How Does VAT Work in the UK?
Value added tax (VAT) is a "consumption tax" that is collected by businesses on behalf of Her Majesty's Revenue and Customs (HMRC). It is charged on goods and services that individuals and businesses buy.
But there are different rates for different types of goods and services, so there's quite a bit to work out for VAT-registered businesses.
The good news is that you can claim VAT relief on your business purchases.
Put very simply:
- You charge your customers VAT
- You're charged VAT as a customer.
- You owe HMRC the difference
Of course, it's more complex than that and there's record keeping and other paperwork to contend with. Don't panic—FreshBooks keeps all these transactions in order, ready for your quarterly reports to HMRC.
Here’s What We’ll Cover:
When Do I Have to Register for VAT?
As soon as your business's annual taxable turnover hits the VAT threshold, you need to register in the UK. For example, the 2020-21 tax year threshold is £85,000. As soon as your turnover reaches that amount, you must register for VAT. From this point, you must charge UK VAT rates on your goods or services and pay the tax on your business purchases.
Some businesses choose to register for VAT when they haven't yet reached the taxable turnover threshold because it makes the best financial sense for them.
You report your VAT sales and purchases to HMRC on specific returns that are submitted every three months.
The balance between the two is crucial to balancing your books. As HMRC summarises: "If you’ve charged more VAT than you’ve paid, you have to pay the difference to HMRC. If you’ve paid more VAT than you’ve charged, you can reclaim the difference from HMRC."
What Are the VAT Rates?
There are different categories of goods and services, including three levels of VAT rates, exempt and out of scope.
Let's deal with what you don't charge VAT on first.
Exempt Goods and Services
If your business only trades in exempt goods and services, you don't need to register for VAT. There is a full HMRC list of all goods and services and their VAT status here. So you can check your own business position. Exempt goods and services include: some health and hospice care, educational establishments, and public postal services. Most of these have their own specific VAT Notice with the individual details of their exempt status.
Outside the Scope
Some items are simply not part of the VAT system and are classed as 'outside the scope' of VAT. This includes things like charity donations and sales from hobbies. But is also includes goods or services you buy or use outside the European Union (EU) and statutory fees. None of these out of scope items are chargeable for VAT and cannot have VAT relief claimed on them.
3 VAT Rates
There are three VAT rates in the UK: Standard rate, reduced rate and zero rate. All of these transactions must be recorded and reported to HMRC on your VAT returns. If you are registered for VAT it's vital that you pay the correct rate of VAT.
Standard Rate VAT
Most goods and services are charged at the standard rate of VAT. This is currently set at 20%.
Reduced Rate of VAT
The reduced rate of VAT is currently set at 5%. An item, or the "circumstances of the sale," may put it into the reduced rate. For example, domestic power, sanitary products and children's car seats are always charged at the reduced rate. But, as in HMRC's own example, mobility aids are only subject to the 5% reduced rate if they are installed in the home of someone over 60 years old. It's important to pay attention to the details of the regulations.
Zero Rate of VAT
This is the trickiest one to get your head around. At first it feels a bit redundant. Goods and services that are zero rate for VAT are classed as 'VAT chargeable'. But the rate of VAT is, literally, 0%. You add 0% to your customers' bills.
Examples of zero rate items are:
- Children's clothes and shoes
- Newspapers and books
- Motorcycle helmets
- Goods supplied to a VAT-registered EU business
- Most exports to non-EU countries
Your customers don't have to pay VAT but, once you register for VAT, you have to record and report zero rated goods and services sales on your VAT return.
HMRC points out that: "Rates can change and you must apply any changes to the rates from the date they change." Which makes some sense of the 0% rate. HMRC have organised all goods and services into their VAT categories. This simplifies any future changes to the VAT rates. At any point, the government can announce that all standard rate VAT goods and services are now 21%. Or that the 0% rate is now 1%. And it's the responsibility of every VAT-registered business to apply that change immediately.
What Is the 2020 COVID-19 Response for VAT in the UK?
Part of the UK government's emergency COVID-19 financial package is being implemented through VAT reductions. The measures were announced on 8th July and are applicable between 15 July 2020 and 12 January 2021. Between these dates, certain businesses in the tourism and hospitality industries can apply a reduced VAT rate of 5% on their goods and services. They are not legally obliged to pass this on to their customers as reduced prices.
The aim of the VAT reduction is to "support businesses severely affected by forced closures and social distancing measures." It applies to:
- Restaurants, cafes and pubs: All food and non-alcoholic drink (alcoholic beverages are not included)
- Takeaway restaurants selling hot and cold food
- Hotels and other holiday accommodation, like caravan and camping sites
- Attractions, like zoos, theatres and museums
- VAT flat-rate scheme, for businesses with turnover under £150,000
It's a good idea to examine the details of the reduced VAT rate scheme with your accountant to make sure your business meets all the criteria and you have all the necessary record keeping processes in place.
What Is the VAT Flat-rate Scheme?
Outside the VAT flat-rate scheme, the amount of VAT you pay or claim back is the difference between the VAT you collect from your customers and how much VAT you pay on your business expenses. Its a fluctuating amount that you have to carefully record.
If your business's taxable turnover is less than £150,000, you can join the VAT flat-rate scheme. This means that you pay a fixed rate of VAT. The rate depends on the industry you're in and if you fit into the 'limited costs business' category.
You only pay HMRC the flat-rate amount. You can keep any VAT you charge over that figure. But you can't claim back VAT relief on your business purchases. It's wise to discuss this as an option with your accountant, to see if its a good fit for your business.
What VAT Records Do I Need to Keep?
You really do need to be meticulous about your VAT record keeping. Luckily for you, FreshBooks does most of the hard work for you, making sure you're ready to submit your VAT returns digitally.
If you're supplying services or goods that are zero, reduced or standard rate, you must make sure that your business is:
- Charging the correct VAT rate
- Keep track of the VAT amount charged, whether your pricing includes or excludes VAT
- Record the correct VAT information on your invoices
- List all VAT transactions in your VAT account
- Show everything on your VAT Returns
Once you're VAT registered, your invoices must include:
- Date of supply and date of invoice (if different)
- Invoice number
- Business name and address for you and the customer
- Your business's VAT registration number
- Brief but accurate description of the goods and services purchased
The slightly more complicated element is being totally clear about the VAT figures. Every invoiced item should show:
- Unit price and quantity, without VAT
- VAT rate you're applying
- Total payable, excluding VAT
- Total VAT to pay
- Any cash discount
When you're new to this, especially for small businesses, it does seem a bit fiddly to do yourself. But clarity in your record keeping is the way to make sure you pay all the value added tax you owe. And it's the evidence of your business integrity.
If you're a small business owner, any tax reliefs and allowances are a welcome cash boost. The turn off for many is usually the process of claiming. At least claiming your VAT refund is done within the VAT return process you're already familiar with.
Let's get the bad news out of the way first. There are some things you can't claim VAT for, including:
- Goods or services that aren't for business use
- VAT exempt purchases
- Anything you spend on business entertainment, like taking clients for lunch
- Items or services bought from an EU country
- Anything you receive as part of a going concern transfer
- Any items you buy within a VAT second-hand margin scheme
OK, some better news now. Other than those things listed above, you can claim VAT back on most goods and services you buy for your business use. If there is a part-business, part-private use situation, you are able to claim the business proportion.
And now for some extra good news! You can claim VAT on some purchases you made before your business became VAT registered. Of course, there are stipulations from HMRC. We wouldn't expect anything less.
The first pre-VAT registration rule, is the timing of the purchases. You can only backdate purchases of goods for four years from the date of you became VAT registered. And you must still have those items, or have used them to make other goods that you currently own. You can also backdate the cost of services for six months form the date you first started to charge VAT.
Another important rule is that these purchases must relate to your current, VAT-registered 'business purpose.' In other words, they must be connected to the services or goods you supply now.
You must have invoices and receipts, with the date of purchase and a description. You also need to have a record of how they are used in your business today. These backdated VAT claims go on your very first VAT Return, in with your Box 4 calculation.
Assets Worth Over £50,000
Business assets that cost more than £50,000 have a different set of rules. They apply if you buy individual computers, other technology equipment, boats, ships or aircraft with a price tag over £50,000+ , excluding VAT. Or if you purchase property or land costing £250,000+, before VAT.
Firstly, how exciting to have a ship as a business expense! Secondly, you may need to use the Capital Goods Scheme to spread your VAT rebate across a number of years.
Reporting VAT to HMRC
You submit a VAT Return to HMRC every three months. Each of these quarters is known as an 'accounting period.' Every VAT return is a full record of all your VAT sales and purchases for that three month accounting period. All VAT-registered businesses must submit VAT Returns, even if they don't owe any VAT or have any to reclaim.
They must show all your figures for:
- Total sales
- Total purchases
- Total VAT you've charged your customers
- Total VAT you've paid on your purchases
- How much VAT you owe HMRC
- How much VAT refund HMRC owes you
Good to know: HMRC usually has your VAT refund to you within 10 days.
HMRC expect most businesses that are registered for VAT to submit their VAT return online. You must submit your VAT return and pay any VAT you owe one calendar month and seven days after the end of your accounting period. As expected, there are financial penalties for missing submission and payment deadlines.