A guide to VAT for start-ups and small businesses
With so much jargon used across different industries, it's easy to be overwhelmed by the idea of registering for VAT. Clive Lewis, Head of Enterprise at ICAEW (Institute of Chartered Accountants in England and Wales), provides a back-to-basics guide to all things VAT to help business owners get their heads around the process.
What is VAT?
VAT was invented by the French in the 1950s and is a tax that all new members of the Common Market/European Union must sign up to when they join. You can only charge VAT on the goods or services that you sell once your business has been registered for VAT. VAT is charged on:
- Business sales, e.g. when you sell goods and services
- Hiring or loaning goods to someone
- Selling business assets
- Items sold to staff, e.g. canteen meals
- Business goods used for personal reasons
- 'Non-sales' like bartering, part-exchange and gifts
If you're a VAT-registered business, you must report the amount of VAT you've charged and the amount of VAT you've paid to HM Revenue and Customs (HMRC).
Compulsory VAT registration threshold
You must register for VAT if your turnover exceeded £85,000 in the previous 12 months (for 2018/19 tax year). You can voluntarily register at any time (if turnover is below compulsory registration threshold).
How does VAT work?
VAT is added to sales invoices. Purchase invoices will have VAT added if a supplier is VAT registered. VAT invoices must have all the required information on them e.g. VAT registration number. Most items incur VAT at the standard rate (currently 20%) but some items are chargeable at the reduced rate of 5% or are zero-rated (0%).
There are items that are zero-rated for VAT or are exempt from the tax. It is worth being aware that the exact definition of a particular item can affect whether VAT is applied to it. There are a number of irregularities in the VAT system, some of which have resulted in fierce debates between businesses and HMRC.
One famous example is the 'Jaffa Cakes case' which went all the way to a tribunal to determine whether they were classed as cakes or luxury biscuits. While cakes are exempt from tax, luxury biscuits are subject to VAT at the standard rate. McVities, the makers of Jaffa Cakes, insisted they were small cakes and eventually the tribunal ruled in favour of this.
The basic system is that, every three months, a VAT return is submitted online to HMRC. Output tax (on sales) and Input tax (on purchases) are netted, and the difference - usually with outputs exceeding inputs - is paid over to HMRC. Where inputs exceed outputs, a repayment will be made by HMRC. Payments can be made in a variety of specified ways.
Cash accounting (or receipts and payments system) if business VAT taxable sales are less than £1.6 million:
- Use receipts from customers and payments to suppliers rather than invoices
- Helpful if cash-flow is a problem and bad debts are an issue
Annual Accounting Scheme:
- You make nine monthly or three quarterly instalments based on an estimate of VAT paid in the previous year or estimated liability
- You must complete one VAT return every year
- You must keep the required records in case of VAT inspection
- Not suitable for businesses that regularly reclaim VAT, as you only get one repayment a year
Flat Rate Scheme:
- Do not have to record and calculate VAT on each transaction
- Pay as a flat rate percentage of turnover as VAT is based on sector figures
- Percentage is less than standard VAT rate because it is the net of Input Tax
VAT schemes for retailers - If you sell to the general public, there are several schemes you might use.
Businesses can post goods abroad if they get small orders from overseas. For bigger orders, most businesses use a courier or freight forwarder. They will ask the exporter to complete a pro-forma invoice, which would include VAT if the goods are subject to VAT in the UK.
Businesses selling digital services, e.g. downloadable videos or software, to consumers in the EU can register for VAT in the EU state of its customer. Or they can complete a UK VAT MOSS scheme return each quarter and make just one payment to HMRC, who pass on the relevant share of VAT to each member state to the VAT authority. To utilise the VAT MOSS scheme a business must register with HMRC. Businesses below the UK VAT threshold selling digital services to EU customers will still need to register and charge VAT.
The change to sales of digital services arose because of changes to “place of supply” rules from being determined by the member state VAT rates of the supplier to those of the customer. The change came into effect on 1 January 2015. There are plans for the EU to extend the MOSS system to cover similar supplies of goods and non-digital services and to bring in a cross-boarder threshold for supplies to individual EU countries.
Many UK businesses avoid the paperwork by selling through a platform such as Amazon.
The rules regarding VAT are likely to be affected when the UK leaves the EU. This will particularly apply to exports and imports. This will dependent on the final negotiations between the UK government and the EU.
For more information on VAT:
If you have concerns regarding whether to register for VAT, you can arrange a free meeting with an ICAEW BAS firm to discuss your situation and what you can do to improve your controls. Visit the BAS website and click on Find a Chartered Accountant. Insert your postcode and find the firms in your area offering a free session.
Clive Lewis is a chartered accountant (FCA) and a chartered management accountant (ACMA). He works part time at the ICAEW (Institute of Chartered Accountants in England and Wales) where he is Head of Enterprise.
Want to learn more about managing your business's finances? Read Clive's tips on controlling your cash flow.