sign up for an online account.
The VAT period can be arranged to coincide with your accounting year-end, which can make keeping your records much more convenient. And to simplify it even more, you can go over to a system of annual accounting for VAT (p. 409).
There is a mis-declaration penalty that can be imposed. If you make a careless or deliberate error in your VAT return, you can be charged a penalty of 100 per cent of the tax under-stated or over-claimed. And if HMRC sends you an assessment that’s wrong, and you don’t tell them within 30 days, the penalty is 30 per cent of the assessment. There is also a penalty of £400 if you submit a paper return without the permission of HMRC.
If you don’t send in your VAT return or if you don’t make the full payment by the deadline, you are ‘in default’. A further default in a 12-month period may lead to a surcharge, which is a percentage of the outstanding VAT. The amount depends on the amount of your yearly sales and whether it is the second or a further default. Surcharges of less than £400 are waived.
Sometimes it is possible to negotiate an extended payment schedule with HMRC, although usually not more than once with a 12-month period. It needs to be a formal written agreement from HMRC.
VAT flat-rate scheme
Businesses with a taxable turnover up to £150,000 can opt to join a flat-rate VAT scheme. This can cut the administration involved. Instead of keeping a record of your inputs and outputs and calculating the VAT due to be paid or reclaimed, under the flat-rate scheme you simply pay VAT as a percentage of your tax-inclusive turnover (including all reduced, zero-rated and exempt income). And you keep the difference between what you pay HMRC and what you charge your customers.
In most cases, the only VAT records you will need to keep are the relevant turnover figures and the flat percentage rate being used. However, you will still have to send out VAT invoices, and you might want to continue calculating your VAT in full to keep an eye on whether you are paying more or less VAT under the flat-rate scheme. If you find you are persistently paying extra, consider opting back out of the scheme. You have to leave this scheme if you expect your sales to be more than £230,000.
The flat rate to be used is set by HMRC and depends on the type of business you are in. The rates are designed to reflect the average VAT payable by firms in the particular sector. Whether you’ll pay more or less VAT if you join the scheme depends on whether your VAT payments are usually more or less than the average for your particular industry. For more information, see www.gov.uk/vat-flat-rate-scheme.
Annual accounting
Instead of submitting a VAT return every three months, relatively small businesses can instead switch to annual accounting. This offers three advantages:
- More predictable cash flow because you make regular payments on account throughout the year.
- A possible cash flow advantage, especially if your turnover is tending to increase each year.
- Less admin – and lower fees if you use an accountant – because you send in just one VAT return a year.
Annual accounting is open to your business if you have a yearly taxable turnover of no more than £1,350,000. You can continue in the scheme until your taxable turnover is likely to reach £1,600,000 a year.
The basic scheme works as follows: you and the VAT office agree an estimate of your likely VAT for the forthcoming year – usually this will be based on what you paid last year. You pay 1/10 of this amount by direct debit from the fourth month through to the twelfth month of your VAT year. Within two months of the end of the year, you submit your annual VAT return, making a final balancing payment if further VAT is due or claiming a repayment if the instalments came to more than the total for the year.
If you prefer, you can opt to pay by three larger interim instalments plus a final balancing payment.
Whichever system of annual accounting applies, both you and the VAT office can adjust the interim payments during the year if new information suggests they are no longer appropriate – for example, if your turnover is well below the previous year, you might request that the interim payments be reduced. You can withdraw from an annual accounting scheme at any time by writing to your VAT office.
Cash accounting scheme
If your yearly sales are £1,350,000 or less, you may be able to opt to use the cash accounting scheme (but not if you also use the flat-rate scheme, see p. 409). With this scheme, VAT is due when you’ve received payment from your customer (not when you’ve invoiced them) and can reclaim VAT on purchases when you’ve paid your supplier. This could be helpful to your cash flow.
Paying the tax
Any VAT that is due to HMRC* is payable within one month of the end of the quarterly accounting period or within two months of the end of an annual period. This is regardless of whether you have actually yet received the money from your customers for the VAT due (unless you are in the cash accounting scheme).
If you fail to pay your VAT on time, you are given a warning and could face surcharges. However, penalties are not automatically applied if yours is a small business (with a turnover up to £150,000). Instead, HMRC will initially offer you help and advice to remedy your late payment problem.
You can claim relief from VAT for bad debts that are six months old and that you have written off in your accounts. You can go back three years to claim bad debt relief. However, if you adopt the cash accounting scheme (see above), you automatically get relief from bad debts by never having to pay VAT on them at all.
Summary
- You do not need to register if the value of your sales is too low, but it could still be worthwhile to apply to do so if you sell to businesses that can claim back the VAT or if you are zero-rated.
- Do not confuse zero-rated with exempt supplies. If you supply only exempt goods, you cannot claim back VAT on goods you purchase.
- If the level of your sales falls below a certain limit (£83,000 for 2019–20 tax year) you can ask to have the registration cancelled.
- You may save on administration and may also save tax if you switch to the VAT flat-rate scheme. You do not have to stay in the scheme if you find it results in your paying extra tax.
- You can save on administration and may benefit from cash flow advantages if you opt for the annual accounting scheme.
- Opting for the cash accounting scheme could improve your cash flow and help with bad debts.
Other chapter to read
27 ‘Keeping the record straight’ (p. 363).