What is VAT and how does it work?
Value Added Tax (VAT) is a tax charged on traders that they recover from their customers, and must declare in a regular VAT return to HMRC.
The VAT rate that businesses charge depends on what goods and services they sell.
VAT is charged on just about everything you can buy – and the goods and services you charge for as a self-employed person are no different.
You charge VAT to whoever is buying your goods and services, and then have to hand it over to HMRC in a VAT return – these are usually done quarterly.
Some goods and services are exempt from VAT. These include:
- Postage stamps or services
- Health services provided by doctors
Get a head start on your 2020-21 tax return with the Which? tax calculator. Tot up your tax bill, get tips on where to save and submit your return direct to HMRC with Which?.
What is the VAT threshold?
You must register for VAT with HMRC if your business’ VAT taxable turnover – i.e. the total value of everything you sell that isn’t exempt from VAT - is more than £85,000 in 2021-22.
Up to this, you can register voluntarily, which may be worthwhile if you can claim a lot of VAT on items bought for your business.
How do I register for VAT?
You can register with HMRC online – this will create a VAT online account (sometimes called a ‘Government Gateway account’), which you’ll need to submit your VAT return.
There are some instances – usually to do with importing or selling from an EU business or country – where you have to register by post. HMRC outlines this fully in its guide to VAT registration.
How much VAT should I charge?
The VAT charged on goods and services can vary depending on what they are.
The current rates of VAT are outlined in the table below.
|Tax rate||% of VAT||What the rate applies to|
|Standard||20%||Most goods and services|
|Reduced rate||5%||Some goods and services, e.g. children's car seats and home energy|
|Zero rate||0%||Zero-rated goods and services, e.g. most food and children's clothes|
The full list of VAT notices can be found on HMRC.
When charging VAT you must always do the following:
- Charge the correct rate of VAT
- Show the VAT information on your invoice
- Show the transaction in your VAT account – this is a summary of your VAT
- Show the amount on your VAT return
If you don’t do all of these things correctly, you may not be able to claim back the VAT on purchases that relate to these sales – eg. Materials bought to provide goods to a customer.
You can only charge VAT if your business is registered for VAT.
You must account for VAT on the full value of what you sell. This is still the case if you receive goods or services instead of money, and if you haven’t charged any VAT to the customer. Whatever price you charge will be treated as including VAT by HMRC.
What are the benefits of registering for VAT?
Even if your business turnover doesn’t exceed £85,000, it can be a good idea to voluntarily register for VAT.
This is because you can claim the VAT tax back on purchases you make in order to run your business. This includes things like tools, laptops, travel and stationery.
You can’t claim back VAT unless you are VAT registered with HMRC.
How does Making Tax Digital affect my VAT return?
As of 1 April 2019, the new Making Tax Digital for VAT scheme has come into force, changing the way you submit your VAT return.
Under the new system, you will be required to:
- register for Making Tax Digital.
- keep digital VAT records.
- submit VAT returns to HMRC using compatible software.
Businesses must register for Making Tax Digital at least a week before their first VAT return is due for the reporting period after 1 April 2019.
If your business has been deferred, you must register at least a week before your first VAT return is due following 1 October 2019.
You can register your business yourself, or your tax agents can register and file on your behalf.
The system aims to make it easier for businesses and individuals to submit their tax figures, and reduce the number of reporting errors that could cause an unexpected tax bill once the figures are corrected.
Making Tax Digital software
HMRC has a list of all compatible software - but there's no indication of product prices or how the software functions, so you'll have to do some research to find which software best suits your business.
Some businesses may already record and file VAT returns using this software, in which case there'll be very little change.
For businesses who use spreadsheets or older systems, bridging software may be a good way to stay compliant with the changes without having to completely overhaul your system.
If you use paper VAT returns, you'll need to prepare yourself for a big change in how you record your figures. You'll need to set up the company on relevant software and add all transactions for the quarterly period you're reporting on.
To find out more, see our news story on who needs to sign up for Making Tax Digital, and what the changes will be.
When do I have to make a VAT return to HMRC?
You usually submit a VAT return every three months.
The return records figures for things such as:
- Your sales and purchases
- The amount of VAT you owe
- The amount of VAT you can reclaim
- Your VAT refund from HMRC
If you’re registered for VAT, you must submit a VAT return even if you have no VAT to pay or reclaim.
It’s possible to sign up to get email reminders when your VAT return is due. You can do this by logging on to your VAT online account, following the link next to ‘VAT messages’ and adding your email address.
Useful link: See HMRC’s guide to submitting VAT returns
What happens if I’m late paying or submitting my VAT return?
If HMRC doesn’t receive your VAT return or your full VAT payment by the deadline, a ‘default’ will be recorded.
This means you may then enter a 12 month ‘surcharge period’. This is like a warning as you won’t get asked to pay a surcharge on your first default.
However, if you default again within this surcharge period you may have to pay an extra amount on top of the VAT you owe, and the surcharge period will be extended by another 12 months.
The surcharge is a percentage of the VAT you owe. The surcharge rate increases each time you default again within that surcharge period.
There are a couple of exceptions. You won’t have to pay a surcharge if you submit a late VAT return and:
- Pay your VAT in full by the due date.
- Don’t owe any tax.
- Are due a VAT repayment.
It’s always best to submit your VAT return on time to avoid any chance of having to pay a surcharge.
VAT return penalties
Even if you submit your VAT return and payment on time, HMRC may issue a penalty fine in the following instances:
- If you send a VAT return that contains a careless or deliberate inaccuracy, HMRC can charge 100% of any tax that’s under-stated or over-claimed.
- 30% of a ‘VAT notice of assessment of tax’ (which you will receive if you don’t submit a VAT return on time) if HMRC sends you a figure that’s too low and you don’t tell them it’s wrong within 30 days.
- £400 if you submit a paper VAT return, unless you’ve been told you’re exempt from submitting your return online.
What if I pay too little VAT?
HMRC may charge you interest if you’ve reported and paid less VAT than you owe.
You’ll be charged 2.75% interest – HMRC will send you a notice telling you how much you owe, and how the figure has been worked out.
If you don’t pay within 30 days, further interest will be charged on the VAT – and this will continue up to a maximum of two years.
What if I pay too much VAT?
You may be able to claim interest from HMRC if there is a mistake on its part that means you’ve paid too much VAT, reclaimed too little VAT, or a payment you were expecting from HMRC was delayed.
You can claim 0.5% interest, usually paid for the whole period from when the VAT was overpaid.
You have to claim the interest separately from the repayment itself by writing to HMRC with the details of the repayment. Any interest you receive counts as taxable income.
If HMRC’s mistake means your customers paid too much VAT, you must refund them as well.
What is the flat-rate VAT scheme?
If your turnover is less than £150,000 it could be worth considering the flat-rate VAT scheme.
Under this scheme, you pay a fixed rate of VAT to HMRC and keep the difference between what you charge your customers and pay to HMRC.
Your flat rate depends on your business type, and you’ll get a 1% discount in your first year as a VAT-registered business.
However, you can’t reclaim the VAT on your purchases – except on certain capital assets over £2,000.
This reduces admin and can be good value for small businesses.
- Find out more: Small business tax: what you need to pay - if you're a small business owner, this guide lists all of the taxes you'll need to deal with