VAT, or Value Added Tax, is a tax on spending. VAT-registered businesses add it to the price of most goods and services they sell. Each business pays HMRC the difference between the VAT it charges its customers and the VAT it pays on its own business purchases. So VAT is collected in stages along the supply chain, and the final consumer bears the full cost. In the UK the standard rate is 20%, with a reduced rate of 5% and a zero rate. A business must register once its taxable turnover goes over £90,000 in a rolling 12 months.
How VAT works: the chain
The idea is in the name: tax on the value added at each stage. Two terms do most of the work:
- Output tax. The VAT a registered business charges on its sales;
- Input tax. The VAT it pays on purchases for the business. It reclaims this by deducting it from its output tax.
The net figure is paid to HMRC on the VAT return. If input tax is higher, HMRC repays the difference.
Illustration only. A furniture maker sells a table to a shop for £100 plus £20 VAT and pays £20 to HMRC. The shop sells it to a customer for £200 plus £40 VAT. The shop deducts the £20 it paid the maker and pays HMRC the balance of £20. HMRC has received £40 in total, which is exactly 20% of the final £200 price. The consumer, who cannot reclaim anything, has paid all £40. Neither business has borne any VAT. Each collected it.
That neutrality only holds if the business can recover its input tax. When it cannot, because its sales are exempt or the cost is blocked, VAT becomes a real cost.
Who has to register
Registration depends on taxable turnover. That is your sales at 20%, 5% and 0%, but not exempt sales. You must register if:
- Your taxable turnover in the last 12 months has gone over £90,000. This is checked at the end of every month on a rolling basis;
- You expect taxable turnover in the next 30 days alone to go over £90,000;
- You are a business based outside the UK making taxable supplies in the UK. For these businesses there is no threshold.
Businesses below the threshold can register voluntarily. If your taxable turnover is expected to fall below £88,000, you can deregister. Our guide to the VAT threshold covers the tests, the deadlines and what to do if you crossed the line without noticing.
The rates and the categories
Every sale falls into one of four categories:
- Standard-rated (20%). Most goods and services;
- Reduced-rated (5%). For example, home energy and children's car seats;
- Zero-rated (0%). For example, most food and children's clothes. These are still taxable supplies, so the seller can reclaim its input tax;
- Exempt. For example, insurance, most financial services and residential rents. No VAT is charged and related input tax is generally not recoverable.
There is also a fifth group: transactions outside the scope of VAT altogether, such as wages, dividends and genuine grants. For the full list, current temporary changes and how to calculate VAT, see our guide to the VAT rate in the UK.
Reclaiming VAT on costs
A registered business can reclaim VAT on goods and services it buys for use in the business, with some limits:
- Valid VAT invoices. You need one to support the claim, and the supplier must be VAT-registered;
- Business proportion only. Where something is used privately as well, only the business share can be reclaimed, and you must keep records showing how you worked it out;
- Blocked costs. VAT on entertaining or hospitality for people you do business with, such as theatre or sports tickets, cannot be reclaimed. Cars are heavily restricted. Full recovery is usually only possible where a car is used only for business;
- Before registration. You can reclaim VAT on goods bought up to 4 years before registration if you still hold them, or still hold goods made from them. For services, the limit is 6 months.
VAT returns and paying HMRC
Most businesses file a VAT return every quarter. The return and the payment are both due one calendar month and 7 days after the end of the VAT period. For a quarter ending 30 September, that means 7 November.
Since the first VAT period starting on or after 1 April 2022, every VAT-registered business must follow Making Tax Digital for VAT. That means keeping digital records and filing through compatible software, whatever its turnover. Our guide to VAT payment covers HMRC's bank details, payment methods and Direct Debit timing.
Smaller businesses can choose simplified schemes:
- Cash accounting. Account for VAT when you are paid and when you pay, rather than on invoice dates. Available up to £1.35 million of taxable turnover;
- Annual accounting. File one return a year and make interim payments. Also available up to £1.35 million;
- Flat Rate Scheme. Pay HMRC a fixed rate of VAT and keep the difference between that and what you charge customers. You cannot reclaim VAT on purchases, except on certain capital assets over £2,000. Available up to £150,000 of VAT turnover.
Common misunderstandings
- "VAT is a cost to my business." For a fully taxable business it should not be. If it is, check for missed reclaims or blocked items;
- "The VAT I collect is my money." It is HMRC's from the moment you invoice, or when you are paid under cash accounting. Businesses that spend it end up in arrears;
- "Zero-rated means I don't need to register." Zero-rated sales count towards the £90,000 threshold;
- "Exempt is better than zero-rated." For the seller it is usually worse, because input tax is lost.
HMRC's own overview, How VAT works, is a useful starting point. The detail sits in its VAT notices. If you are approaching registration or setting up your first VAT return, our VAT registration and VAT returns services handle the process from the effective date onwards.