How Does VAT Work? A Simple Explanation

Updated on July 19, 2022

Many financial terms may sound strange to people who are new to the business world.

When you first create a company and set up your firm, there are many distinct words you’ll need to become familiar with, from dividends to corporation tax.

You’ll find one that seems extremely familiar among a plethora of unfamiliar terms: VAT.

VAT is not just a financial concept for business owners. When you make a private purchase of products or services from a company, you’ll frequently hear about VAT. When you are the one imposing the VAT on your goods and services, what exactly is it and how does it operate?

What Is VAT?

Taxes on nearly all goods and services are known as VAT, or Value Added Tax.

The basic premise of VAT is that consumers pay a tax on the things they purchase based on their value. Because the VAT rate is calculated as a proportion of the purchase price, the cost to the consumer increases as the price rises.

Customers are not responsible for paying VAT because it is a “consumption tax,” not a “business tax.” Essentially, the firm acts as a tax collector for the government by adding VAT to its costs and pricing.

When Should Your Business Start Charging VAT?

When you’ve collected a certain amount of tax, you must start charging VAT. After a few more years, this sum will soar up to £85,000.

All goods and services receipts are subject to VAT when gross income exceeds £85,000 Before the threshold is reached, no VAT has to be paid.

For example, just 5% of a company’s annual revenue of £90,000 is subject to VAT at the time of initial registration.

Exempt from VAT: the rest of its VAT is not due if your yearly income is £84,999 or less.

A VAT charge to customers will always raise or drop a business’ prices, thus small enterprises should avoid charging it right away.

If you want to stay competitive, you may have to cut prices if you don’t want to lose customers.

By providing lower prices to customers, small businesses with low incomes can maintain their financial stability and continue to do business.

When your annual income is less than £85,000, you must be VAT registered.

The £85,000 allowance does not reset at the beginning of the following tax year, unlike tax allowances.

If you are VAT registered, you must pay VAT on all goods and services.

How Does VAT Work?

You must begin collecting VAT as soon as you reach the threshold for the VAT tax.

With HMRC, you need to register for VAT. Self-assessment tax returns are similar to VAT returns in this regard.

It is possible to register for VAT as a lone proprietor. If you have a limited company, you must register your small business for VAT.

VAT registration is mandatory. An investigation and fines will be issued if you file an income tax return for your firm that exceeds the £85,000 level, but you have not registered for or paid any value-added tax. VAT is a mandatory tax.

You can charge VAT to clients on goods and services if you’ve registered for VAT and are making enough money to do so.

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How Do You Charge VAT?

It’s a cinch to add VAT to a purchase. VAT can be added as a percentage of the cost of your products and services.

It all comes down to how much you charge clients.

The VAT is simply included in the price of the merchandise if you are a retail worker and price tag your goods.

Buying a product means paying for the item’s price, plus any applicable sales tax.

The way you handle this may vary depending on the nature of your firm. You can include both the usual expenses of services and the VAT tax on an invoice you send to customers.

As soon as the buyer has paid the complete price, you set aside the VAT amount for your VAT return.

Keep in mind that VAT money is not yours, and that you should not use it as additional revenue. VAT payments.

How Much VAT Should You Charge?

The basic VAT rate is required for most small firms. 20% of the product’s price is covered by this fee.

As an example, the standard rate isn’t the only charge for goods and services.

In addition to VAT, there are two further forms of taxation:

In the case of goods and services, the reduced rate of VAT is 5%.

Items that are regarded to be necessities for a luxurious lifestyle are subject to this tariff. Car seats for youngsters, energy-saving activities, charitable fees, and mobility assistance for the elderly are among the items on this list of necessities.

Zero rate products and services are those for which VAT is levied at 0%, as defined by the European Union.

Sales of these items are exempt from VAT. Many sorts of food, children’s clothing, travel arrangements, and medical supplies and equipment are included in this list of necessities.

Even zero-rate products necessitate recording both of these rates on your VAT return.

Exempted items and services are the only ones you don’t need to keep track of for VAT purposes.

These include things like health care, financial and credit services, and charitable fundraising events.

Visit the government website to get a complete list of items that are reduced, zero, or exempt from VAT.

How Does a VAT Return Work?

All VAT registered businesses and individuals are required to submit a VAT return.

A VAT return, in contrast to a self-assessment tax return, is not submitted annually but rather every three months.

An income statement sent to HMRC for tax payments and record keeping, similar to the self-assessment tax return (SAR).

VAT returns are automatically generated as part of the registration process. VAT returns can be filed online.

In a VAT return, all of your sales of goods and services, including any VAT payments, are listed in detail.

You’ll be able to see how much VAT you paid and how much you owe the government on your tax return.

However, things aren’t quite so straightforward. All of your purchases will be subject to VAT because you are a business.

Because you’ve already paid VAT, you may be eligible for a reduction in your VAT rates or possibly a revenue refund.

VAT can only be claimed on expenses directly related to your business.

On a self-assessment tax return, this is exactly the same.

VAT can be claimed on VAT returns to make things as simple as possible when filing annual returns.

A VAT refund will be given to you if your expenses exceed your income.

It’s possible to minimize your VAT bill if the amount of money you’ve paid out is less than the amount you’ve earned.

Unless you paid any VAT on expenses during the three months covered by your VAT return, you will be responsible for all the VAT you have billed.