Ahh, VAT. Most people have heard of it, but not many understand it – and we know that it’s confusing for many self employed, contractors and small business owners.
Although the ins and outs may be tricky to grasp for first-timers, the sooner you get your head around HMRC’s VAT rules the better it will be for your business.
First things first – what is VAT?
VAT – or Value Added Tax – is a tax charged on most goods and services in the UK and the EU. When you buy a product that is eligible for VAT in a shop, for example, VAT is automatically included in the price you pay.
There are three rates of VAT which are applied to goods and services. Standard Rate (currently 20%), Reduced Rate (currently 5%) and Zero Rate (0%, obviously). Items may also be exempt (or ‘outside the scope’) of VAT.
“Aren’t Zero rated VAT and VAT exempt the same thing?”, you may be asking. Well, no. Zero-rated means that the goods are still VAT-taxable but the rate of VAT you charge your customers is 0%. You still have to record these sales in your VAT accounts and report them on your VAT Return, which means you can reclaim VAT on your expenses.
VAT exempt items are outside of all VAT schemes and are not taxable. You do not include sales of exempt goods or services in your taxable turnover for VAT purposes. And if you buy exempt items, there is no VAT to reclaim.
In both cases you don’t add VAT to the selling price, but zero-rated goods or services are taxable for VAT – albeit at 0%.
Sales of zero-rated items count as ‘taxable sales’ as far as the registration threshold is concerned, along with sales that are subject to 5% or 20% VAT.
Examples of goods and services and their VAT rates
|Standard Rate (20%)
||Reduced Rate (5%)
||Zero Rate (0%)
|Web Design services
||Energy efficiency materials (insulation etc.)
||Most financial services
|Electronics (laptops, smartphones etc.)
||Domestic utilities (gas, electricity etc.)
||Protective clothing (helmets, boots etc.)
||Property renovations and alterations
||Printing of brochures
|Purchasing software or software licenses
||Buying a helicopter!
|Majority of other goods and services
||Children’s car seats
||Most construction activities
Standard Rate vs Flat Rate schemes
When you register for VAT you have two choices of schemes. The first, Standard Rate, involves manually reclaiming VAT on every eligible item you buy or sell. The second, Flat Rate, is open to businesses with an expected turnover of less than £150,000 (in the next 12 months) and was introduced to simplify the VAT system for freelancers, contractors and small businesses.
On the Flat Rate scheme you will use a predetermined VAT rate based on your industry type and pay this over to HMRC. First you add the Standard VAT rate of 20% to your sales invoice amount, then you collect the full amount from your client. Next you apply your sector percentage to this (gross) amount, which is then paid over to HMRC via a VAT return. The difference between the two rates is retained by your business (company) as income.
Example using the 14.5% Flat Rate
Your business charges £1,000 to a client for services your company provides. The client will pay £1,200 including the Standard Rate of VAT amount at 20% (£200). Your business pays HMRC the industry Flat Rate of VAT amount at 14.5% of £1,200 which is £174. The business accounts for the difference (£26) as income.
You can’t reclaim the VAT paid on your purchases under the Flat Rate scheme – except for certain capital assets over £2,000. Flat Rate sector percentages include the following industries:
|Limited cost trader
||Other B2B services
||Any other service
When you register for the Flat Rate scheme for the first time, HMRC allows you to apply a 1% discount in the first year.
You can see a full list of sectors and their associated rates here.
Who can register for VAT?
There is a common misconception that only people operating their own limited company can register for VAT, when actually VAT registration is open to sole traders as well. You can voluntarily register whenever you like, however there comes a point when legally you must register.
When must I register for VAT?
Registration is mandatory if your turnover for the past year has exceeded the VAT registration threshold.
HMRC has stated that From 1 April 2017 to 31 March 2019 the registration threshold is where your turnover is above £85,000. It’s important to note this is calculated on a rolling basis, so we’re talking about your turnover in the twelve months directly preceding the current month.
If you know your turnover will reach the threshold soon, you should allow enough time to register. If you fail to notify HMRC in time, you may be liable to pay a penalty!
There are some situations in which it may be beneficial to register voluntarily before you reach the threshold.
If you’re planning on splitting your business, you need to be careful you’re not in breach of HMRC regulations on disareggation.
Why would I consider voluntary VAT registration?
- You can reclaim the VAT on your expenses (Standard Rate scheme)
- You can register for a reduced Flat Rate of VAT to reduce the administration involved in preparing your quarterly VAT return (Flat Rate scheme)
- If your clients are large companies who are themselves VAT registered, registering could be advantageous. Your clients will be used to seeing prices inclusive of VAT, and will be able to reclaim the VAT
- It may make your business more credible in the eyes of your clients, in the same way that having a limited company makes you appear more ‘professional’.
Why might I not want to register voluntarily?
- If your clients are smaller companies and not VAT registered themselves, the addition of VAT may make you seem more expensive. Registering for VAT usually requires you to add 20% to your invoices, and if your client isn’t VAT Registered, they cannot reclaim this
- With VAT registration comes additional responsibility. You are required to complete and file a VAT return, usually every three months. If a return is late, there will be a penalty from HMRC
- When you are VAT registered keeping track of your cashflow and profit involves additional work.
How do I report VAT?
For VAT Registered business, a VAT return is required (usually every quarter) to tell HMRC how much VAT you have paid and received. All VAT Returns are filed online, and can usually be handled by your accounting software. Depending on your income and expenses you may need to to make a VAT payment to HMRC or you may be owed a refund.
What should I do next?
If you are close to the VAT threshold or think you may be, then your accountant should be able to advise you on whether you should consider registering and what scheme would be best for you. If you don’t yet have an accountant or are thinking of switching, then why not speak to Crunch – our combination of online accounting software and unlimited access to a dedicated client manager and expert accountants could be just right for you. Find out more about how we can help you and your business here.