This guide outlines the subject of value added tax (VAT), explaining how the tax works and should you be VAT registered, covers basic issues such as the difference between an input and an output tax, and between zero-rating and exemption.

VAT is an ‘indirect’ tax. VAT is a tax on consumption, and is charged and reclaimed by businesses in the transaction chain. The tax eventually ‘sticks’ with private individuals and companies that cannot recover their VAT, normally at the end of the chain.

Inputs and outputs.  Inputs are the goods or materials your business buys, or the expenses it incurs; input tax is the VAT incurred on them. Similarly, outputs are sales and certain other transactions upon which your business has to charge output tax.

How it works.  VAT is charged by the supplier and recovered by the customer at each stage of the commercial chain, until one reaches the final consumer – see example below.

A manufacturer buys in materials costing £2.00 on which he incurs input tax of 35p (Note: all examples show VAT at 17.5%). He then sells on to the wholesaler B Ltd at £5.20, he charges output tax of 91p, deducts the input tax he has paid (totalling 35p), and pays the balance of 56p to HMRC on his next return.
B Ltd, in turn, sells on to the retailer C & Co at £6.50, he charges output tax of £1.14 and pays 23p (difference between £1.14 and 91p) to HMRC.
Finally, C & Co sell to Mrs A, the consumer, at £10 (£10.00) on which the output tax is £1.75. The net sum due to HMRC is 61p (difference between £1.14 paid to B Ltd and £1.75 charged to Mrs A).
Note A ltd, B ltd and C ltd are all VAT registered businesses, they charge output VAT on their sales, incur Input VAT on purchases, offset Output VAT against Input VAT and pay the difference to HMRC.  Mrs A, however, is a consumer, she is therefore not VAT registered, and she pays the full amount of VAT on her purchase and can’t claim any of it back. 

The tax works in the same way no matter whether the business is a manufacturer, a wholesaler, or a retailer, whether it supplies goods or services, or whether it is acting as an agent. VAT is charged down the chain of transactions until reaching someone who is not registered for VAT. Thus, VAT covers every single commercial transaction, although not everything is standard-rated.

A ‘consumer’ for VAT purposes is not just a citizen buying in a private capacity. It also includes any organisation not registered for VAT, either because it does not make any taxable supplies, or because its sales are below the registration limit. It also includes the non-business side of an organisation, like a charity, whose main activity is outside the scope of VAT, but which is registered because it is also in business: for instance, it might have a charity shop making taxable supplies.

Categories of VAT. 
1. The standard rate of VAT, at the time of writing, is 17.5%.

2. There is also a reduced rate of 5%, which covers various supplies such as fuel for domestic heating, women’s sanitary protection, and certain work in converting or renovating residential accommodation.

3. There is also a zero rate. Zero-rated sales are taxable at a nil rate of tax, although these still count as taxable supplies. The business doesn’t have to charge any output tax on zero-rated sales, but can recover all the related input tax. At the time of writing, such goods as food, books and newspapers, and children’s clothing are zero-rated, in the long term, it is likely that the UK will also tax these items at a positive rate of VAT.  Incidentally, other EU Member States tend to refer to what we call zero-rated as exemption with recovery.

4. Exemption is not a rate of tax. Thus, although the good news for the business making exempt sales is that it charges no output tax to its customers, the bad news is that it cannot recover the input tax it incurs in making those exempt sales.  Examples of exempt transactions are insurance premiums, interest on loans, sales of shares on the Stock Exchange, and healthcare.

5. Outside the scope of VAT. 
There are two main kinds:
•        sales, mostly of services, for which the place of supply is treated as being outside the UK, are outside the scope of UK VAT. Input tax incurred in the UK may or may not be recoverable.
•        sundry transactions which, for a variety of reasons, are not subject to VAT. Because these are business transactions, input tax related to them is nevertheless recoverable. Examples include:
(i)       a government subsidy paid to a manufacturer towards the cost of building a factory in a high unemployment area;
(ii)      transactions between companies within the same VAT group.
(iii)     goods located outside the UK at the time of their supply.

6. Non-business.  If a transaction is non-business, any related input tax is not recoverable.  Any such non-business transactions that go through business accounts are likely to be expenses rather than income, examples being:
•        local authority business rates.
•        staff wages and salaries.

VAT is charged on all kinds of transactions. It catches for instance:
•        sales of goods;
•        sales of services—whether manual repair work or professional charges such as those of accountants and lawyers;
•        charges between associated businesses, often called ‘management charges’;
•        leasing or renting goods;
•        royalties from copyright and similar rights;
•        certain sales of land and buildings;
•        sales in the canteen, or of old equipment, to staff etc;
•        recharging staff salaries to a third party.

It is irrelevant whether the transaction is part of the profit-earning sales of the business, or simply something which is incidental to it, such as sales in the canteen. If the business charges somebody money, or accepts payment in kind for it, the transaction is probably within the scope of VAT.
As a rule of thumb, all supplies are standard-rated unless legislation specifically exempts, zero-rates, or reduced-rates them.

Should you register?
From  1 May 2009 the registration limit is £68k a year, but it is increased in each Budget
A business has to register for VAT if:
(a)      its taxable outputs, which include zero-rated sales (but not exempt, non-business, or outside the scope supplies), have exceeded the registration limit in the previous 12 calendar months—unless it can satisfy HMRC that its taxable supplies in the following 12 months will not exceed a figure £2K under the registration limit, ie £66K currently; or
(b)      there are reasonable grounds for thinking that its taxable outputs in the next 30 days will exceed the limit; or
(c)      it takes over ‘as a going concern’ a business to which (a) or (b) applies.
If a business is not registered but might be liable to do so, take professional advice on the basis of all the facts. There are penalties for late registration so it could be expensive to delay!

Make sure to get the registration date right as both early and late registration can lead to problems. 

Why would a business want to register voluntarily?
Simply a business does not want to register for VAT if it sells mostly to the public, and charging VAT means that it either must increase its retail prices or reduce its profits.

On the other hand a business does want to register for VAT if it sells to other registered businesses, which are fully taxable. They can recover the VAT which is charged to them. The costs of the business are reduced by the input tax, which it can recover.

If a business sells to businesses which have exempt outputs, such as finance or insurance brokers, undertakers, schools or hospitals, which cannot recover all their VAT, they may prefer that their suppliers are not to be registered for VAT. However, they have to pay VAT on most of their transactions with other businesses anyway, and being VAT registered may give it an increased credibility, which will make it easier to sell to them.

When considering voluntary registration always take into account the extra costs (both financial and time) associated with being VAT registered.

VAT Schemes:  below is an outline only of three of the VAT Schemes that small businesses could use.  The rules are very complex and it is advisable to seek professional advice when considering using any of the schemes outlined below. 

Annual Accounting Scheme
The purpose of the Annual Accounting Scheme is to help small businesses by allowing them to submit only one return annually. In the meantime, they pay fixed sums based on the previous year’s liability.
Key points:
•        To join, the taxable turnover limit must not exceed £1,350,000 pa.  The business must cease using the Scheme if its taxable turnover exceeded £1,600,000 pa in the previous accounting year of the Scheme;
•        The business makes nine monthly payments of 10% of the total paid in the previous year or, if newly registered, the amount it is expecting to pay in the next 12 months. Alternatively, it can choose to pay 25% quarterly;
•        If the interim payments have been set too high or too low because the trading pattern has altered, HMRC may agree to change them;
•        Payments have to start on the last working day of the fourth month of the Scheme’s accounting year. They must be by standing order, direct debit, or other electronic means, not by cheque;
•        The annual VAT return is submitted, together with any balance due to HMRC, two months from the end of the Scheme’s accounting year; ie a business gets an extra month over the time limit applicable to a normal return;
•        The business is not allowed to start the Scheme if it owes a significant debt to HMRC, but they will not necessarily refuse the use of it if the business only owes a small amount.

When considering joining the Annual Accounting scheme choose the start date carefully as it can help the cashflow (spread payments over the months when you get most of your income); you might also benefit from having to complete the return over a quieter period or co-insed the VAT return completion with your Annual Accounts preparation.

Cash Accounting Scheme
The Cash Accounting Scheme is a valuable concession for small businesses. If a businesses turnover does not exceed £1,350,000 a year, it can use the Scheme without reference to HMRC. The business issues tax invoices as normal, but only accounts for VAT when, and to the extent, that payment is received. Thus, the business gets a cash flow advantage, which can be considerable, depending on how long customers take to pay their bills, not to mention automatic bad debt relief!

This advantage is offset by the fact that the business cannot recover input tax until it pays its bills, so the Scheme is most useful to a business selling services rather than goods, and which, therefore has relatively low taxable inputs.
Retailers selling for cash do not use the Scheme because they already have the money at the point of sale.

Can it be used together with other Shcemes?

•        a business can use the Cash Accounting Scheme together with the Annual Accounting Scheme;
•        alternatively, with Annual Accounting , it can also use the Flat Rate Scheme for Small Businesses ;
•        a business cannot use the Cash Accounting Scheme with the Flat Rate Scheme for Small Businesses. However, that does not really matter, because the Flat Rate Scheme has its own version based on when payment is received.

Flat Rate Scheme
Key points:
•        Calculate the VAT due on the Scheme Turnover using a Flat Rate percentage instead of the standard rate. That percentage depends on the trade sector into which the business fits;
•        The Scheme Turnover is gross of VAT, not net. It also includes any zero-rated and exempt sales, not just standard-rated and reduced-rated ones;
•        The sum calculated with the Flat Rate percentage is what the business owes HMRC. A business cannot reclaim input VAT on costs, except for capital expenditure exceeding £2,000 including VAT.

Will I pay less VAT under the Scheme?

A business could pay less VAT using the Scheme — it does work for some businesses. However, it could also cost extra.  As one of the advantages of the Scheme HMRC claim quicker bookkeeping and easier VAT returns as businesses can record their purchases and their sales as gross sums. However it is advisable to record the input and output VAT as failure to calculate the actual input tax paid but not recoverable, means no check on whether less or more VAT is paid under the scheme.