Basics of the UK VAT System

VAT is a tax where a business charges VAT on its sales and recovers VAT on its purchases. The amount that is paid over to the tax authority will be the difference between the tax charged on sales and the amount recovered on purchases.

The great advantage to governments is that they collect some of the tax before the final sale to the consumer of the good or service. Also since the recovery of VAT is linked to accounting for VAT on sales it is self-policing. It is not surprising that a tax that brings in tax earlier and is administered by business has proved popular worldwide. Most countries now have a VAT system.

Although some VAT systems are indeed very simple, the one we have in the UK is not. This is in part because it has various reliefs built-in. There are also different rates of VAT which give different entitlements to recover VAT.

VAT Liabilities

In the UK the following VAT treatments (or VAT liabilities) apply to sales

The Standard Rate

This is the default. If you sell a service or a good it will be subject to VAT at 20% unless the legislation states otherwise. There is not a list of things subject to standard rate VAT but only lists of things where a different liability applies.

The standard rate is a taxable rate of VAT. This means you can recover VAT on the purchases you buy to make such supplies.

The Zero Rate

This is also a taxable rate of VAT but is super reduced to zero. This means that although you don’t charge VAT on sales you can recover VAT on purchases. This means if you only make zero-rated supplies then you will be in a repayment position. . Examples might be shops selling books or export businesses. These businesses will recover VAT on your purchases and have no VAT to account for on your sales. HMRC will regularly pay them money.

The 5% Reduced Rate

This applies to a list of specific supplies. Including work converting buildings into flats and fuel and power.  The 5% rate is a taxable rate and allows you to recover VAT on purchases.

Exempt Supplies

There is frequently confusion over exempt supplies. Whereas with direct tax if something is tax-exempt it means there is no tax, this is not true of VAT. This is because if your supply is exempt you don’t charge VAT on your sales but also suffer a restriction on your ability to recover VAT on purchases.

VAT exemption is often confused with zero-rating which is not surprising because journalists and ministers use the terms interchangeably. But the two are very different. When you make zero-rated supplies you can recover all the VAT you incur on your purchases and therefore don’t pay or suffer any VAT. In contrast, when you make exempt supplies you cannot recover the VAT you incur on your costs. So the owner of a bookshop selling zero rated books can recover VAT whereas a Dentist selling exempt dental treatment cannot. A business making exempt supplies suffers ‘ sticking tax ‘ in a similar way to a private individual.  A VAT exemption is effectively a different way of taxing things.

Outside the Scope

The standard, zero, reduced and exempt rates of VAT apply to supplies made in the course of business. Yet you may obtain income without making a supply. For example a donation or a compensation payment (possibly) or dividend income. This is outside the scope of UK VAT as there is no supply. It may have consequences for VAT recovery. You may also make supplies that are outside the scope of UK VAT because they are made outside the UK. For example, if you provide services to a French VAT registered business your supply will be outside the scope. Generally, VAT on purchases can be recovered in such cases.

VAT Registration

You are obliged to register for VAT when your income from taxable supplies (standard rated, reduced rate and zero-rated)  exceeds the VAT registration limit. This is an annual limit.

VAT Recovery

A VAT registered business can recover some of the VAT it incurs. For a commercial company that only makes taxable supplies VAT recovery is quite straightforward – it can likely recover all of the VAT it incurs. A VAT registration that undertakes activities that the VAT system regards as non-business (for example free activities)  will need to apply a non-business VAT restriction. For a VAT registration that makes business supplies that are both taxable and exempt there will be another restriction – the partial exemption restriction. Both the business/non-business and partial exemption recovery stages made require an apportionment. See VAT Recovery