Value-added tax (VAT) – Comprehensive Guide

Value-added tax (VAT) is a consumption tax added to taxable supplies at each stage of the supply chain for most goods and services.

The general principle is that the customer ultimately pays the charge the Value-added tax (VAT). Each business in the supply chain will charge the next business VAT. And the business can generally reclaim this as long as they are VAT-registered.

Registering

Not all businesses charge VAT, even if they make taxable supplies.

A business can become VAT registered in two ways – compulsorily or voluntarily.

A business must register for VAT if it meets either of two turnover tests:

  • The taxable turnover for the last 12 months exceeds £85,000.
  • The expected taxable turnover in the next 30 days exceeds £85,000.

The first of these tests is a look back test that must be monitored on a monthly basis. Once the turnover exceeds £85,000, the business must register within 30 days of the end of the month it exceeded the threshold. For example, if a business exceeds the threshold on 9th July. The business must register by 30th August. Then it will be treated as registered business for VAT purposes from 1st September.

The second test requires some forecasting. Looking at invoices that are likely to be raised in the forthcoming month. If the expected turnover will exceed £85,000, the business must register by the end of the 30-day period. And it will be treated as VAT registered from the date they first realise the 30-day test will be met.

It is also possible to register voluntarily – as long as there are at least some taxable sales. This can be a sensible option. If the customers are mainly VAT-registered businesses, they will be able to reclaim the additional charge anyway.

Supplies and VAT tax

Taxable supplies are subject to VAT, but there are several different rates that apply.

The standard rate of VAT in the UK is 20%. This applies to most goods and services which are not exempt. However, there are three other rates to consider.

Reduced rate

Certain goods and services – including children’s car seats, domestic energy and sanitary products – are subject to VAT at a reduced rate of 5%.

Zero rate

Some goods and services are taxable, but are subject to VAT at 0%. Examples include children’s clothing, sanitary products and most basic foodstuffs. It is important to understand that this is not the same as being exempt.

Exempt supplies and zero-rated supplies

Zero-rated supplies still count as taxable. Consequently, they are taken into account when looking at the registration tests. A business making zero-rated supplies can register for VAT, but a business making wholly exempt supplies cannot. A business that makes a mix of taxable and exempt supplies is said to be partially exempt. It can register for VAT, but is subject to special rules which restrict the amount of input tax it can claim.

For further information on which rates apply to goods and services, consult HMRC’s guidance.

Once a business is registered, it must consider its VAT record keeping requirements.

In order to reclaim it input tax on the VAT returns, the business must ensure that the invoices it receives from its own suppliers are valid VAT invoices, and that VAT has been correctly charged.

What is a valid VAT invoice? The information required to be shown on the invoice depends on whether it is a full invoice, or a simplified invoice for retail supplies under £250. HMRC has provided a table detailing what needs to be included. here. 

Making returns

A VAT return is due by the seventh of the second month following the end of a VAT quarter. For example, for the VAT quarter ended 31st March, the return is due by 7th May. Following the rollout of Making Tax Digital for VAT. This must be done using HMRC compliant software. This software exports information from the accounting system to HMRC electronically via the Application Program Interfaces platform.

Partial exemption

As mentioned earlier, where a business makes both taxable and exempt supplies, special rules apply. These are needed because input tax can only be reclaimed to the extent it relates to taxable supplies. In many cases, this will be obvious – for example. Where a business purchases stock subject to standard rate VAT to sell onward. However, there will be some costs that relate to both taxable and exempt supplies – for example. Heating and other overheads where the different activities are made from the same premises.

Input tax that cannot be directly attributed to either taxable or exempt supplies is called residual input tax. This must be apportioned between the two types of activity. The amount apportioned to the taxable supplies can be included in the input tax claim on the VAT return. The amount apportioned to the exempt supplies cannot be recovered. That said, there are rules which allow full recovery of exempt input tax if the total value is insignificant.

The standard method of apportionment is based on the turnover attributable to taxable and exempt supplies in the period. It is possible to agree a different method with HMRC. If the standard method doesn’t reflect the true split of cost centres between the activities.

The need for special schemes

VAT compliance, particularly with the advent of Making Tax Digital, can be disproportionately arduous and complex for smaller businesses. The compulsory registration threshold of £85,000 is not a particularly large amount. A fledgling business can easily find itself being legally required to comply with the VAT legislation early in its life. Even where the threshold is not exceeded, the complexity and extra costs of VAT compliance may put businesses off registering voluntarily. Potentially costing them thousands of pounds in unclaimed input tax. VAT record checks are more frequent than for other taxes too.

Different VAT Schemes

Flat Rate Scheme

What is the flat rate scheme?

The flat rate scheme, as the name suggests, is a scheme whereby you apply a flat rate of VAT to all of your sales, rather than the normal standard rate.

The flat rate scheme allows you to apply a single flat rate percentage to your turnover and ignore all the input VAT that your business has incurred.

How does it work across industries?

Each industry has its own flat rate for the flat rate scheme. So, for instance, a pub might have a rate of 6.5%, a restaurant might have a rate of 12.5%.

If the business joins the flat rate scheme, it will simply aggregate the total VAT-inclusive sales in the period and apply a relevant percentage to this total. The result of this is the amount payable to HMRC.

However, when looking at VAT-inclusive turnover, everything that is within the scope of VAT must be included. So, if a business has zero-rated, reduced-rated, or exempt income, the turnover from these must be included in the FRS calculation. For this reason, if a business is seeking to join the FRS that is about to make large sale that would be zero-rated or exempt, it will be worth considering delaying the joining date.

Under the FRS, the business does not account for its purchases, and so doesn’t recover input tax – unless the expense is for a capital item and the VAT inclusive cost of the individual purchase exceeds £2,000.

The appropriate rate of VAT is still charged to the customer. The relevant percentage only applies to the VAT return when working out what is due to HMRC.

If you’ve got businesses which have more than one activity within them, perhaps a pub which sells food, then you need to look at the turnover within that business to determine which is the predominant activity, and then apply the flat rate scheme for that activity.

One special category relates to low-cost traders. So if your costs of your business are below £250 a quarter, then you may need to apply to special low-cost rate, which is 16.5%. This would apply for people like management consultants for instance where essentially most of their costs are negligible, but their output is all standard rated.

Who can use the scheme?

The flat rate scheme is purely voluntary. It’s available if you want to opt into it or not if you don’t.

To join the scheme, a business must complete form VAT 600FRS.1 Once HMRC approves the application, the FRS can generally be used from the start of the next VAT period – unless HMRC accept there is a good reason to start earlier. In order to join the FRS:

The business must be making taxable supplies, and therefore be eligible to register for VAT. Businesses only making exempt supplies are therefore excluded.

  • The business cannot be associated with another business.
  • The business’ expected taxable turnover excluding VAT in the next year must not exceed £150,000.

A  business will be specifically excluded from the FRS if:

  • It is not VAT registered.
  • It uses the second-hand margin scheme, tour operators margin scheme, or auctioneers scheme.
  • It has to use the capital goods scheme.
  • It was previously using the FRS and 12 months hasn’t elapsed since it left the scheme.
  • It is, or has in the previous two years, been registered in the name of a VAT group or division, or was eligible to join an existing VAT group.
  • In the previous year, it has accepted a compound penalty offer, been convicted of an offence in connection with that, or has been assessed with a penalty involving dishonest conduct.
  • At the anniversary of the FRS start date the business’ total income (including VAT) in the year then ending (excluding sales of capital assets) is more than £230,000
  • There are reasonable grounds to believe the total value of the business’ income for the next 30 days alone will be more than £230,000 (excluding sales of capital assets).
  •  

The cash accounting scheme

The cash accounting scheme allows small businesses to pay VAT on sales when their customers pay, and also to reclaim VAT on purchases when they have paid their supplier.

What is the cash accounting scheme?

The cash accounting scheme is a voluntary arrangement, whereby you can account for your VAT on a cash basis rather than on an invoice basis.

Traditionally, VAT is dealt with by reference to the date on an invoice, rather than date that invoice is paid. So you might sell some goods today and issue an invoice, you may not be paid for it for three or four months. Traditionally, you would account for the VAT on the date of the invoice. But under the cash accounting scheme, you can delay that until the invoice is actually paid. In the same way with goods you buy, normally you would account for the input VAT on the date of the invoice. But you can, under the cash accounting scheme, account for it on the date you actually pay for the goods or services.

What are the advantages and disadvantages?

The main advantage of the cash accounting system is cash flow.

Under the cash accounting system, you’re not paying the output VAT on your sales until you’ve actually been paid by your customers. This could be several months later if you’re offering standard credit terms. That means it’s not really an advantage if you’re in a retail operation where your customer is paying at the point of sale, because the downside is that you don’t recover your input VAT on your costs until you actually pay for them.

Eligibility

A business can only join the CAS if:

  • There are no VAT returns outstanding.
  • The business has not been convicted of a VAT offence in the last year.
  • The business has not accepted an offer to compound proceedings in connection with a VAT offence in the last year.
  • The business has not been assessed to a penalty for VAT evasion involving dishonest conduct in the last year.

Restrictions

Some transactions cannot be accounted for under CAS and must continue to be accounted for using standard VAT rules. The following are excluded to keep the scheme simple:

  • Goods that are bought or sold under lease purchase, hire purchase, conditional sale or credit sale agreements.
  • Goods imported or acquired from an EU member state, or goods removed from a customs warehouse or free zone.
  • Certain goods on which the purchaser must account for output tax on their VAT return on the supplier’s behalf due to the reverse charge – for example, for construction services between CIS-registered entities.
  • Supplies where the business issues a VAT invoice and payment of that invoice is not due in full within six months of the date it was issued.
  • Supplies of goods or services where the business issues a VAT invoice in advance of making the supply or providing the goods.

leaving the scheme

The scheme is purely voluntary. But if your turnover exceeds £1.35m, then you’re excluded from the scheme. So most small businesses will be eligible to use the scheme if you want to.

If the business turnover exceeds £1.35m the business may not have to leave the CAS straight away. In fact, it can remain in the scheme until turnover exceeds £1.6M in a 12-month period. This is a “look back” test and needs to be done on a rolling basis.

The annual accounting scheme

The annual accounting scheme aims to allow businesses to make advance VAT payments towards their VAT bill, based on their last return (or estimated if you’re new to VAT).

What is the annual accounting scheme?

The annual accounting scheme, as the name suggests, means you only need to submit one VAT return, once a year. This is a simplification to make life easier particularly for small businesses.

You’re eligible to join the scheme providing your turnover is below £1.35 million.

What are the advantages and disadvantages?

The main advantage of the annual accounting scheme is certainty – you know exactly how much you’re going to be paying each month. Payments are made for nine months at a fixed rate, and then there’s a final tenth payment when you file your end of year return and then any additional VAT is paid or any excess VAT is recovered.

The main disadvantage would be, if you’re entitled to a refund, then you’re delaying that refund until you get to the end of the year.

Who can use this scheme?

The annual accounting scheme is a purely voluntary arrangement, but you must have a turnover below £1.35 million in order to enter the scheme.

Once you are in the scheme, you need to monitor your turnover, because if your turnover exceeds £1.6 million, then you need to exit the scheme.

One advantage of the scheme is that you can combine it with the flat rate scheme. So you have not only a known payment each month, but actually a known liability for the whole year.

Restrictions

A business cannot join the scheme, regardless of the level of expected turnover, if it:

  • Is a member of a VAT group or division.
  • Has, within the previous 12 months, ceased using the AAS.
  • Has an increasing VAT debt.
  • Has entered insolvency proceedings.

Paying instalments

Once on the AAS, a business will make nine instalments equal to 10% of the previous year’s annual VAT liability, or 10% of the estimated liability for the next 12 months.

The first payment is not due until the end of the fourth month of the annual period. The remaining payments are then due at the end of each month – up to and including month 12.

It is possible to request quarterly instalments instead of monthly instalments if it suits the business. If this option is chosen, three instalments of 25% will be made by the end of months four, seven and 10, with any balance or refund being reconciled by the standard deadline – within two months of the end of the 12-month period.

Margin schemes

What is the margin scheme?

The margin scheme for VAT involves paying VAT on the margin – the profit you make on the sale of goods – rather than the ins and outs.

Normally with VAT, you pay output VAT on the sale of goods, and recover input VAT on the goods you’ve purchased, and you pay the difference over to HMRC. Under the margin scheme, you are only paying VAT on the profit margin you make. This is particularly useful for second-hand goods where you may not have had any input VAT on your purchase of goods, but when you sell them you’re likely to have charged standard rates.

Who can use the scheme?

Anybody can use the margin scheme if they’re buying and selling goods without recovering input VAT on the purchase. Typically, this will be second-hand goods, works of art, or antiques and things of that nature.

There is a special variation of the scheme which deals with second-hand cars and has its own particular rules and regulations.

What about keeping records?

In order to apply VAT to the margin on the sale of goods, you need to be able to identify not only what the selling price is, but also what the purchase cost was, so that you can work out the margin on which you’re applying the VAT. In order to do that, you need to keep special stock records – very detailed records – of each individual item which you buy and sell.

Eligibility and restrictions

Unlike some other schemes, there is no turnover limit on the general margin scheme.

This is because the scheme is aimed at certain types of business, rather than certain sizes. However, there are strict steps that must be followed when buying or selling goods which are set out in HMRC’s current guidance

Goods must be eligible goods that have been acquired in eligible circumstances. Eligible goods include:

  • Second-hand goods, including second-hand cars.
  • Works of art, such as paintings and sketches.
  • Antiques and collectors items – this does not include precious metals or stones.

Goods will generally be acquired in circumstances where no input tax has been reclaimed, or the business would have been entitled to reclaim it.

Leaving

Similarly, the business can stop using the margin scheme at any time – it will simply change the way it accounts for VAT on the return, accounting for VAT on the full sales price instead of just the profit.

Get in touch with one of our experts and have a obligation consultation. We are here to help you make the right decision for your business.