What is VAT and when can it affect your business?

Do you know exactly what VAT is, and when it might affect your business? Or does it leave you feeling confused?

Over the next four weeks, Emily Coltman ACA, Chief Accountant to FreeAgent – which provides an online accounting system for small businesses and freelancers – will guide you through the ins and outs of VAT. First, an introduction.

The basics

“VAT” is short for Value Added Tax, and it is a tax that’s charged on most sales of goods and services in the UK.

Sales on which VAT would normally be charged are called “taxable sales”. Sales that are exempt from VAT – or outside the scope of UK VAT – are not taxable sales.

Exploding the VAT myths

There are quite a lot of myths surrounding VAT, so here is the important information you need to debunk fact from fiction.

1. Firstly, when you sell goods and services to your customers, you won’t charge VAT unless you’re registered with HM Revenue & Customs (HMRC) to do so, which is usually known as “registering for VAT”.
2. Secondly, only businesses can register for VAT, not members of the public.

And not all businesses have to register for VAT. You only have to register your business if its annual taxable sales are over the limit set by HMRC, currently £77,000.

VAT charged and reclaimed

If your business is registered for VAT, then it has to charge VAT on all the taxable sales it makes to all its customers. This is important, because there’s another myth that you only have to charge VAT to customers who are themselves registered.

That’s unfortunately not true – you would have to charge VAT on all your taxable sales.

The VAT you charge to your customers is called “output VAT”.

Your business will also be able to reclaim some of the VAT that its suppliers charge. I say “some” advisedly, because there are some supplies on which VAT can’t be reclaimed, such as entertaining anyone other than staff. VAT that can be reclaimed is called “input VAT”.

VAT-registered businesses must file a regular report called a VAT return to HMRC. The VAT return shows the business’s output VAT, less its input VAT. The difference is what the business must actually pay to HMRC.

We’ll look more at completing VAT returns in a later article in this series.

When a business must register for VAT

You can choose to register your business for VAT before its taxable sales reach £77,000 a year, unless you’re only making sales that are exempt from VAT or outside the scope of VAT. In that case you would never register for VAT.

Registering before you have to is called “voluntary registration”, and can help your cashflow, because being registered for VAT allows your business to claim back input VAT on its costs.

However, in some cases it’s not a good idea to register for VAT voluntarily, aside from the extra administrative burden.

The key to identifying whether or not your business should register early is to look at who its customers are.

If your business’s customers are other businesses who are likely to be registered for VAT, then they will be able to reclaim the VAT that you charge them, so you can go ahead and register as soon as you want to.

But if your business’s customers are the general public, or small businesses who may not register for VAT, leave registration as long as you can.

This is because being registered for VAT means you have to charge them VAT – but because they’re not registered, they can’t reclaim that back from HMRC, meaning that they feel your prices are higher.

So let’s see how that works

Molly is our cleaner. She’s not registered for VAT. She charges us £12 per hour, so for a morning’s cleaning we pay him £42.

But if Molly were to register for VAT, she would have to charge us VAT at 20% on top of what we already pay her. That means she would charge us £42 x 1.2 = £50.40, an increase of £8.40, or £2.40 per hour.

Because individuals can’t register for VAT, we can’t reclaim that input VAT back – so that represents an increase in Molly’s fees as far as we’re concerned.

How to register your business for VAT

You can register either by filling in a paper form or registering here .

From 15th October, you’ll be able to register to file your VAT returns online at the same time as you register for VAT.

HMRC will then process your application and let you know whether or not it has been successful.

Remember that it does take time for HMRC to do this – sometimes up to several weeks – so make sure you factor this in.

Beginning to charge VAT

Once you are registered for VAT you must make sure that all your invoices for taxable sales are compliant VAT invoices.

Most bookkeeping software packages – including FreeAgent – will do this for you automatically.

Between the date your registration starts and when HMRC issue their acceptance, you need to consider whether you’re going to include VAT in your prices to your customers (you can’t issue VAT invoices yet but you can gross up your prices to include it), or ask them for more money at a later stage to cover the VAT.

So, to go back to the example of Molly the cleaner, if she were to apply to be registered from 1st October, for each morning’s cleaning she did for us in October she could charge us £50.40 instead of £42 – and then, once her registration comes through, she would need to issue another set of invoices for her October sales, which would need to be VAT invoices compliant with HMRC’s rules.

Alternatively, she could keep charging £42 for a morning’s work in October, but once her VAT registration comes through, she would have to go back over all the sales dated between the date from which the registration takes effect and the date she received the VAT acceptance from HMRC, work out the VAT she would have charged on those sales, and invoice her customers for that VAT – which the customers might not be very happy about.

Invoices that are issued for VAT alone are called “VAT-only invoices”.

The next step in the VAT journey is to make sure you charge and reclaim the right amount of VAT – and that’s what we’ll look at in the next article.

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