Value Added Tax (VAT)

VAT is an indirect tax on the consumption of goods and services. It is charged at each stage of the supply chain, but the final economic burden falls on the end consumer. Businesses registered for VAT act as collection agents for HMRC.

How VAT works:

• A VAT-registered business charges VAT on its sales (output tax) and pays VAT on its purchases (input tax)
• The business pays the net amount to HMRC: Output tax − Input tax = VAT payable (or reclaimable if input > output)
• VAT is therefore only a cost to the business if it cannot recover its input tax (e.g., because it makes exempt supplies)
• For a fully taxable business, VAT is neutral — it passes through the business and is ultimately borne by the consumer

Standard rate: 20% — applies to most goods and services.
Reduced rate: 5% — applies to domestic fuel and power, children's car seats, and certain other specified items.
Zero rate: 0% — applies to food (most), children's clothing, books and newspapers, public transport, new residential construction, and exports.
Exempt: No VAT is charged. See below.

Compulsory registration:

A person (individual or business) must register for VAT if:

• Historic test: At the end of any month, the value of taxable supplies (standard + reduced + zero-rated, but NOT exempt) in the past 12 months has exceeded the registration threshold of £90,000 (2024/25). Registration is required within 30 days of the end of that month, effective from the first day of the second month following the breach.
• Future test: At any time, there are reasonable grounds for believing that taxable supplies in the next 30 days alone will exceed £90,000 (e.g., a single large contract). Registration is required immediately.

Voluntary registration:

A business making taxable supplies can register voluntarily even if below the threshold. Benefits include: ability to reclaim input tax on purchases, enhanced credibility with business customers, and pre-registration input tax recovery. Disadvantage: administrative burden, and if customers are consumers (not VAT-registered), the prices become 20% more expensive (or the business absorbs the VAT and reduces its margins).

Deregistration:

• Compulsory: A person must deregister if they cease making taxable supplies
• Voluntary: A person may apply to deregister if they expect taxable supplies in the next 12 months will fall below the deregistration threshold of £88,000 (2024/25 — slightly below the registration threshold to avoid repeated re-registration)
• On deregistration, VAT may be due on any stock and assets on hand (unless the total VAT on these items is ≤ £1,000)

Pre-registration input tax: On registration, a business can recover input tax on: goods acquired in the 4 years before registration (if still owned at registration), and services acquired in the 6 months before registration (if for business use).

The VAT treatment depends on the type of supply:

Critical distinction between zero-rated and exempt:

• Zero-rated supplies are taxable supplies (at 0%). The business charges no output tax but CAN recover input tax. Zero-rated supplies count towards the registration threshold.
• Exempt supplies are not taxable supplies. No output tax is charged AND input tax attributable to exempt supplies CANNOT be recovered. Exempt supplies do NOT count towards the registration threshold.

This distinction is hugely important. A business making only zero-rated supplies (e.g., a food wholesaler) can reclaim all its input tax — it receives net VAT refunds from HMRC. A business making only exempt supplies (e.g., an insurance company) cannot reclaim any input tax — VAT on its purchases is a real cost.

Output tax: VAT charged by a business on its sales (supplies made). Collected from the customer and paid to HMRC.

Input tax: VAT paid by a business on its purchases (supplies received). Reclaimable from HMRC (subject to partial exemption rules).

VAT payable to HMRC = Output tax − Input tax

If input tax exceeds output tax (e.g., a zero-rated business), HMRC refunds the difference.

Non-deductible input tax (cannot be recovered even if the business is fully taxable):

• VAT on business entertainment (client entertaining) — exception: entertaining overseas customers is recoverable
• VAT on motor cars — unless the car is used 100% for business (e.g., driving instructor, taxi, pool car) or is bought for resale (dealer). VAT on vans, lorries, and motorcycles IS recoverable.
• VAT on goods and services not used for business purposes

VAT returns: Most businesses file VAT returns quarterly, with the return and payment due 1 month and 7 days after the end of the VAT quarter (if paying electronically — which is now mandatory for most businesses under Making Tax Digital). For example, a VAT quarter ending 30 June: return and payment due by 7 August.

A business that makes both taxable and exempt supplies is partially exempt. It can only recover input tax attributable to its taxable supplies — NOT input tax attributable to its exempt supplies.

Three categories of input tax:

1. Directly attributable to taxable supplies: Fully recoverable
2. Directly attributable to exempt supplies: NOT recoverable (it is a cost to the business)
3. Non-attributable (residual/overhead): Apportioned between taxable and exempt using a standard method — typically based on the proportion of taxable to total supplies by value

De minimis rule: If the total exempt input tax (directly attributable + apportioned residual) is both:

• ≤ £625 per month on average (£7,500 per year), AND
• ≤ 50% of total input tax

Then ALL input tax is recoverable (the exempt portion is treated as de minimis — trivially small). This simplification benefits businesses with a small proportion of exempt supplies.

The tax point determines when a supply is treated as taking place for VAT purposes — it determines which VAT return period the supply falls into and when the output tax becomes due.

Basic tax point:

• Goods: The date the goods are removed by the customer (collected) or made available to the customer (delivered)
• Services: The date the services are performed (completed)

Actual tax point (overrides the basic tax point if earlier or later):

• If a VAT invoice is issued or payment is received BEFORE the basic tax point → the earlier date becomes the actual tax point
• If a VAT invoice is issued within 14 days AFTER the basic tax point → the invoice date becomes the actual tax point (the "14-day rule"). This is the most common scenario — most businesses issue invoices shortly after delivery/completion.

In summary: Tax point = the EARLIEST of: date of payment, date of invoice, or basic tax point (delivery/completion). Exception: if the invoice is issued within 14 days after the basic tax point, the invoice date takes precedence.

A VAT-registered business making a taxable supply to another VAT-registered business must issue a VAT invoice within 30 days of the tax point. The invoice is the customer's evidence for reclaiming input tax.

Required contents of a full VAT invoice:

• Unique invoice number and date of issue
• Supplier's name, address, and VAT registration number
• Customer's name and address
• Description of goods or services supplied
• Quantity and unit price (net of VAT)
• VAT rate applicable and the amount of VAT charged
• Total amount payable (including VAT)
• Date of supply (tax point) if different from the invoice date

Simplified invoice: For supplies of £250 or less (VAT inclusive), a simplified invoice is acceptable — it needs only: supplier name and VAT number, date, description of goods/services, and total amount including VAT (the VAT rate or amount need not be separately shown).

Penalties for errors on VAT returns:

• Errors up to £10,000 (or up to 1% of turnover if greater, max £50,000) can be corrected on the next VAT return without penalty
• Larger errors must be disclosed to HMRC separately
• Penalty rates for inaccuracies follow the same framework as income tax: careless (0-30%), deliberate (20-70%), deliberate and concealed (30-100%) of the potential lost revenue

Late payment penalties (from January 2023):

• Up to 15 days late: No penalty (but interest accrues)
• 16-30 days late: Penalty of 2% of VAT outstanding at day 15
• 31+ days late: Additional 2% of VAT outstanding at day 30, plus a daily penalty at 4% per annum of the outstanding amount

Late submission penalties (points-based):

• Each late submission adds a penalty point
• When the threshold is reached (e.g., 4 points for quarterly filers), a £200 penalty applies for that and each subsequent late submission
• Points expire after a period of compliance (e.g., 12 months of on-time filing for quarterly filers resets to zero)

Interest: HMRC charges late payment interest from the due date. Repayment interest is paid on overpayments.

The flat rate scheme and cash accounting scheme cannot be used together. The annual accounting scheme can be combined with either the flat rate scheme or the cash accounting scheme.