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What is VAT?

July 27, 2021

Whether you're a small business owner, a student, a company employee, or a pensioner, everyone in the UK has paid VAT. VAT is a general tax on consumption that has been implemented by increasingly more countries since its inception during the First World War.

Since being introduced in the UK in 1940, VAT has become a crucial component of our modern economy. After Income Tax and National Insurance, VAT payments are the third-largest contributor to the UK tax fund. As of 2014, 166 of 193 countries in the UN use VAT, which includes all OECD countries apart from the USA.

Getting to grips with VAT is relatively simple, but it is crucial for smaller businesses and the self-employed to be aware of when they must start charging VAT and what can be claimed back in rebates. If you need a helping hand to stay on top of your tax returns, Ember can simplify and optimise your taxes and expenses automatically for you.

In this article, we are going to cover the details of VAT, what it is, how the rates vary, and how businesses and the self-employed can both charge and reclaim it.

What is VAT?

Value-Added Tax (VAT) is a tax levied on most products and services at each stage of production, distribution, and sale. The tax is relative to the value of the product, so a percentage of the unit price is added for taxation. Not all countries use VAT and the rate varies in the countries that do from as low as 1% up to almost 30%. In countries such as India, Canada, Australia, New Zealand, Singapore, and Hong Kong, VAT is known as a 'Goods and Services Tax' (GST). 

VAT is an indirect tax, which means it is levied on a product before it reaches the customer and is charged at the same rate regardless of who the customer may be or what their income is. This is in opposition to a direct tax, which is charged based on income or on how much profit a company makes. VAT is also defined as a consumption tax as the consumer is charged the full VAT and the business pays none of it. Most VAT expenditure that a business pays can be claimed back.

It is vital that businesses and the self-employed understand the thresholds and rates of VAT, as well as what they are entitled to reclaim. These figures will all vary from country to country and are liable to change in line with the economic climate, so let's jump in and have a look at how VAT works in the UK.

VAT rates in the UK and across the globe

Since 2011, the standard rate of VAT in the UK has stood at 20%. However, some goods are deemed to be more essential than others and have a reduced rate of 5%, others have a 0% rate, and some goods are exempt from paying VAT altogether. Goods that are at 0% are subject to change and could be brought into the higher rates, whereas exempted goods will remain exempt. 

VAT was introduced in the UK as a 'Purchase Tax' in 1940 to help raise taxes during the Second World War. The rate started at just over 33% but rose up to 100% to fund the increasing costs of the conflict. As well as being raised, the standard rate of VAT is sometimes temporarily lowered in an effort to boost consumption. For example, after the financial crash of 2009, VAT was reduced from 17.5% to 15% for two years as unemployment levels were high and there was a need to encourage household expenditure. The reduced rate was also temporarily extended to other goods and services after the initial stages of the Coronavirus pandemic, again in an effort to boost spending.   

All countries in Europe have VAT and the European Union sets a minimum rate of 15% for EU countries. The highest rate is in Hungary where it is 27%. However, countries within Europe but outside of the EU are able to set their own rates, with Andorra's being the lowest at just 4.5%. Although no longer in the EU, the UK rate is about average when compared to other European countries.

Which products have VAT?

The majority of goods and services in the UK have the standard rate of 20%. However, there are some products that have a reduced rate and others that have none at all. 

Goods such as children's car seats and elderly mobility scooters have a reduced rate of 5% as they are deemed to be essential for some consumers. Other goods such as smoking cessation products and energy-saving equipment also have a reduced rate as they are beneficial for both the consumer and their community.

Some products are not charged any VAT as they are deemed to be essential for all consumers. This includes many food items, equipment for disabled people, and children's clothing.

VAT is not to be confused with excise taxes. Excise taxes are implemented to raise the price of a product as both a deterrent and as a means to help pay for the eventual cost of the buyer. For example, cigarettes and alcohol consumption typically cost the NHS large amounts of money in healthcare, so the excise tax puts the price up to deter their initial purchase and also raises money to cover the healthcare costs. Excise is also levied on products such as fuel and gambling services. As well as excise taxes, these products also have VAT.

What services have VAT?

Services are sales that are made with no goods exchanged. Services are subject to the same rates of VAT as goods, but some services are exempt in an effort to promote their use. For example, taxis and cars pay VAT, whereas buses and trains do not. Buses and trains are exempt from VAT as they are considered to be essential, but it is also a means of encouraging people to take public transport to reduce carbon emissions.

Services that pay VAT include taxis, the hiring and loaning of goods, lifestyle services (such as massage or manicure), restaurants and hospitality, and bridge and tunnel tolls.

Services with tax exemptions include education and training services and facilities, train tickets, bus tickets, funeral services, and healthcare.

The VAT that is paid for all goods and services is paid for by the consumer and not the supplier or business.

Where does VAT go?

VAT does not go to the business that supplied the product, it goes directly to the government.

As we saw earlier, VAT accounts for the third-highest tax revenue for the UK government. The amount of VAT raised has increased every year from 2010 until 2019, which saw a record high of £132 billion, roughly equivalent to £4,700 per household. This figure then dropped sharply after the onset of the Coronavirus pandemic to £101 billion. As consumption fell, so did tax revenue. It is therefore within the government's best interest to always encourage spending by altering the VAT rate.

As we can see from these figures, VAT is a vital component in funding the modern economy.

Is VAT progressive or regressive?

Many people criticise VAT as a regressive tax. This means it is paid by all people at the same rate no matter their income. It is argued that this impacts lower earners more than higher earners.

In 2017, an ONS report found that the poorest fifth of UK society spent 30% of their income on indirect tax, with VAT accounting for the largest outgoings. The same report found that the richest fifth spent 14.6% of their income on indirect tax. People with less money will spend a much larger percentage of their income on VAT, which many argue proves that VAT is regressive as it increases the rate of inequality. 

However, advocates of VAT claim that it is a progressive tax. This means that as you earn more, you pay more. Higher earners may pay less of a percentage of their income on VAT, but their net contribution is greater. Those who consume more will end up paying more. Higher-income households are more likely to consume and will therefore pay more VAT.

VAT for businesses and the self-employed

Some businesses will have to charge VAT on their goods and services and some will be exempt as their turnover is below the VAT threshold. It is also possible for businesses to reclaim much of their own VAT expenditure. The same is also true for those who are self-employed.

Governments around the world offer VAT refund incentives as it encourages businesses to keep a record of invoices. This not only saves domestic businesses money but also helps to curb any tax avoidance on unclaimed profits.

When should you start charging VAT?

In the UK, there is a VAT-free threshold of £85,000 per year. So a business can have an annual turnover of up to £85,000 before charging (and paying) VAT on their goods and services. For example, if a business turned over £100,000 in a year, it would only pay VAT on £15,000. This applies to self-employed people too.

Once a business or a self-employed person has exceeded the threshold, they must register with HMRC via gov.uk and claim a VAT number. VAT must then be added to the cost of the goods or services provided.

How to charge VAT

If you run a business or are self-employed and have an annual turnover that exceeds £85,000, here is a simple guide on how to charge VAT:

  • Make sure your goods or services are eligible for VAT. As we saw earlier, many products are exempt from VAT, so it is best to ensure that your product is eligible. If it is, be sure to determine if you should charge the standard rate (20%) or the reduced rate (5%).
  • Work out the VAT of a single unit price. You do this by multiplying the unit price without VAT by 1.2 (standard rate) or 1.05 (reduced rate).
  • Show the VAT information on any invoices you write. 
  • Show the transaction in your VAT account. Your VAT account will be set up when you register with HMRC.

And there you have it! It's not complicated to charge VAT, but it is vital that any business does so if they exceed the threshold, otherwise they are liable to an investigation, fines, and even criminal charges.

How to reclaim VAT

Any business can reclaim VAT spent on goods and services purchased solely for business use only. For example, telephone calls made for business purposes can have the VAT reclaimed. Also, self-employed people who work from home may be eligible to reclaim much of their home-office VAT expenditure, such as heating or electricity bills during their working hours. So it is vital to keep records and receipts of payments as VAT rebates can save a lot of money.

However, there are some products for which VAT cannot be reclaimed. For example, anything purchased for private use, goods and services that are used to make VAT-exempt products, or luxuries and business entertainment costs.

To reclaim any VAT, you must keep a record and receipts of all purchases and then submit a VAT return to HMRC. 

Keeping on top of your or your business's tax returns can be a challenge, which is why our accounting service automates your tax returns for you.

Summary

You would be hard-pressed to find a day in which you didn't contribute something towards VAT. While many of us will go our lives without realising just how much we are paying, it's vital for businesses and the self-employed that they are aware of when they should start charging VAT and what they are eligible to reclaim. This will not only ensure that they stay on the right side of the taxman, but could also end up saving them significant amounts of money on business expenditures each year.

So if you run a small business or start-up, try Ember today to keep on top of your tax returns. By simplifying and optimising your taxes, we can save you money from day one, with your first month on us –no strings attached.

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Daniel Hogan

Daniel is a Deloitte-trained, fully qualified Chartered Accountant with experience in the finance software space. It was during his tenure managing a finance system in the UK that he grew dissatisfied with the lack of synergy and automation in the space, compelling him to co-found Ember.