What is VAT and how does it affect my small business?
A beginner's guide to value added tax (VAT), when to register, the rates, output and input tax, deregistration, and the Cash Accounting Scheme
What is VAT? Value Added Tax, or VAT, is a tax most suppliers of goods and services charge by adding it to those goods and services.
Business supplies include selling goods, renting and hiring goods, business stock used for private reasons, services including hairdressing, charging an admission price for buildings, and providing supplies as a self-employed person.
What VAT rates are there and how do they differ?
VAT rates vary according to the goods and services supplied. There are four categories:
- Exempt supplies. Including education, finance, insurance, and the services of doctors and dentists (but not some other services, such as osteopaths). There is no VAT charged on exempt supplies. If you only supply exempt services, you cannot usually register for VAT. However if you are VAT registered and have some exempt supplies, you may have difficulty claiming back all your input tax.
- Zero rate. Charged on most food (but not restaurant or takeaway meals), children's shoes and clothing, prescriptions, books and newspapers, new house sales and prescriptions. If the only goods you supply are zero-rated, you may not have to register to VAT – but you do have to apply for exemption from registration.
- Reduced rate. A rate of 5% that includes fuel and power used in homes and by charities.
- Standard rate: Now 20% (as of 4/1/2011), and applied to all goods and services which do not fall into the other three categories. The rate was temporarily lowered to 15% in 2008 during the recession to help declining consumer confidence. However, in January 1 2010 it returned to the original rate of 17.5%, and as of January 4 2011 it was increased to 20% in an effort to lower the UK's budget deficit.
Once your turnover reaches the threshold (currently £85,000) – or will within 30 days – you must register for VAT. To work out whether you have to register, you can ignore the value of any capital assets – buildings, vehicles or equipment – you have sold and any exempt supplies.
Putting off registration can be expensive as you may have to pay the HMRC the tax that you should have collected plus a fine as well. There are severe penalties for late registration and for VAT evasion.
Most businesses collect more VAT from their customers than they pay to their suppliers. They then fill in a quarterly VAT return, and pay the surplus to HMRC. If you need to register, you have to account for VAT whenever you supply goods and services.
Understanding output tax and input tax
For VAT purposes, the tax you charge on those supplies is your output tax. Customers registered for VAT who are using your supplies for their business then register the tax you charge them as their input tax.
Input tax is the VAT you have paid your suppliers for business purchases and expenses. It includes VAT on raw materials and things you buy to re-sell, as well as business equipment, business phone calls and payments for professional services, such as accountants' fees.
If you regularly pay out more VAT than you collect, you can fill in a return every month and claim a refund from the HMRC. However you cannot reclaim input tax on some cars, certain entertainment expenses or if you only supply exempt goods and services.
Remember that it is you, not your business, who is registered for VAT. Registration covers all parts of your business, so you need register only once. If you bought your business as a going concern, you need to look at the taxable turnover to see whether you need to register. Your registration date will be the day you took over the business. If the previous owner was VAT-registered already, you may be able to retain the existing VAT number.
When can you deregister from VAT?
If the turnover of your business falls below a certain limit you can cancel your VAT registration. Currently, the deregistration limit stands at £81,000.
What is the Cash Accounting Scheme for VAT?
VAT rules are changing, year by year, to make the tortuous business of registering and filling in VAT returns easier.
There are now special schemes to make life easier for small and medium sized enterprises. The Cash Accounting Scheme for VAT lets you account for VAT on the basis of payments you have made and received, instead of on the basis of invoices issued.
This means that you automatically have bad debt relief and it also helps if you allow periods of credit or have late payers.
The Cash Accounting Scheme limit applies to businesses with a turnover of up to £1.35m. You can use the scheme until your turnover reached £1.6m.
Annual accounting removes the slog of quarterly tax returns from small businesspeople. Once you have been VAT registered for a year, you can send in just one annual return and pay monthly by direct debit.
What records do you have to keep for VAT?
Rather like keeping records for the HMRC, you need to be meticulous about VAT record-keeping. You need to record all your business transactions, and keep documents including bank statements, bills, receipts and cheque stubs to back them up. You also need to separate your business transactions from your personal finances.
For VAT purposes, you must keep a record of all the supplies you make and receive, and a summary of VAT for each tax period covered by your tax returns. Records must be up to date and easy to find, and if you register for VAT you must keep your records for six years.
Many businesses choose to employ an accountant or at least a bookkeeper at this stage, to take the headache out of paperwork and leave them time to get on with running their business, especially since there are severe penalties for failing to keep records.
When a builder asks for payment in cash, you naturally assume that he is being less than open with the taxman. But he may have another, more urgent, issue on his mind – the desire to avoid getting involved in VAT, the bane of many a small businessperson's existence.
“When small businesses complain about burdens on business and regulation, VAT always comes out either at or near the top,” confirms John Davies, head of business law at the Association of Certified and Chartered Accountants. “[But] the government is now trying to make it easier for small and medium enterprises to deal with VAT.”
The limit for VAT registration is continually being raised. As mentioned above, currently you have to register for VAT if your annual taxable turnover in the last 12 months exceeds £85,000 or if the value of taxable supplies is likely to exceed that sum in the next 30 days.
Although that may sound like a lot, for a very seasonal business, which makes most of its profit at Christmas, for example, it is easy to breach the limit very quickly. And since VAT registration reflects turnover not profit, a small builder who makes a relatively small profit but deals with expensive materials may have to register.
For those who grumble about being an unpaid tax collector for the government, there are compensations.
Being registered for VAT can actually save you money and some opt for voluntary VAT registration before they reach the limit. And recent changes to the law mean that VAT returns are becoming simpler.
Find out more on how to register for VAT here.