What do I need to know about VAT?

Value added tax or VAT is a tax which is charged when a VAT registered business sells goods or services. It is a sales tax collected by businesses on behalf of the government.

A business which is registered for VAT will charge VAT to its customers at a rate set by HM Revenue & Customs (HMRC). The rate will be dependent on what is being sold, though most supplies are taxed at 20%. The customer pays the VAT to the supplier at the same time as paying for the goods. The supplier collects the VAT and pays it over to HMRC periodically. 

This additional income does not belong to the business that charged the VAT. 

Where the customer is VAT registered themselves, VAT charged to them can be reclaimed from HMRC (there are special rules for this). The amount payable or receivable is calculated by completing a VAT return. 

There are three rates of VAT. The rate to be charged by the business is predetermined based on the item that is being sold or the service being offered. The rates are:

• Standard rate at 20% – this applies to the majority of goods and services
• Reduced rate at 5% – gas and electricity used in the home for example
• Zero rate at 0%  – includes books and newspapers, children’s clothing, public transport and most food (excluding meals-in and takeaways).

A business will need to charge VAT when:

• it is VAT registered (this could be because they have registered compulsorily or voluntarily) and
• it has as made a taxable supply (sale of goods or services).

A business’ taxable sales will include any items sold where VAT has been charged at any of the above rates (even zero rate). 

Certain items will be exempt for VAT (for example insurance, education, and training, subscriptions, doctors and dentist services) or completely outside the scope for VAT such as employment income and dividends received. These items will not be included in your taxable sales figure (for VAT purposes).

From a sales perspective, you will need to state the rate of VAT applicable to that sale when you are preparing your sales invoices.

If you use a software package you will only need to do this once when loading your product list into the system. Once the rate of VAT has been set, each product will be allocated a code. These codes will then be used when preparing invoices and the VAT (at the relevant rate) will be calculated.

Many businesses prepare their own VAT returns but if you are unsure on any aspect of this then a bookkeeper or accountant will be able to advise you. 

For an overview of whether the items you are selling should include VAT or not, you can find further guidance at GOV.UK

When you become VAT registered you will need to start keeping VAT records showing details of the VAT you have been charged and the VAT you have charged your customers. 

Assuming you want to retain as much of the sale yourself as before – i.e you don’t want to charge the customer the same in total but now give some of it to HMRC for VAT – then the price that your customer pays will automatically increase. For example, if you aren’t VAT registered and sell  a product for £100 then this is the total amount your customer will pay. Once you become VAT registered, VAT will be charged on top and so the cost of the product being sold to your customers will increase by 20% to £120.  

Where the customer themselves is VAT registered, they will be indifferent to your VAT status as any VAT charged to them can be reclaimed (rules do apply here though as some VAT charged is non reclaimable e.g. VAT on a car purchase). However, where you are in business and selling to a private customer then they are unable to reclaim the VAT which makes you now more expensive and possibly less competitive. 

Think about a painter and decorator that does work in both commercial and private properties. The VAT charged on the commercial work maybe isn’t an issue, because the customer is likely to be VAT registered and will be able to recover the VAT charged to them. The private customer won’t be able to do this and may instead look for a painter and decorator that is not VAT registered or offers a cheaper service and in turn pay less for the service.

However, a small business that is VAT registered can be very appealing to other businesses and customers: it gives the impression of being bigger and more established.