Let’s talk about VAT – the basics

Value Added Tax – otherwise known as “VAT” – is something most people have heard of. You might have seen it on a shop receipt without thinking much about what it is. But unless you work in the wonderful world of accountancy, the complexities of VAT will be a mystery to you. This can all be especially daunting for a business that is newly registered for VAT. So, what is VAT and how does it operate?

VAT is an indirect tax. This means it is charged on the value of goods or services rather than on income and profits. While direct taxes are paid directly from the taxpayer to HMRC (sometimes via employers), VAT is collected by a VAT registered business from its customers and then passed on to HMRC. The business is effectively a middleman.

The most common VAT you will see is the Standard Rate of VAT, which is currently 20%. Therefore, normally, a VAT registered business will be required to charge 20% of VAT on their sales. It is here where the terms “net” and “gross” come in. The net sales price is excluding VAT and what the business reports as their turnover. The gross sales price is including VAT.

For example, take a record shop that is VAT registered. They sell a vinyl record for £18 to a customer. This is the gross price. A common misconception is that the VAT is calculated on the gross amount. In this case, 20% of £18 is £3.60. However, the VAT is calculated on the net amount:

A quick way of working out the VAT from the gross amount, if this is what you are starting with, is by dividing by 6. (This is because the fraction is 20%/120% which is equivalent to 1/6.)

Therefore, should our record shop sell £6,000 worth of records over a certain period they would need pay £1,000 of VAT to HMRC.

One “bonus” of being VAT registered is that you can reclaim any VAT it has incurred on business expenses (with some minor exceptions, such as for entertaining). This is called “input VAT”, while the VAT on sales is called “output VAT”.

So, say our record shop incurred £400 of input VAT buying the records from the distributor (amongst other business expenses), they can deduct this before they handover the output VAT on their sales:

Sometimes the input VAT will be greater than the output VAT and the business will receive a refund from HMRC.

While this might seem like a perk, the purpose of this is to ensure the end customer only pays VAT on the combined net amounts and underlying value added by the business in the chain (hence the name).

As VAT will increase the price of a good or service to the end user, the government sets different VAT rates for certain things. For example, there is zero rate of VAT for essential stuff, like basic food, books, children’s clothing, public transport and (now, post-Brexit) sanitary products. (Note, food is a hugely complicated area as a bag of potatoes (deemed essential) is zero-rated, but a bag of crisps (deemed a luxury) is not.) There is a reduced rate of 5% for domestic light and heat costs. There are also exempt products, such as insurance and financial charges, where VAT cannot be charged (and crucially, input VAT cannot be reclaimed either).

While any business (except those with solely exempt supplies) can register for VAT voluntarily, there is a VAT registration threshold that is currently £85,000. If a business’ turnover exceeds this threshold in any 12-month period they will be required to register for VAT. (There is also a requirement to register if you expect your turnover in the next 30 days to reach this, but that is aimed for businesses that will hit the ground running.)

This does pose an issue for businesses selling directly to consumers. For example, take a wedding entertainer. They currently charge £2,000 per wedding. As they have slowly gained a reputation and popularity, they now have a wedding booked for 50 Saturdays in the next year, i.e. their turnover will be £100,000. They will at some point exceed the £85,000 threshold. As they now need to account for VAT, they either have to add on VAT to their £2,000 fee, i.e. increase to £2,400, making them more expensive to their customers, or keep their fee the same but have to pay over 1/6^th of their fee (£333) to HMRC, leaving them with less cash in their pocket (£1,667).

This is not an issue for businesses that sell to other VAT registered businesses. Take the same entertainer who instead decides to accept a residency at a bar where they played every Saturday night for the same £2,000 fee. Since the bar is VAT registered, it makes no difference if the entertainer adds £400 of VAT as the bar will simply reclaim this as input VAT.

This might make a voluntary VAT registration seem like a good option, especially if you have a lot  of input VAT on your expenses, but VAT comes with some extra administrative requirements. The business will need to have good record-keeping processes as they strictly can only reclaim input VAT where there is a VAT invoice from the supplier, and they need to issue a VAT invoice to their customers. Furthermore, the business will need to file quarterly VAT returns using bookkeeping software. Luckily, modern bookkeeping software is packed with useful tools to help ensure you capture all your purchase invoices.

This is only a brief overview of what is an incredibly complicated subject matter. There are many nuances and things can get quite complicated (for example, if you start importing or exporting goods). You could spend days studying VAT (as indeed I have as part of my qualification) and still only have a basic understanding, so it is always worthwhile referring queries to an expert.

While it is not essential, VAT registration is often the point at which a business decides to use an external accountant to help handle their tax affairs. This gives them peace of mind they are doing things correctly. Often the savings available from reclaimed input VAT will help justify the additional expenditure on accountant alone.

These are general examples and not formal advice. Also, tax law is constantly changing, so the issues discussed here might now be out of date. Each taxpayer is different; therefore, we recommend that you consider your options carefully with an expert before taking any action.

If you want to discuss any of the above, or any other matter, just give us a call on 020 7183 3383 or email info@kma-spotlight.com.