The government introduced VAT in 1973 to generate additional revenue. VAT applies to all 'taxable supplies' VAT including the sale of goods and services.
VAT is added to everything a business sells (if registered). This is known as ‘Output VAT’.
Concurrently when a business buy goods or services from other businesses, VAT can be claimed back from the purchase total. This is known as ‘Input VAT’.
The amount of tax paid to the government is the ‘Output VAT’ minus the ‘Input VAT’.
The VAT registration threshold is £85,000. If annual business turnover exceeds this threshold then a business has to register for VAT (large penalties apply for failure to do so). If annual business turnover is under the threshold, then it is not mandatory to register. However, it is then obvious that business turnover is less than £85,000, which you may not wish to advertise.
There are 3 alternative schemes suited to small business, each with their own pros and cons.
A business pays a fixed rate of VAT to HMRC, and keeps the difference between what the customer is charged and what is paid to HMRC. For example an IT consultant’s flat rate is 14.5%, they charge the customer 20% VAT, and keep 5.5.%. Different types of businesses pay different rates. These rates are listed on the government website. VAT payments are calculated as a fixed percentage of your total turnover. In this scheme VAT cannot be reclaimed on purchases - except for certain capital assets over £2000. To join the scheme VAT turnover must be £150,000 or less (excluding VAT), and you must apply to HMRC.
VAT returns are based on when money for purchases or sales physically changes hands, not the date stated on invoices. This is a good scheme if you use cash accounting. Otherwise you risk paying VAT on sales you’ve not yet been paid for (as is the case with the flat rate scheme!).
You do one VAT return a year, whereas with the other 2 schemes you do so once a quarter. Based on the figures in this annual return, you then make monthly payments in the following year. These start in month 4 and continue until month 12, a total of 9 payments. There is a balancing payment in month 14.
If you’re able to sync your annual VAT return with your financial year, you’ll avoid additional paperwork too. And spreading the payments out will help with budgeting and financial forecasting. To be eligible for the scheme you need a maximum annual turnover of £1.35 million.
When a business is VAT registered, it is normally required to add VAT when invoicing a client for services and keep a record of the VAT charge to be added to VAT returns.
You can reclaim VAT paid on goods and services purchased for use in your business.
You are in business when, for example, you earn an income by carrying on a trade, vocation or profession - by being self-employed or through another entity, such as a limited company.
If you carry on a trade, for example, you receive money for appearing on a television programme, you provide a service to a customer (in this case, the television production company) for a reward. Any VAT on monies received from the customer can be reclaimed.