How VAT can affect your small business

 In Accounting Tips, Small Business Accounting

Do you understand Value Added Tax? Do you know if your business needs to pay it? Read our simple guide to find out

If you run your own business you’re likely involved in everything from sales and operations to keeping records and paying tax.

The workings of UK value added tax (VAT) however can be confusing, and getting to grips with VAT obligations fills many entrepreneurs with dread. 

No one likes paying tax. But reaching the VAT threshold is a sure sign your business is growing – and some small businesses actually register for VAT before they are legally required to. 

Why? Let’s take a closer look.

What is VAT and how does it work?

Value added tax is levied by the government on sales of goods and services. Any business with an annual turnover exceeding £85,000 – the VAT threshold – is required to register for VAT and submit a quarterly VAT return.

VAT-registered businesses have to do three things:

  1. Charge VAT – currently 20% – on the goods or services you sell to customers and other businesses 
  2. Pay VAT on the goods and services you buy from other businesses 
  3. File a quarterly VAT return to HMRC

In principle the VAT you pay should balance the VAT you charge, so it is only the difference that needs sorting through your tax return. You either pay HMRC an amount owed or receive a refund for what HMRC owes you.

Applying VAT in your day-to-day operations

When adding VAT to invoices the amount needs to be listed separately, first showing the cost of the goods or services before VAT, the VAT amount with the percentage rate charged, and the total sum due.

There are three different VAT rates: 

  • Standard rate (currently 20%)
  • Reduced rate (currently 5%)
  • Zero rate (0%)

Some goods and services are VAT exempt, for example education-related services and sales of antiques. Some industries have their own specific VAT rules.

VAT has to be charged on the full sale price of the product or service, even if goods in part exchange or barter was accepted as partial payment.

When revenues approach the VAT threshold

Businesses that sell to other VAT-registered businesses will experience less disruption when they reach the VAT threshold. Their customers will simply reclaim the VAT they have paid from HMRC. 

Businesses that sell to individual customers however will be suddenly charging what amounts to a price increase of 20 per cent, as individuals can’t claim back the VAT they’ve paid. 

In many cases the impact of lost custom compels businesses to keep prices the same and take the 20 per cent ‘hit’ to their own revenues.

When it does come time to pay there are three schemes designed to simplify the process for small businesses:

1. Flat rate VAT scheme

Businesses with annual revenues under £150,000 can choose to pay VAT under the Flat Rate Scheme. VAT payments are calculated as a percentage of the total VAT-inclusive turnover, making it easier to submit returns since individual sales records don’t need to be submitted. 

Businesses can’t reclaim VAT on any purchases made under the flat rate scheme. However the lower percentage rate – normally between 9% and 14% depending on sector – is designed to take account of this.

2. Annual accounting scheme

Businesses eligible for this scheme can sidestep the requirement to submit a quarterly VAT return and make nine monthly (or three quarterly) interim payments, then complete one return at the end of the year. They then pay any balance owing or receive a refund at year end.

The annual VA scheme reduces paperwork and makes it easier to manage cash flow. Its available to businesses with turnover under £1.35 million.

3. Cash accounting scheme

Under HMRC’s cash accounting scheme, businesses only have to pay VAT when they’ve been paid by their customers. The reverse is also true – a business can only reclaim VAT once its suppliers have been paid.

Cash accounting is available to businesses with an annual turnover of no more than £1.35 million.

Registering for VAT is mandatory once the £85,000 threshold has been reached, but some businesses register before they are required to. Here are some of the pros and cons to that approach:

VAT registration: The Pros

  • If the business is VAT registered, customers and suppliers will assume your annual revenue is greater than £85,000 – you can appear larger than you actually are
  • Adding a VAT registration to business correspondence can add credibility 

VAT registration: The Cons

  • Sales or profits may be impacted if customers can’t reclaim VAT
  • Additional paperwork and administration
  • HMRC penalties for errors

Making Tax Digital

As of April 1st this year, businesses above the VAT threshold must comply with the government’s new Making Tax Digital (MTD) programme, meaning VAT tax records must be kept electronically and returns submitted digitally using approved software. For more on MTD and how it works, see our blog ‘Making Tax Digital’ [link to most recent MTD post once live].

If you are unsure about your business’ VAT obligations, contact us today.

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