How Does VAT Work And Which Tax Scheme Is Right For You?

If you are about to become VAT registered you might be left asking how does VAT work, and what does it mean for my business?

VAT can be a confusing subject for new and experienced business owners alike. You must become VAT registered when your business turnover has reached the VAT threshold.

What Is The VAT Threshold?

VAT Threshold

In the UK a business currently must register for VAT if its annual turnover is more than £85,000. This figure changes yearly and usually increases on the 1st of April each year.

There are certain items that are VAT-exempt such as charitable donations. These items can be excluded from your income and should be deducted from your turnover.

Once you have registered for VAT, you must include it on all receipts and invoices which you issue after the VAT registration date.

It is also possible to register for VAT if your turnover is less than £85,000. This would be beneficial to any business with a higher amount of VAT on expenses than on income.

Which Services Are VAT Exempt?

Certain services are exempt from charging VAT.

This applies to the following:

  • Subscriptions and membership organisations
  • Finance, credit and insurance
  • Shares and bonds
  • Betting
  • Fundraising events by charities
  • Education and training
  • Medical care
  • Commercial land and building selling, leasing and letting

If your business provides a service that falls into a VAT exempt category, then you don’t need to include VAT on your sales. However, if you pay for any of the above services, you also won’t be able to reclaim any VAT.

Some items, as well as services, are also exempt from VAT.

Which Items Are Exempt?

vat on goods

The following are examples of goods that are VAT exempt (there are many more):

  • Antiques
  • Charity shop goods
  • Equipment for the blind
  • Royal mail postage
  • Books and printed goods
  • Children’s clothing

Now that you’ve established whether you need to register for VAT it’s time to work out which VAT scheme is the right one for you. There are three basic VAT tax schemes which apply to most businesses.

They are; cash accounting, flat rate and annual accounting. Which one applies to your business will depend upon your turnover, type of business and costs.

VAT Cash Accounting – Instant bad debt relief

Who Can Use It

In order to use the Cash Accounting VAT Scheme, your business must:

  • Have an estimated turnover of less than £1.35 million (which is VAT taxable).
  • Be registered for VAT.

You aren’t able to use the VAT Cash Accounting Scheme if:

  • You have committed a VAT offence in the last 12 months, such as VAT tax evasion.
  • You have outstanding VAT payments or you are behind on your VAT Returns.
  • Your transactions have payment terms of six months or longer.
  • Your business deals in goods which are imported from within the EU.
  • VAT invoices are raised in advance.

How it Works

how does vat work

VAT cash accounting means that you only pay/account for the VAT which is due after you have been paid by your customer. You can then also only reclaim VAT back once you have paid your supplier.

This is different from invoice-based VAT accounting where figures are reported and tax is due even when customer and supplier invoices haven’t been paid.

Cash accounting means income/sales are recorded when they are received, and any expenses are recorded in the same period which they are paid.

For this reason, VAT cash accounting is referred to as instant bad debt relief. This is because you don’t pay VAT on a sale or transaction until you receive payment for those goods or services. Therefore, if your customer pays late you don’t need to pay the VAT until they pay you.

The VAT cash accounting scheme is used by many small businesses as it is helpful if they have customers who regularly pay late, or experience ‘bad debt’.

However, this scheme also means that you can’t claim back any VAT on payments to suppliers until you have actually paid it. This can become a problem for businesses that buy their stock on credit.

If you are eligible and wish to join the VAT cash accounting scheme you may do so at the start of the VAT accounting period. Unlike other VAT schemes, you don’t have to inform HM Revenue and Customs when you do.

Is It The Right Fit?

If your business is regularly paid quickly and you regularly reclaim more VAT than you pay then an alternative VAT scheme may benefit you.

VAT Flat Rate Scheme

Who Can Use It

In order to use the VAT Flat Rate Scheme, your business must:

  • Have a predicted annual turnover of under £150,000 (excluding VAT).
  • Be registered for VAT.

You aren’t able to use the VAT Flat Rate Scheme if:

  • You have left the scheme in the last 12 months
  • You are closely associated with other businesses.
  • You have committed a VAT offence within the past 12 months.

You are required to leave the scheme if you are no longer eligible and you are able to voluntarily leave the scheme at any point.

How it Works

how does vat work

The VAT flat rate scheme requires a business to pay a fixed percentage of its annual turnover.  Businesses then get to keep the difference between the amount of VAT paid to HMRC and the amount of VAT paid to them by customers.

The flat rate of VAT that a business pays depends upon the type of business and how much it spends on goods.

The amount of payable tax on the VAT Flat Rate Scheme is calculated by multiplying a business’s VAT flat rate by its turnover (VAT-inclusive).

For example, if a business has a turnover of £100,000 and a flat rate of 10%, it would pay a flat rate of £10,000 (10% of £100,000).

A business that spends a low amount on goods (note that the cost of services, eg telephone bills, is not included in the calculation of ‘spend’ for this purpose) is known as a “Limited-cost business”.

A “limited-cost business” is one that spends less than 2% of its turnover or less than £1000 per year on goods.

Limited cost businesses pay a flat rate of 16.5% which is higher than other flat-rate scheme businesses.

If your business is NOT classed as limited-cost then its flat rate will depend on the type of business which you run.

Examples of flat rates are:

Advertising 11%

Catering services 12.5%

Food manufacture 9%

Pubs 6.5%

You can find a full list of flat rates on HMRC’s website here.

Is It The Right Fit?

This scheme simplifies the VAT process and ensures that all businesses pay roughly the same amount of tax.  The VAT flat rate scheme requires much simpler record-keeping and is easier to forecast. It also benefits from lower fixed rates and is helpful for managing cash flow.

Unlike VAT cash accounting, businesses that wish to join the VAT flat rate scheme must apply to HMRC.

The VAT flat rate scheme works for a lot of small businesses; however, it may not be beneficial for businesses that spend very little on goods or buy and sell outside of the UK.

These businesses may benefit from using the annual accounting VAT scheme.

Annual Accounting VAT Scheme

how does vat work

Who Can Use It

In order to use the Annual Accounting VAT Scheme, your business must:

  • Have a predicted annual turnover of under £1.3 million (excluding VAT).
  • Be registered for VAT.

You aren’t able to use the Annual Accounting VAT Scheme if:

  • You have left the scheme in the last 12 months
  • You have outstanding VAT payments or you are behind on your VAT Returns.
  • You are insolvent.

You are required to leave the scheme if you are not eligible or reach a turnover of more than £1.6 million.

How it Works

The Annual Accounting VAT Scheme allows businesses to make monthly or quarterly payments towards their annual VAT bill, but they need only submit ONE VAT return per year.

Under standard VAT accounting schemes, businesses must submit VAT returns and make payments FOUR times per year. Payments can be made by direct debit, standing order, or another electronic format.

The annual accounting VAT scheme can also be used in combination with either the Cash Accounting VAT Scheme or the Flat Rate VAT Scheme.

The amount of tax that a business will pay is calculated based on their last VAT Return (or if your business is new to VAT, an estimated amount).

Payment Dates

Monthly Payments:

If you pay monthly, then payments are due at the end of months four – twelve and you must pay 10% of your estimated VAT bill at each payment.

Quarterly Payments:

If you pay quarterly then payments are due at the end of months four, seven and ten and you must pay 25% of your estimated VAT bill at each payment.

VAT Return:

Your VAT Return is due two months after your businesses year-end. Final payment must then be made which makes up the difference between the amount paid in advance and the actual tax due in your VAT Return.

If your business paid too much in advance payments, then you can apply for a refund. Your instalments for the next tax year can also be adjusted to reflect your turnover more accurately.

Is It The Right Fit?

By using the annual accounting VAT scheme businesses can submit just one VAT return per year but make regular payments in instalments.

This scheme reduces administration time considerably as you only need to submit one VAT Return rather than four. Annual accounting provides additional time to submit the VAT return and can also aid cash flow as payments are made in instalments.

However, if a business regularly reclaims VAT then this scheme may be difficult to manage. This is because it is only possible to be refunded overpaid VAT once a year.

Which Scheme Is Right For Your Business?

VAT is a complicated system and each scheme will have its pros and cons depending on the type of business. If you are unsure which scheme is right for your business then it is advisable to meet with a qualified advisor.

If you have any questions about this article or VAT for your business then get in touch with our friendly team at KA Farr & Co. We’ll be more than happy to talk it through with you.