VAT stands for Value Added Tax. And no, I don’t think there has been a more boring acronym before.
But if you’re setting up a business in the UK, VAT is an important thing that your business needs to understand. If you don’t understand it, you won’t be able to correctly register for it, or perhaps even miss out on much-needed tax relief and help that your business can benefit from.
So, to help you navigate this tax minefield, we’ve created this complete beginners guide for you. Or, VAT explained for dummies if you prefer.
So, sit down, make yourself comfortable and put your learning hat on.
So, what is VAT?
The first section in our VAT explained for dummies guide needs to tell you exactly what it is.
As mentioned, VAT stands for Value Added Tax. It’s also sometimes known as a goods and services tax. Now, that’s not super helpful, so let’s break that down some more.
It’s a consumption tax placed on almost all goods and services that are sold. If it’s not essential, the government wants to tax it. It’s a way for them to raise revenue from customers spending habits.
The good thing about VAT tax is that it’s percentage-based. That means instead of the government charging a flat sales tax for every non-essential item you buy, you get charged a small percentage. So, the higher value the item, the more tax you pay.
- If you purchased a children’s toy worth £1, the tax you pay on that toy would only come to 20p.
- However, if you purchased a brand new laptop worth £1,000, you would be paying £400 in tax.
This means the level of VAT is always proportionate to the good or services you’re buying. If the government were to use a flat sales tax of say, £20, you would instead have to pay a £20 tax on both a £1 toy and a £1,000 laptop. That wouldn’t be fair at all.
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Do all businesses charge VAT?
Not at all. It is only charged if a company is VAT registered.
In some cases, it’s an obligation for companies to be registered, which we’ll cover in the below section.
For most small businesses or start-ups, you don’t need to charge VAT. This is great for you, because it means you can offer your customers lower prices while you get your business up and running.
It also gives you an advantage over bigger companies, making sure that the market stays competitive and isn’t monopolised by the bigger firms.
Do I need to be VAT registered?
No, not every business needs to be VAT registered. In fact, most small businesses and start-ups choose not to be registered.
You only need to be VAT registered by law if ALL of the below points apply to your business (as of 2021).
- You are a business that is actively selling goods or services;
- Selling products or services that are NOT exempt from VAT. Non-VAT products or services include things like food and drink, betting, antiques, healthcare or education. You can see a more detailed list of these items in the following section.
- Live in the UK, or your place of business is in the UK. (For more information on setting up a business in the UK as a non-resident, see this guide).
- You have an annual turnover of more than £85,000.
If that sounds like your business, then you’re going to need to register for VAT within 30 days.
If you release that your annual turnover is going to be more than the £85,000 threshold, you must register your business within 30 days of realisation, not when you exceed the threshold. So for example, if you realise on May 7th that your turnover will go over the threshold by July, you need to register within 30 days of May 7th.
If your annual turnover goes over £85,000 and you haven’t registered, you have 30 days to register since the point of exceeding your turnover.
If you don’t meet these requirements, you can also register voluntarily. There are some plus sides to this, which we’ll cover later in the article.
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What products or services are VAT-exempt?
VAT applies to most non-essential products or services. So, if something can be classed as essential, it doesn’t usually qualify.
There are, of course, exceptions to that rule. By their very nature, food and drink are essential for us to survive. But, some items of this category qualify, such as alcohol, confectionery or snacks, takeaways, restaurants, ice cream, soft drinks or catering services.
Basic food, such as vegetables, fruits and the like will always be except. But those premium snacks and items that you don’t really need? They’ll be charged at 20%.
I get it. Sometimes I feel like chocolate is essential to my life. But, really, I can live without it.
The following products and services are also VAT exempt:
- Sports activities, and physical education like tennis or ice skating lessons for children;
- Betting or gaming services, such as bingo, online lottery games or lottery tickets;
- Cultural events or exhibits, such as theatre performances, museums or even zoos;
- Antiques;
- Charitable goods or services;
- Building services or equipment for disabled people, including ramps, wheelchairs, canes, vision or hearing aids;
- Healthcare goods or services, including prescriptions, sanitary pads, incontinence products, or professional health care;
- Educational goods or services as long as they are provided by schools, universities, colleagues or any other eligible body. (Classing something as educational doesn’t quite cut the mustard here);
- Power and utilities, including energy-saving services, materials or heating;
- Certain building and construction services, such as building ramps or passageways for disabled access or charitable purposes;
- Parking or garages;
- Freight transport or containers;
- Printing brochures, leaflets or pamphlets;
- Postage costs or packaging;
- Publications, including books, magazines, music and newspapers;
- Children’s clothing, footwear or babywear;
- Protective and safety equipment;
- Insurance or financial services and investments.
For a full list, see the HMRC website here.
What happens if I don’t register for VAT?
If you’re a UK business that sells VAT goods and has an annual turnover of more than £85,000, you are legally obligated to register for VAT.
If you don’t register within 30 days of exceeding your threshold, you will be accountable for a late registration fee, which will cover how much you would have owed in the period you weren’t registered.
Depending on how late your registration is, you may also have to pay a penalty. The bottom line? If you’re obligated to pay VAT, get registered as soon as you can.
Can you get an exemption for being VAT registered?
Yes, you can get a VAT exemption from the HMRC in certain circumstances.
This happens if your annual turnover temporarily goes over the threshold, but is expected to drop again in the next 12 months. For example, if you’ve seen a recent boom that has affected your income, but is not expected to last.
In order to get your exemption, you will need to write to the HMRC and send them the evidence of your turnover and how it’s projected to drop below the threshold. They will review your case and issue and confirm an exception in writing, or register you for VAT.
When should you volunteer for VAT registration?
Volunteer VAT registration can be beneficial for a lot of businesses, particularly if your primary audience is other businesses (B2B).
This is because all VAT registered businesses can claim back the VAT that they have spent. So if you’re selling to other registered businesses, they’ll be able to claim back any tax that comes with your goods.
And more importantly, you’ll be able to claim back any VAT that you purchase. If you’re buying a lot from other businesses, this can make a big difference to your tax returns at the end of the year.
Secondly, registering for VAT might give the impression that you’re a much larger, and more well-established business than you currently are. This could help you win some new clients and increase your profits.
However, there are downsides to voluntary registration. If you sell directly to customers, you might notice a loss in sales as they don’t want to pay your VAT increased prices. It can also have a negative effect on your tax returns – and cost you more in accounting fees or bookkeeping practices.
If you’re not sure, it may be worth talking to an accountant before you make a decision, as they’ll be able to help forecast what being VAT registered will mean for your businesses’ finances.
How do I register for VAT?
Need to register for VAT? This process is actually a lot simpler than you might think.
In fact, most businesses can register online through a simple form. Make sure you have details such as your turnover, business activity and bank details to hand, as you’ll need to enter this information to complete the process.
There are some cases where you cannot register online. This includes:
- If you’re joining the Agricultural Flat Rate Scheme, which is an alternative VAT scheme designed exclusively for farmers;
- If you’re an EU business that’s distance selling or importing goods to Nothern Island;
- If you want to apply for a VAT exception, which we’ll cover in a later section.
If any of the above applies, you’ll need to complete a separate form in the post, or write directly to HMRC.
If you don’t want to register yourself, you can always appoint an accountant or agent to register and submit VAT returns on your behalf. If you’re not sure what the best thing to do for your business, it might be best to go through an accountant or agent for less stress and that added peace of mind.
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- Instructions on how to create your own HMRC Government Gateway account to activate your registration online, sent to you by email
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Do I need an accountant to register for VAT?
No, you don’t need an accountant to register for VAT. But for some businesses, having one is preferred to deal with your registration and tax returns on your behalf.
If you don’t have an accountant yet, take a look at our best questions to ask when hiring an account to make sure that you hire the best match for your business.
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What is a VAT return?
If you are VAT registered, you will have to complete a VAT return each year. This will detail your total sales and purchases, and how much tax is on them.
Your return will be used to calculate:
- How much VAT you owe to the HMRC. This is the amount that you have charged your customers.
- How much VAT you can claim from the HMRC. This is the amount that you’ve paid for as part of a business purchase.
- The total amount that you will have to pay HMRC, or that will be refunded to your account.
Even if you have no VAT to claim, or pay to HMRC, you still need to complete these returns to keep your records up to date and accurate.
To make your returns easier, you may want to consider using an accountant to manage your finances, or investing in accounting software instead. Accounting software is a great way to automatically keep a track of your income, expenses and records to make tax returns easy, quick and accurate.
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How do you charge VAT?
This one is pretty simple. If you’re VAT registered, you just need to add the VAT cost to the final price tag.
If you have a brick and mortar retail shop, for instance, you would just have to update your existing price tags with the new price.
If you invoice for your services, you just need to add VAT to your invoices. When doing this, it’s always good practice to break down the cost in the invoice and include tax as a separate charge, rather than just increase the final price.
So on an invoice, you might have your expenses listed like this:
- Materials – £40
- Labour – £160
- Subtotal – £200
- VAT – £40
- Total payable – £240
This also makes it easier if you are charging another VAT registered company, as they’ll be able to record and see how much they are paying to later claim back on their returns.
How much VAT should you charge?
In the UK, the standard rate of VAT is 20%. So, in most circumstances, if you’re VAT registered you’ll charge an extra 20%.
So if something costs £50, you’ll charge an extra £10. This brings the total price to your customers to £60.
However, there are some items that have a reduced rate of 5%. This is for items like:
- Children’s car seats;
- Home energy or power;
- Energy-saving materials, such as insulation or solar panels;
- Mobility aids for the elderly;
- Nicotine patches and gum.
Certain building and construction services also have a 5% tax rate, such as renovating a dwelling that’s been empty for at least 2 years or converting premises to increase the number of dwellings in a building.
And just to be clear, a dwelling means a house, flat or another place of residence. So in this guide, if an old home got converted into a set of flats, it would fall under the 5% reduced VAT rate.
It’s always good to keep an eye on these lists and changes for your business. For example, last year sanitary products fell under the 5% rate. But as of the 1st of January 2021, the government has stopped charging VAT on these products.
Changes like this don’t happen often, but they do happen. In fact, this change was only brought about after years of campaigns by those who work with vulnerable women and girls who cannot afford access to sanitary products. If you’re selling custom artwork, it’s very rare that you’ll have a set of campaigners wanting to make that VAT free.
When not to charge VAT
There are some things that you don’t charge VAT on, including items like health services, insurance or postage.
You can view other examples of non-VAT items in the earlier section, or view this full list on the gov.uk website.
You also shouldn’t charge for VAT if your business is not VAT registered.
How does VAT impact your tax returns?
Being VAT registered can make a big impact on your tax returns because you can claim back any value added tax that you have paid on your purchases.
So, for example, if you’re a builder that pays VAT on materials, you can claim it all back at the end of the year.
What VAT can you claim back?
You can claim back on any value added tax that your business has paid for. This is calculated through your VAT returns, which will basically deduct all the tax you’ve paid for from the tax you have charged as a business.
If you’ve paid for more VAT than you’ve charged, you’ll get a nice big return from the HMRC.
Do you need to be VAT registered to charge VAT?
Yes. It’s illegal to charge VAT if you are not VAT registered.
But that doesn’t mean your company will need to register. In fact, for most small businesses or start-ups, VAT is something that you don’t need to worry too much about, unless your threshold is exceeding £85,000 a year or if you are selling products or services that are not exempt.
But for this question, let us break it down real simple.
Are you registered for VAT?
- Yes? Charge for VAT!
- No? Do not charge for VAT! It’s illegal!
What happens if I charge VAT and I’m not VAT Registered?
As we’ve stated in the previous section, charging for VAT when you’re not VAT registered is illegal. This means you’re going to face some penalties here.
And by penalties, we mean you’re going to have to pay up.
- As a minimum, the HMRC will charge you 10% of the VAT.
- At a maximum, the HMRC will charge you 100% of the VAT, plus interest until the amount is paid in full.
The exact percentage they’ll charge you depends on how the situation came about. If it was down to a careless error or mistake that you disclose to them, they’ll typically go easy on you. However, if you’re deliberately tried to conceal tax charges from them, you can expect to get hit with the full penalty here.
And here’s a little heads up: don’t try and sneak this past the HMRC. They’ll find out and it won’t be pretty.
What if I’ve charged VAT by mistake?
First up, don’t panic. We can rectify this.
There are two things that you need to do if you’ve charged VAT by mistake.
- Issue a credit note and refund to your customer
When you’re doing this, take the time to explain the situation and what went wrong, so they can amend their own tax records if they’ve claimed for it. It’s best if we don’t start a chain reaction of wrong tax returns from one mistake.
If you have more than one customer, you’ll need to do this for everyone that you’ve incorrectly charged.
- Make an unprompted disclosure to HMRC
You’re going to have to come clean to the HMRC here before they find out and punish you.
It’s like making a confession to your parents that you’ve broken one of their ornaments before they find it broken. This is one of those situations where you need to bite the bullet, rather than face the wrath when they eventually find out. And trust me, they’ll always find out.
So, make a disclosure to HMRC and tell them how the situation came about. Make sure to show records of how you’ve refunded your customers as well.
The best-case situation here is that HMRC will go easy on you and charge the minimum 10% penalty to your business. It may seem harsh, but remember they could charge you a 100% penalty, and interest until it’s paid in full.
The HMRC will look kindly to unprompted disclosures though, so take the 10% penalty as a slap on the wrist and let’s learn from your lesson here.
What is postponed VAT accounting?
Postponed VAT accounting is a system introduced in January 2021 which allows any VAT registered businesses to pay for any outstanding tax on imported goods during their annual return, rather than the moment they’re imported into the UK.
Why the change in systems? You guessed it, it’s Brexit.
Post-Brexit trading has different rules to follow than when the UK was inside the EU.
Since January 2021, all VAT registered businesses have to pay VAT on imports coming into the UK from anywhere in the world.
Without the postponed VAT accounting system, businesses would need to pay the tax upfront out of their own pockets, which could pose a cashflow problem that didn’t exist before, particularly if you’re importing a lot of goods in a single move to sell over the coming months.
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How does postponed VAT accounting work?
If you’re using the postponed VAT accounting system, you need to state this on your customs declaration when importing your goods.
There are two ways you can fill this out on your customs declaration form.
The first uses the CHIEF (Customs Handling of Import and Export Freight) system. Using this, you will need to enter:
- your EORI number, which will need to be entered into box 8 (Header Consignee) or box 44 (Registered Consignee), depending on which option is applicable to your business.
- ‘G’ as the method of payment in Box 47e.
If you don’t already use CHIEF, you can apply to this system on the gov.uk website here. However, in order to use this, you’ll also need to get commercial software that can also submit CHIEF declarations which are listed here.
If you don’t use CHIEF, you can state your use of postponed VAT accounting using the customs declaration service.
To do this, you’ll need to enter your VAT registration number header level in data element 3/40. This will then be recorded against your EORI at the declaration level.
There are cases in which you can use the postponed VAT accounting system to claim for someone else or have another company such as a freight forwarder, customers agent, or fast parcel operator claim on your behalf. Full details about who can be used to import goods on your behalf can be found on the gov.uk website.
Whatever option you use, make sure that you’re 100% confident before you submit your customs declaration, as this cannot be changed once it’s submitted.
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Are you importing goods less than £135 in value?
If you’re importing goods into the UK that are less than £135 in value, then a different set of importing rules will apply, in which VAT will be charged and accounted for at the point of sale.
However, you can choose to use postponed VAT accounting on goods of any value, including ones below £135.
Adding postponed VAT accounting to your VAT return
After you’ve stated that you’re using postponed VAT accounting on your customs declarations, you need to make sure that you include them in your annual VAT returns. Overwise, you could be facing some hefty penalties for avoiding paying.
On your return, you’ll need to state:
- The total amount of how much postponed VAT you owe in box 1 of your return;
- The total amount of how much VAT you can reclaim on imported goods in box 4;
- The total ex-VAT value of imported goods in box 7.
The key to getting this right is to keep a detailed record of all your imports and VAT. Now, this could mean hours of trawling through receipts and customs forms, or you could track everything easily and accurately with accounting software.
Not only will accounting software help you keep track, but it’ll also help you keep an accurate record of your books and make your end-of-year accounting a breeze.
Not using accounting software yet? Our reviews of the best accounting software on the market can help find your perfect match.
Are you required to use postponed VAT accounting on your imported goods?
No, you don’t have to use postponed VAT accounting on your imports. This is an optional system – so you can choose not to use it at all.
However, postponed VAT accounting is a great benefit to your cash flow. Rather than having to pay tax upfront on your imports, you can wait until your annual VAT return to settle them as part of your overall payment.
This means you won’t have any extra unexpected costs when importing goods and can make your returns easier, especially if you use accounting software to monitor and record your imports.
If you do want to use postponed VAT accounting, you’ll need to declare it on your customs declaration. If you don’t, proceed as normal. Just be aware that once you submit your customs declaration, it cannot be changed. So make sure you’re confident in which way you choose.
VAT explained for dummies: a summary
VAT is a tax that applies to any non-essential goods or services. Most start up businesses won’t need to charge for it, but if you:
- Have an annual turnover of over £85,000 a year;
- Sell goods or services that are NOT exempt;
- Are based in the UK.
You are legally obligated to register for VAT and you’ll need to complete a VAT return.
You can also voluntarily register, which can be a benefit to some businesses as they’ll be able to claim back VAT spent.
If you’re unsure if you should be registered, or if you need help completing your forms, you’ll want to talk to an accountant or make use of software for help and guidance.
For more information about accounting and starting your online business, be sure to check out the Business4Beginners website for more.
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