How Does VAT Work?
VAT is a tax on consumer spending. Under the system, every VAT registered business is effectively a tax collector.
Most transactions are standard rated (currently at 17.5% in the UK at the time of writing). However, transactions could also be zero-rated, exempt or outside the scope of VAT.
A VAT registered business has to pay (to HMRC) the amount of output tax (that is the VAT it charges on it’s sales) less the input tax (the VAT that it pays on it’s purchases). Sometimes, this figure is negative (for example, if the business is engaged in making zero-rated supplies – that is, the goods/services that the business sells are zero-rated for VAT purposes), in which case, the business can reclaim the VAT from HMRC.
Each vat registered business charges VAT (normally at 17.5%) on it’s VATable supplies and so on, down the chain, until eventually the consumer (or non-vat-registered business) bears the final cost of the VAT.
The Symmetry of VAT
I’m just going to show the effect of VAT by considering a hypothetical supply chain of VAT-registered businesses, Company, A, B, C.
Company A makes a widget and sells it to Company B for £100+VAT = £117.50
Company A’s output VAT (the VAT on it’s sale) is £17.50 which it pays to HMRC
Company B’s input VAT (the VAT on it’s purchase) is also £17.50 and can be reclaimed, giving a cost of only £100
Company B does a bit of additional work and sells the super widget to Company C for £150+VAT = £176.25
Company B’s output VAT (the VAT on it’s sale) is £26.25 which it pays to HMRC
Company C’s input VAT (the VAT on it’s purchase is also £26.25 and can be reclaimed, giving a cost of only £150
Company C does a bit more work and sells the resulting super-duper widget to D for ££200+VAT = £235
Company C’s output VAT (the VAT on it’s sale) is £35 which it pays to HMRC.
Let’s suppose that D, is a private individual, who is therefore not registered for VAT.
D therefore cannot reclaim the £35 of VAT that it’s paid.
So the total cost to D is £235.
D bears the entire cost of the eventual VAT charge.
If a business is making zero-rated supplies, (ie, the products or services it sells), it charges VAT at zero percent, as opposed to charging no VAT. The distinction, although pedantic, is important: These businesses can reclaim all the VAT on the purchases.
(Some examples of zero-rated goods are given here)
If a business is making exempt supplies, it cannot charge VAT on it’s sales and it cannot reclaim the input VAT on it’s purchases.
If a business makes only some exempt supplies, it would only be able to claim the VAT on purchases related to it’s VATable supplies. (The Partial Exemption area of VAT is a whole huge area of VAT rules, in itself, which I will address in a later post)
A private individual, is completely outside the VAT system. Obviously, they cannot charge or reclaim any VAT at all.
HMRC deems these individuals to be “out of scope”.
Rates of VAT on Supplies
There are different rates of VAT on supplies
VAT Exempt Supplies
Some supplies are exempt from VAT, such as insurance, finance and education. If you ONLY supply exempt goods/services, you will be exempt from VAT and will be unable to register for VAT. This also means that you will be unable to reclaim any VAT from your purchases.
If part of your supplies are exempt, you will still be able to register for VAT and may be able to claim a proportion of your input VAT (VAT on your purchases)
VAT zero rated supplies
Some goods and services are zero rated for VAT. These include books, newspapers, childrens clothing and children’s footwear.
Suppliers of zero-rated VAT goods/services can register for VAT and reclaim the VAT on purchases.
VAT reduced supplies
Generally, electricity and gas have a reduced VAT rate (5% at the time of writing). Children’s car seats, giving up smoking aids and sanitary products also have a reduced VAT rate.
Outside the Scope of VAT
There are some things that are completely outside the scope of VAT. These include donations to charity, personal activies outside your business, MOT testing and tolls .
You do not charge or reclaim VAT on transactions that are outside the scope of VAT.
The Difference Between Zero-Rated VAT, VAT Exempt and Out of Scope VAT
There is sometimes confusion over what the difference between Zero-Rate VAT, VAT Exempt & Out of Scope VAT.
Zero-Rate VAT items, such as books, childrens clothes and some food, do have VAT on them, it’s just at zero percent, so the actual VAT is nil. However, the net purchase cost of zero-rate items still goes in Box 7 of a VAT Return. Suppliers of zero-rated goods/services can still reclaim all their input VAT (the VAT on their own purchases)
VAT Exempt items, such as postage stamps, do not have VAT on them (not even at 0%). The VAT is nil. However, the net purchase cost of VAT Exempt items still goes in Box 7 of a VAT Return. Suppliers of Exempt goods cannot reclaim the input VAT (the VAT on their own purchases) relating to Exempt Supplies.
Out of Scope items are completely outside the VAT system – like payroll transactions, payments to HMRC.
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