Almost everyone running a business will come up against Value Added Tax (VAT). This chapter explains what it is, how it will affect you, and what records you will need to keep and why.
What Is Value Added Tax?
Value Added Tax (VAT) is a 17.5% tax on consumer spending. It was brought in on 1 April 1973 to replace the old purchase tax system; it went part-way towards harmonisation with taxes charged by the countries within the EEC (now the European Union). The tax is administered by HM Customs & Excise (
not the Inland Revenue).
VAT will affect many aspects of your trading, and you’ll have to decide whether to register the business for VAT purposes and, if so, how to handle the extra information in your accounting records. This chapter therefore gives a general introduction to VAT so that you can get an idea of what’s involved.
How Does Vat Work?
Under VAT, every business is in effect a tax collector. The tax is a charge on the sale of goods or services by a business which is registered for VAT. (Certain transactions are exempt from VAT or are charged at a zero rate; details of these are given on page 58.) On most other transactions the rate of VAT is currently 17.5% of the price of the goods. These transactions are called taxable supplies and the VAT which you must charge on your sales is called output tax.
On the other hand, when a registered business purchases goods (or services) from another registered supplier it must pay to that other business the VAT which that business charges. This tax on purchases coming into the business is called input tax.
A business registered for VAT has to pay to the Customs & Excise the amount of output tax minus the input tax. If the input tax is greater than the output tax you can get the difference back from the Customs & Excise.
Example
Suppose a shop purchases a radio for £80 wholesale; it has to pay the wholesaler an additional £14 input tax. When the shop sells the radio to a consumer for £100 it charges a further £17.50 output tax and the customer has to pay the shop £117.50:
The shop must therefore pay to the Customs & Excise the difference of £3.50. As you can see, there has been an increase in the value of the radio at the shop of £20. This is the ‘value added’ bit. The net effect of paying tax (on the difference between the output tax and the input tax) is to tax the value added by the business – £20× 17.5% = £3.50. It is this idea that gives the tax its name.