What is VAT?
Value Added Tax is an indirect tax aimed at consumers.
If a business meets certain criteria then it has to charge VAT on its sales of goods and services.
In a supply chain there are usually a series of businesses selling to each other until the final product or service reaches the consumer.
Generally, businesses can reclaim the VAT they incur on their costs of sales and overhead at each step of the supply chain and so ultimately the consumer is the one who ends up bearing the cost of VAT.
VAT is a regressive tax and typically makes up a larger proportion of budget for a low income household compared to a high income household.
The key legislation is the Value Added Tax Act 1994 (“VAT’94”). There are also Statutory Instruments and in certain cases the detailed rules are set out in HMRC notices and leaflets.
HMRC’s notices are very helpful to explain the rules and are aimed at businesses, whilst their internal manuals also go into significant detail. There is also a lot of case law where HMRC or taxpayers have taken each other to court over how the rules are interpreted.
Whereas many other taxes and accounting rules are principles based, VAT is almost rules based due to the large number of specific rules set out in legislation and case law to cover specific circumstances and scenarios.
Businesses have to charge VAT on their goods and services if they meet the criteria below. The most common rate of VAT is 20%, so if their net price excluding VAT is £100, they would need to charge a gross price of £120 including VAT.
Key criteria for charging VAT
Under s.4 VAT’94, VAT shall be charged on any supply of goods or services made in the United Kingdom where:
- it is a taxable supply,
- made by a taxable person,
- in the course or furtherance of any business carried on by him.
If these criteria are not met, a supply is outside the scope of VAT, and VAT registration is not possible.
1) Taxable supply
A taxable supply is a supply of goods or services made in the United Kingdom other than an exempt supply (s.4(2) VAT’94). Consideration must be charged for services rendered, even if its only £1. Free services are excluded from VAT.
There is a list of exempt supplies in Schedule 9 of VAT’94.
In addition to exempt supplies, certain sales made outside of the UK may also be outside the scope of VAT.
2) Taxable person
A business would be a taxable person if it is able to register for VAT, either voluntarily or compulsorily.
Its compulsory for a business to register for VAT if their annual sales exceed £85,000.
3) In the course or furtherance of any business
HMRC have set out a number of key questions based on case law, such as:
- Does the activity have a certain measure of substance in terms of the quarterly or annual value of taxable supplies made?
- Is the activity conducted in a regular manner and on sound and recognised business principles?
- Is the activity predominately concerned with the making of taxable supplies for a consideration?
To achieve the economic target of indirectly taxing consumers, businesses can reclaim the VAT that they pay to their suppliers, if they meet certain criteria. So if the gross purchase cost is £120, including VAT, then they can reclaim £20 VAT, so their net cost is £100.
Input VAT is the total VAT suffered on purchases, but these could be incurred in relation to taxable supplies, exempt supplies or non-business activities.
Under S.26(1),(2) VAT’94 a business can reclaim input VAT attributable to taxable supplies in the course or furtherance of their business (i.e. the same supplies on which output VAT is charged as defined in S.4 VAT’94 mentioned above). This is known as “input tax”.
Input VAT cannot be reclaimed on expenditure relating to:
• activities outside of VAT or non-business activities
• blocked items such as cars and entertaining
• exempt activities unless they are below a set level (de minimis of £625 on average per month and half of total input tax in period)
VAT Registration & administration
If a business makes taxable supplies and they are provided in the course of business, then they can register for VAT.
A business would then account for VAT by adding 20% (usually) output tax to their sales invoices and submitting a return to HMRC on a periodic basis (normally quarterly). On the return, they would then reclaim input tax, which is the VAT on purchases related to the provision of taxable supplies.
If output tax exceeds input tax, then a business would need to pay this excess to HMRC.
If input tax is higher, HMRC would pay the difference to the business.
On the VAT registration form an effective date is chosen (can be in the past) and VAT needs to be accounted for after this date. However, input VAT can also be reclaimed for expenses related to taxable supplies in the 6 months prior to registration.