How Does VAT Work?
Whether you are a consumer, or a small business owner, you are likely already familiar with the basic concept of the Value-Added Tax (VAT) that is assessed on the majority of purchases.
On the consumer end of the equation, VAT is simply an additional cost that must be paid when making a purchase. However, if you are operating a small or mid-sized business VAT can be a much more complex, and serious matter.
In this post, we will provide an in-depth overview of what VAT is, how it works, and what it means to your business.
What Is VAT?
VAT is a consumption tax, similar to a sales tax, that is assessed on the sale of goods or services. In contrast to a sales tax, which is generally collected in one lump sum when the sales transaction is finalised, VAT is levied at various stages of the sales journey.
This means that VAT is not only collected from the consumer at the moment of the transaction, it is also charged at each stage of the supply, manufacture, and production process. As a business owner, you are responsible for paying VAT payments to your suppliers for both finished products, as well as the raw materials required to manufacture those products.
You are required to pay out VAT, commonly referred to as Output VAT, to your suppliers regardless of the size, and scope of your business sales or revenue. However, you may recoup some of this Output VAT, by passing on the charge to your end consumers in what is known as Input VAT. You can begin to charge Input VAT when your business reaches the minimum revenue threshold, or you voluntarily opt to become a VAT-registered business.
How Is VAT Charged?
VAT is charged as an additional cost that you pass on to the end consumer of your products during the final sales transaction. In this particular aspect, VAT functions similar to a traditional sales tax.
However, unlike traditional sales tax which is generally charged as one predetermined percentage set by the regulatory agency in charge of taxation, VAT percentage rates may differ depending on the type of product or service that you are selling.
There are four main VAT percentage rate categories that encompass most varieties of consumer transactions,
Standard Rate VAT:
The Standard Rate of VAT is set at 20% of the purchase price. The standard rate VAT is levied on the majority of consumer purchases of goods and services.
Reduced Rate VAT:
The Reduced Rate VAT of 5% is levied on a select group of predetermined consumer products or services such as fuel and power supplied to charitable housing, or select safety equipment such as children’s car seats.
Zero Rate VAT:
Zero Rate VAT is, as the name implies, a 0% tax rate applied to items deemed to be essential purchases. Which products are, or are not considered essential goods is pre-determined by the governing agency but generally includes necessities such as grocery food items, children’s clothing, drug prescriptions, newspapers, books, and home sales. Zero Rate VAT items may also be referred to as VAT Exempt.
If your business sells Zero Rate VAT items or services exclusively, then your business may qualify for VAT-exempt registration. In order to claim VAT exempt status, you must first apply, and be approved, before registering as a VAT Exempt registered business.
When Do VAT Charges Apply?
VAT is imposed on the vast majority of goods and services sold in the UK.
VAT must be levied on:
- All products or services that are sold to end consumers
- All supplies purchased for business use including finished goods AND raw materials
- Goods that are loaned to others
- Liquidated assets
- Earned commissions
Now that we have listed the goods and services that are assessed VAT, let’s look at the list of select goods and services which are considered VAT exempt.
The government declares some goods and services to be VAT exempt. As a general rule, these goods and services are considered to be essential necessities and as such the government does not want to impose any excess taxation on these products or services.
VAT Exempt goods and services include:
- Goods and services provided by or to charitable organisations
- Services provided by energy utility providers
- Services provided by healthcare and medical professionals and providers
- Education-related goods and services
- Insurance, financial, and investment-related services
This is not an exhaustive list, and items that qualify as VAT exempt may change periodically according to community needs as determined by the government.
How Does A Business Become A VAT-Registered Business
As we discussed briefly in an earlier section, in order to recoup the cost of the Output VAT paid to suppliers, a business must apply to become a VAT-registered business. There are some important factors to understand when it comes to understanding when and how to apply for VAT-registered business status.
The law requires that all businesses must apply to become VAT-registered businesses, and must begin charging VAT when their annual revenue exceeds £85,000 in a given tax year. This is a strict requirement, and businesses are required to register within 30 days of the date that they cross the VAT registration revenue limit threshold.
Businesses may also opt to apply for voluntary VAT-registered business status in order to begin charging VAT. There are both pros and cons to choosing to voluntarily attain VAT-registered status. You will be adding additional red tape to your business operations, however, once registered you will be able to regain some of the revenue that you are currently paying out to suppliers in Output VAT.
What Is The Benefit Of VAT Registration?
As a VAT-registered business, you are able to file VAT returns to the government allowing you to have some portion of the Output VAT paid out to suppliers refunded to your business. Of course, obtaining this refund from the government requires precise, and comprehensive record keeping on the part of your business. However, most business owners find that the recouped revenue is well worth the extra hassle.
The VAT system is too complex and the minutiae are beyond the scope of this blog post. However, we hope that we have provided you with a solid overview that will serve as an excellent jumping-off point to embark on your own research into the VAT system, and its impacts on your small business.