In this post we offer a general introduction to VAT.
This guide links to external resources were it was appropriate to do so.
Topics covered include:
- A definition of VAT
- What is a VAT return
- Available VAT schemes
The history of VAT
VAT stands for Value Added Tax. VAT is a form of ‘consumption tax’ charged on both goods and services. VAT is applied at 20% to the ‘value’ added to goods or services. This ‘value’ is added to the goods or services either in the manufacturing or distribution process.
The concept of VAT was thought up by a German industrialist in 1918 and first adopted by the French in 1954. It was not until 1973 that VAT was introduced in the United Kingdom, a requirement for the UK’s entry into the European Economic Community (EEC). Before 1973 the UK applied a ‘purchase tax’ instead.
Who pays VAT
Ultimately VAT is only paid by the consumer. This is because VAT-registered businesses claim back the amount of VAT they may have paid when acquiring goods or services. Businesses thus act as an unpaid tax collector for the Chancellor. In a purely business-to-business transaction when both buyer and seller are VAT-registered the Treasury will receive no-VAT since both parties in the chain claim back VAT they have paid.
VAT is perhaps the most controversial form of tax, earning it the nickname of ‘Very Awkward Tax’. Since VAT is purely a consumer-tax, many social-commentators have criticised VAT for unduly burdening the poor.
How important is VAT to a modern economy?
VAT accounts for roughly 15% of revenue collected each year by the Treasury. In 2013/14, £105.3 billion was collected in VAT. In 1978/79 the Treasury collected just £4.9 billion from VAT.
VAT is vital for the fragile economies of many developing countries such as India and Pakistan who cannot generate enough revenue via income taxation. Even the France relies on VAT for around 50% of its overall revenue.
When and how to register for VAT
Businesses must register for VAT once their revenue reaches £82,000 over the last twelve months. This threshold changes each year. Click here for more information. Businesses have 31 days in which to register for VAT once this threshold is reached. Businesses may register for VAT voluntarily before revenue reaches this threshold. Voluntary registration is popular for businesses involved in ‘business-to-business’ transactions. This is because VAT registration allows new businesses an ability to appear more established, particularly in the eyes of their suppliers and customers.
You may register for VAT by clicking here. Once you’ve registered for VAT, HMRC will send you a VAT registration certificate detailing your VAT number, date of registration and when you must send in your first VAT return and accompanying payment.
VAT rates you must charge once registered
There exists three rates of VAT and the correct rate depends on the nature of goods or services you sell.
VAT rates are as follows:
- 20% standard rate
- Zero rate – example goods charged at 0% VAT include animal feed, drinks and plant produce
- 5% rate – example goods charges at 5% include aids for the elderly and domestically produced fuel
Click here for a comprehensive list of goods and services and the correct VAT rate to apply for each.
What is a VAT Return?
A VAT return details the exact amount of VAT you have paid to your supplier (input tax) and amounts charged to your customers (output tax). Most businesses submit their VAT return to HMRC on a quarterly basis. The number of VAT returns submitted each year depends on the VAT scheme you join. Please read below for more details on different VAT schemes.
VAT registered businesses must submit a VAT return even when no VAT is due e.g. when all transactions relate to zero-rated goods or services.
The VAT return subtracts VAT on purchases (input tax) from VAT on sales (output tax). If you pay more VAT on purchases than you receive on sales, HMRC will refund you the difference.
What must I include on my VAT return?
A complete VAT return contains the following fields:
- Total sales and purchases amount
- Amount of VAT you reclaim
- Amount of VAT you owe
- Total VAT refund due
You VAT return is completed online. Click here to register with HMRC.
Available VAT Schemes
You must elect for an appropriate ‘VAT accounting scheme’ when you first register for VAT. Below we list the four most common forms of VAT accounting schemes currently available.
Standard VAT accounting
Standard VAT accounting requires you to pay VAT on invoices raised by way of ‘payment on account’. This means you must pay VAT on sales even if your customer has not yet settled his or her bill. However you may reclaim VAT on invoices your supplier has raised even when you have not yet settled your bill e.g. when you receive goods or services under credit terms.
Standard VAT accounting may hurt your cash flow situation if you offer your customers generous credit terms. Click here to learn more about managing your cash flow.
Flat rate accounting
When a flat rate VAT scheme applies you pay VAT according to a fixed percentage of your revenue. This percentage is determined according to the industry you operate in. For instance, accountants, architects and solicitors pay 14.5% of their revenue in VAT. Food retailers pay VAT at only 4%. Click here to view a comprehensive list of different industries and the correct rate of VAT to apply for each.
To be eligible for flat rate VAT accounting your business must have generated £150,000 or less (exclusive of VAT) in revenue over the last twelve month.
When a cash accounting VAT scheme applies your liability to pay VAT only arises once customers pay for goods and services you provide, not the earlier date of when an invoice was raised. Cash accounting is favourable for businesses who offer generous credit terms. However cash accounting prevents your business from reclaiming VAT on purchases you have not yet paid for.
To be eligible for cash accounting your business must have generated now more than £1.35 million in revenue over the last twelve month.
When an annual accounting VAT scheme applies HMRC estimates your VAT bill for the year based on the previous year’s VAT bill. You make an advanced payment at the start of the tax year based on this estimate. At the end of the tax year you either top up this amount if you made an underpayment or apply for a refund if you paid too much.
The key advantage of annual accounting is that you submit only one VAT return for the entire year. This scheme is unsuitable for businesses who must regularly reclaim VAT.
To be eligible for annual accounting your business must have generated no more than £1.35 million in revenue over the last twelve months.
Click here for more information on annual accounting schemes.
Several variations of retail accounting VAT schemes currently exists. The most common retail accounting schemes include:
- Point of sale scheme – when the retailor has the ability to calculate VAT at the time of sales e.g. through the use of an computerised cash register
- Apportionment scheme – applicable when the retailer buys goods for resale. This is not allowed for services or where the retailer also manufactures the goods
- Direct calculation scheme
HMRC requires retailers earning more than £130 million per annum to set up a bespoke retail scheme. A retail scheme may be combined with a cash accounting VAT scheme described above.