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What is VAT? UK VAT basics

Published 13/11/2020

What is VAT, and VAT in the UK

We’ve all heard of VAT and recognise its place in commerce, but what is it, what exactly is our liability and how does it apply in the UK? Our simplified VAT guide takes a closer look at the ins and outs of this goods and services tax, from the obligations of paying it to the harsh implications of tax evasion.

Definition of VAT

VAT stands for Value Added Tax and is the UK’s equivalent to GST (goods and service tax). Simply put it’s a tax on the goods and services you sell that is payable to the Inland Revenue. Currently the standard VAT rate is 20% but some goods such as gas and electricity and children’s car seats carry a reduced rate of 5%. Some goods are exempt from VAT and are 0-rated. This applies to food, transportation and children’s clothes. The standard rate of VAT was increased to 20% from 17.5% in January 2011.

Why do we pay VAT? It’s a fee to the government for trading in its territory. Anything we earn as a business within the UK we must pay a percentage of, to our government, as a tax to HMRC. Taxes collected by HMRC are used by the government for public spending on things like education, health and state pensions. Exactly how this is spent can be viewed in the annual Budget.

VAT is the third largest source of government revenue after income tax and national insurance.

Understanding VAT

Most of us probably have negative connotations when it comes to our understanding of VAT. This is largely because it’s something we have to pay and often something we don’t factor in. From a consumer perspective if a business quotes us a price for a product or a service, sometimes they give a net figure and neglect to include the VAT.  The consumer then gets the bill and realises it’s more.

From a business perspective, an annual or 6-monthly VAT return is submitted by the company to HMRC for tax owed for the previous year and is usually a hefty sum to cough up in one go. Enterprises need to be careful not to spend the VAT before it’s due.

VAT is classed as an indirect tax because it’s paid by the business as opposed to the consumer. Some people describe VAT as a regressive tax because the VAT applies to consumption rather than on a person’s individual income, meaning it can be detrimental to poorer classes, especially when the goods purchased are necessity items like replacement white goods and essential repairs or maintenance.

How does VAT apply in the UK

VAT is levied on the gross margin of a product or service at each and every point of the supply chain, from manufacturing to sale.

If you are a business or a sole trader involved anywhere in the supply chain, you are liable for VAT payments under the Value Added Tax Act 1994. New businesses must register for VAT with HMRC and will be issued with a VAT registration number, which must be included on all your invoices.

VAT is only payable after a threshold is met, meaning there is a tax free amount you can earn as a business. The current UK VAT threshold is £85,000 and has been frozen until 2020. If your turnover of taxable supplies exceeds £85,000 in a year then you are liable to pay HMRC 20% of your turnover thereafter.

The amount of VAT you pay is offset by the VAT you can claim on the purchases you have made. In short when it comes to doing your VAT return, you calculate the amount of VAT due on your output VAT (sales) and deduct your input VAT (purchases). The balance is what is payable to HMRC.

Failing to pay VAT can have some serious implications. Unpaid VAT bills are largely due to late payments as a result of administrative issues or cash flow problems. Although there is some leniency here, late payments do incur a surcharge liability notice for a first time offence and a fine for any future late payments. More seriously, however, tax avoidance and tax evasion are a growing problem that cost the UK £5.3 billion in 2017.

Companies sometimes conceal their income in offshore accounts to avoid paying VAT or fiddle their accounts to show a lower income than was actually collected. The current penalty in the UK for tax evasion is an appearance at a Magistrate’s Court where you will be sentenced to a maximum of 6 years in prison or liable to pay a fine of up to £20,000.

Conclusion

Love it or hate it, VAT is an obligatory tax that every business must pay if they meet the threshold. Businesses should keep the VAT saved in an account and leave it untouched, so that they can comfortably pay the VAT bill when it comes to doing the return. Companies can do their own VAT returns in-house, but if in any doubt, it’s advisable to call in the services of a trustworthy accountant to do the work for you. It could save you a lot of time, resources and a potential fine!