How to pay VAT: A guide for small business owners

Many small business owners lose sight of value added tax (VAT) because they are below the compulsory registration threshold when they start.

It comes as a shock when their business has grown to the point where they must register and start charging VAT.

For those who may be approaching the threshold, Clive Lewis, head of enterprise at the Institute of Chartered Accountants in England and Wales (ICAEW), shares a back-to-basics guide to all things VAT.

What is VAT?

VAT was an invention of the French in the 1950s and became a tax which all new members of the Common Market/European Union have had to sign up to when they join. You can only charge VAT on goods or services that you sell once your business has been registered for VAT.

VAT is charged on business sales – in other words, when you sell goods and services. This includes the following:

• Hiring or loaning goods to someone

• Selling business assets

• Commission

• Items sold to staff such as canteen meals

• Business goods used for personal reasons

• 'Non-sales' like bartering, part-exchange and gifts

If you're a VAT-registered business, you must report to HM Revenue & Customs (HMRC) the amount of VAT you've charged and the amount of VAT you've paid.

Compulsory VAT registration threshold

You must register for VAT if your turnover exceeds £83,000 in the previous 12 months (for 2016/17 tax year). You can voluntarily register at anytime (if turnover is below compulsory registration threshold).

How does VAT work?

VAT must be added to sales invoices and purchase invoices will have VAT added if a supplier is VAT registered. VAT invoices must have all the required information on them, such as the VAT registration number.

Most items incur VAT at the standard rate (currently 20%) but some items are chargeable at the reduced rate of 5% or are zero-rated (0%).

VAT-free

There are items that are zero-rated for VAT or are exempt from the tax. It is worth being aware that the exact definition of a particular item can affect whether VAT is applied to it. There are a number of irregularities in the VAT system, some of which have resulted in disagreements between businesses and HMRC.

One famous example is the Jaffa Cakes case, which went all the way to a tribunal to determine whether they were classed as cakes or luxury biscuits. While cakes are exempt from tax, luxury biscuits are subject to VAT at the standard rate. McVities, the makers of Jaffa Cakes, insisted they were small cakes and eventually the tribunal ruled in favour of this.

VAT returns

The basic system is that, every three months, a VAT return is submitted on-line to HMRC.

Output tax (on sales) and Input tax (on purchases) are netted and the difference, usually with outputs exceeding inputs, is paid over to HMRC. Where inputs exceed outputs, a repayment will be made by HMRC. Payments can be made in a variety of specified ways.

Various other schemes

Cash accounting (or receipts and payments system) if business VAT taxable sales less than £1,350,000

• Use receipts from customers and payments to suppliers rather than invoices raised on customers or received from suppliers to calculate the payment to HMRC

• This scheme is helpful if cash flow is a problem and bad debts an issue

Annual accounting scheme

To be eligible, the business must have an annual turnover of less than £1,350,000.

• You make nine monthly or quarterly instalments based on an estimate of VAT paid in previous year or estimated liability

• You must complete one VAT return every year

• You must still keep the required records in case of VAT inspection

• Not suitable for businesses that regularly reclaim VAT, as you only get one repayment a year

Flat rate scheme

The scheme is for businesses with a turnover less than £150,000 a year, excluding VAT.

• Do not have to record and calculate VAT on each transaction

• Pay as a flat rate percentage of turnover as VAT is based on sector figures

• Percentage is less than standard VAT rate because it is net of input tax

VAT schemes for retailers

If you sell to the general public, there are several schemes you might use.

Selling overseas

Businesses selling digital services to consumers in the EU can either register for VAT in the EU state of its customer or complete a UK VAT MOSS scheme return each quarter and make just one payment to HMRC who pass on the relevant share of VAT to each member state to the VAT authority.

The change to sales of digital services arose because of changes to 'place of supply' rules from being determined by the member state VAT rates of the supplier to those of the customer. The change came into effect on 1 January 2015. There are plans to create a digital single market by extending the scheme to all goods and services with effect from 2018.

Many UK businesses avoid the paperwork by selling through a platform such as Amazon.

Relevant resources

• How to pay Self Assessment tax

• Advantages and disadvantages of registering your e-commerce business for VAT

• Self-employed people: How to find last-minute help with your tax return