Contractor’s guide to VAT

What is output tax?

Output tax is the VAT that is added to goods and services that are sold by a contractor. Generally speaking, when a contractor sells goods or a service, they must create an invoice with the VAT added at the agreed rate (normally 20%, but sometimes 5% or 0%).

To calculate the amount of VAT that should be added at a rate of 20%:
(the value of the goods or services  100) x 20
This amount is then added to the price of the goods or services

For example:

If you charge a daily rate of £250 per day and work for 3 days, and the VAT rate is 20%:
£250 x 3 days = £750
(£750  100) x 20 = £150

Therefore, the total amount that you would charge on the invoice is:

£750 (goods or services) + £150 (20% VAT) = £900 total

When you are creating an invoice with VAT on it you will also need to check for other details that must be provided, such as a unique invoice number.

It is essential that you also keep copies of your output tax VAT invoices. This is because you will need them at the end of each quarter.

What is input tax?

The term ‘input tax’ refers to the VAT that a contractor’s suppliers charge on their invoices – in other words, the VAT that is charged to the contractor when they buy goods or services. Of course, this amount is calculated by the supplier, but when you receive an invoice with VAT charged on it, you must keep the invoice to enable you to offset it at the end of the quarter against the VAT that you have charged yourself.

If you have been given a total value and are looking to calculate the amount of VAT that you have been charged on the item or service, the calculation is as follows:

((the total amount that you have been charged)  (100 + VAT %)) x 20

For example:

If you buy a piece of equipment for £450 and have been charged VAT at 20%,
£450  (100+20) = 3.75
3.75 x 20 = £75 = the VAT that you have paid at 20%

This means that the actual value of the piece of equipment before VAT is £450 – £75 = £375.00

How do I work out my VAT return?

As a limited company contractor, you have a responsibility to account for your VAT affairs every quarter. It is recommended that you fulfill this – and pay your VAT bill every three months for two main reasons.

• Firstly, it is a good idea to spread your administration out over the year to avoid a huge workload at the end of the year.
• Secondly, it is much easier to keep track of your finances when you do not get a big bill at the end of each year.

You do have the option of paying just once a year, but we do not recommend this, especially to smaller businesses and contractors.

At the end of each quarter, HMRC will send a VAT form to anybody that is VAT registered to be filled out and paid for that quarter (by the end of the next month).

Put simply, filling out your VAT return is a case of calculating the difference between your business’s output tax and your business’s input tax.

So, the calculation is

output VAT – input VAT = the amount of VAT that you owe to the HMRC

In the example above, therefore, if we imagine that the contractor only worked for those 3 days and only bought one piece of equipment, the calculation is as follows:

£150 (output tax) – £75 (input tax) = £75 (VAT to pay HMRC)

This process of offsetting the input tax against the output tax can mean that businesses are able to save great amounts of money if they do it properly and that they are effectively getting some items for a lower price. It can be worth the extra paperwork, time, and accountant’s fees for some businesses – but not all.

Disadvantages of VAT registration

Depending on the nature of your business as a contractor, VAT offsetting (and, therefore, being VAT registered) may not make sense financially.

If you often work with businesses that are not VAT registered, you cannot offset the VAT that you have been charged, and, therefore, could lose out. This is typical of charities, parts of the public sector, and if your business deals a lot with the general public. If this is the case, you will need to include the VAT into your price, which can have a knock-on effect of limiting your ability to compete with other businesses.

Another situation whereby it may not be beneficial for you to become VAT registered is if you do not regularly buy items from suppliers. If you are creating digital goods, for example, and are creating them from scratch, you will have fewer outgoings to pay for, and therefore less VAT to offset against your VAT. In this case, it might not make financial sense for you to register.

It is important to remember, however, that if your business has a gross income of £85,000 or more each year, you are required by law to become VAT registered. 

Some contractors get around this by creating two companies – one that is VAT registered, and one that is not. They can then decide which customers should be allocated to which business, ensuring that they not only offer the best prices to customers but also benefit from the VAT offsetting process. This is a legal solution that many contractors, as is setting up two non-VAT registered companies that do not reach the threshold without the need to register.

Deregistering from VAT is an option if your business has registered for VAT but your turnover falls under the de-registration threshold of £83,000.

VAT inspections

When you are VAT registered there is the chance that you might have your VAT accounts inspected by the VAT inspectors. This is to ensure that businesses are carrying out their VAT affairs in a legal manner. This will happen roughly every six years but can be more often than this – at the discretion of the VAT inspector.

If all of your VAT claims have been made legitimately and your paperwork is in order, this inspection is nothing to worry about. If, however, you are found to have not made accurate claims, you can be fined for VAT returns of up to six years ago.