How well does your business account for Value-Added Tax (VAT), if at all?
Do you understand the different rates, schemes, and how they're applied?
VAT is a vital area of business taxation that you have to get right, it takes the form of a fee in almost every phase of goods and services being produced and/or distributed. It's another tax amongst the likes of Corporation Tax, National Insurance, and Business Rates (to name a few) that you'll likely have to manage efficiently and make payment.
Whether you meet the threshold for registering for VAT, or not, you'll probably deal with suppliers who are, and so you'll pay VAT on their products and services. This means VAT will likely impact on how you price things for your customers!
In this blog post we provide you with a guide as to how VAT works as a tax for SME businesses. We look at the various aspects of it, the threshold, how rates differ for various products and services, the different schemes you choose from to apply the tax, calculating your liability, and the record keeping required to manage all of this and stay compliant.
This post specifically covers:
What is VAT?
VAT is a tax levied on goods and services at the point of sale. It applies to almost all goods and services that are purchased in the UK. This means consumers ultimately pay for the tax, whilst businesses charge, pay and collect it on behalf of HM Revenue & Customs (HMRC).
There are 3 main rates of VAT through which VAT is applied in the UK to different types of goods and services depending on their purpose and nature. The standard rate is applicable to most goods and services. The reduced rate pertains to things such as energy saving materials and children's car seats. Zero-rated goods can include books, children's clothing, and food. Of note, all 3 rates apply to land related services.
Standard rate - 20%
Reduced rate - 5%
Zero-rated - 0%
It is compulsory to register for VAT if:
Taxable turnover, also referred to as VAT taxable turnover, refers to sales that are subject to the various rates of VAT. Some income may be exempt from VAT, if for example it has a non-UK place of origin.
There may be instances where you may want to register before breaching the threshold. Referred to as a voluntary registration, this can help your cash flow as being registered for VAT allows your business to claim back input VAT on your costs.
Pursuing such a strategy doesn't likely work if your customers are members of the general public (consumers), or small businesses that themselves haven't registered for VAT. Doing so means you would have to charge your customers VAT, something they then wouldn’t be able to claim back. Consequently your customers would likely end up paying more for these goods or services.
You can use this tool courtesy of HMRC to help you:
You can register for VAT online. HMRC then review your application and once they accept it, you'll get a VAT online account and they will send you a certificate within 30 days. This contains your unique VAT registration number.
It is from the date of registration that you must apply and pay HMRC any VAT due on relevant sales income. Needless to say, you're likely to apply for VAT registration from a specific date. This means there will be what is described as an 'interim period' between the date of application, and the date your certificate and VAT number arrive.
During this timeframe you'll have to charge VAT on any relevant sales, however, you won't be able to issue VAT invoices until your VAT registration number arrives. Consequently you'll have to add the correct rate of VAT onto any invoices you issue to your customers, from the date you applied to be registered.
It is possible to submit retrospective VAT claims for goods or services acquired prior to your VAT registration. You can reclaim VAT on goods purchased up to 4 years before your registration date, but this is provided that the VAT was paid on items you still possess, or that were made use of in the production of goods you still own.
For services, the timeframe is shorter, you can reclaim VAT on services acquired up to 6 months before your registration date. These goods or services have to be intended for the business you've registered for VAT.
You should probably include claims in your initial VAT return to ensure that you retain all relevant invoices and receipts, as well as documentation detailing how these purchases are connected to your specific business activities.
Calculating VAT
The VAT that you apply, or charge, to your customers is known as 'output VAT'. So, you need to calculate, or obtain professional advice, to ascertain how much output VAT you should charge dependent upon the goods or services that you're supplying.
You may also be able to reclaim some of the VAT that your suppliers charge. This is referred to as 'input VAT' and keep in mind that there's specific regulation as to which supplies can, and can't, be reclaimed.
The VAT system works whereby you have to declare the output VAT you've charged, and the input VAT you're claiming by filing a VAT return to HMRC every 3 months. This will then display the VAT you owe, namely your output VAT minus your input VAT.
If your input VAT is greater than your output VAT then HMRC will provide you with a refund.
Once you've subtracted your input VAT on purchases, from your output VAT on sales, you'll then need to complete your VAT return. Usually you have to do this and pay what you owe, if anything, within one month and seven days of the relevant accounting period.
VAT periods are month ends, date of registration is usually 1st of any given month. The introduction of Making Tax Digital means you have to sign up for this scheme before your first return is due as you won't be automatically enrolled.
There are different VAT schemes that you can choose from depending on your circumstances, eligibility, and needs. Regulation and reporting requirements vary among each as we explain below.
Which scheme you select depends on how your business operates, if say you usually pay more VAT on your purchases than you charge on sales, it can be useful for you to register for a scheme which allows you to make VAT submissions more frequently so that you can claim the VAT back sooner.
This is the most common accounting process by which VAT is calculated. It works whereby records are kept of the VAT applicable to all your purchases and sales. You have to account for the VAT on the date that the transaction took place and then complete a quarterly return to pay the VAT you owe, or get a refund.
This method enables you to claim back any VAT on your purchases for the date that appears on the invoice you received, as opposed to when you paid your supplier and money exchanged hands. You could potentially therefore get the claim back before you've paid your supplier depending on the credit terms they work to.
However, this can also work the other way whereby you have to pay HMRC the VAT on all your sales invoices, and potentially your customers haven't paid up yet. So this method can have both positive and negative consequences for your cash flow. Your VAT bill therefore is the difference between what you've charged customers for VAT compared to the VAT you've paid for purchases.
Ideally, for this to work well you need customers who are prompt payers and where the payment terms that you adhere to for suppliers are more generous than those you offer to your customers. Or, yours is a cash generative business where transactions only occur with immediate payment.
Similar to the standard VAT accounting method, the key difference is annual rather than quarterly filing deadlines. Upon completion of your VAT return, you then have to make payments every quarter for the estimated VAT that you'll owe. The difficulty with this is that at times through the year you may end up over, or under-paying HMRC.
Under the Flat Rate Scheme, you charge VAT to your customers and pay VAT to suppliers in the usual way. However, preparing your VAT return and paying your VAT liability to HMRC is done differently.
You don't add up all the VAT you charge and then subtract the VAT you reclaim. Instead, you tally up all your sales, which includes all the VAT you've charged. You then pay a percentage of those sales to HMRC.
The exact amount of your liability will depend on the trade your business conducts. You can find out more about these flat rates per category here, if your business makes sales that cross more than one category then you choose the percentage that applies to the majority of your sales and apply that to your total.
Other schemes based around invoices don't take account of whether your business has been paid when you submit your VAT return. In the cash accounting scheme however, you only include invoices in your return when they have been settled up, namely when payments have actually been received.
On the flip side, you also only deduct VAT from your purchases when you've actually made payment, not when you receive the invoice from your suppliers. You can join this scheme if you have sufficient reason for believing that your taxable turnover in the next 12 months won't exceed £1.35m along with other criteria including:
These are a special set of schemes used only by retail businesses that sell a large amount of low value, and/or small quantity items that may have different VAT liabilities. This is because using the Standard VAT method could be very difficult and complex for these items.
Instead, using a VAT retail scheme enables these businesses to calculate any VAT owing at the standard, reduced, and zero rates as a proportion of sales.
This scheme can be used to reduce the charged VAT burden on certain second-hand books, antiques, collectors' items, and works of art. It works whereby VAT isn't charged on the full selling price of an item but the difference between the purchase price and the selling price. This is known as the margin.
The margin is then multiplied by a VAT fraction of 1/6 (or 16.67%) to ascertain the VAT payable. There are strict regulation around what qualifies, so you need to look into this carefully and as with all things accounting and tax, you need to keep well organised records and documentation to make this work effectively.
This method can help improve your profit margin by reducing the cost of goods sold through a lower VAT rate on specific, second-hand items.
How to make a VAT payment
You make payments electronically through online banking, CHAPS, or BACS. HMRC doesn't accept cheques, or postal order payments when you submit your online VAT return. You need to make sure the funds are cleared in HMRC's bank account by the deadline. Should the deadline fall on a weekend then the funds must be cleared on the last working day before the due date.
As covered earlier, in your VAT return you report the total amount of VAT you've charged, which is known as input VAT. This is evidenced by the invoices you've issued. You also report output VAT, namely the VAT you've paid out through eligible business expenses such as business supplies, fuel, and subsistence costs which again have to be backed by the invoices you've received.
The difference between the 2 totals, output VAT minus input VAT, determines whether you have a VAT bill, or you should claim a refund. In cases where there's a repayment due following a filing, HMRC will usually settle this within 30 days of receiving your VAT return.
If your business has enrolled in the government's VAT initiative, Making Tax Digital, you can monitor your VAT repayments online. Should the repayment exceed 30 days, you could potentially qualify for a compensation of up to £50, referred to as the repayment supplement.
Late filing penalties work on a points-based system. You therefore rack up a penalty point for each late submission that you make. Once you reach a specific threshold of points, a £200 penalty applies but this threshold varies depending on your submission frequency. The points towards penalties works as follows:
| VAT return submission frequency | Points threshold |
| Monthly | 5 |
| Quarterly | 4 |
| Yearly | 2 |
The deposit is defined as an advance payment by a customer as a means to securing the supply of goods and/or services. This applies whether the deposit is refundable, or non-refundable. When your business requests a deposit, you have to account for VAT either at the time deposit is issued or when that amount is received. It's a case of whichever of those occurs first as this establishes a tax point, namely the date at which VAT is chargeable.
The above applies not just to deposits but also advance payments. Here's how VAT is treated for other types of deposits:
For hotel bookings, there is a reduced value rule that allows the charge for the sleeping accommodation portion of the supply to be relieved from VAT when a guest stays for more than 28 consecutive days. However, the accommodation supply remains taxable, and the standard input tax rules continue to apply.
In the event that a transaction is cancelled and a deposit is refunded, your business has the opportunity to adjust the VAT amount that was initially accounted for. You then align it with the amount that's been refunded. If no refund is issued, then there's no possibility to amend the VAT accounted for in the deposit. That's the case for hotel accommodation, even if the room or reservation is subsequently re-sold to another customer. So, any deposits retained or charges for "no-shows" will be liable for VAT.
The reverse charge mechanism shifts the requirement of reporting and then paying VAT on goods and services from the supplier (the entity making the sale) to the purchaser (the recipient). It tends to be applicable to cross-border transactions where VAT compliance is complicated by the need to understand and adhere potentially to different sets of regulations.
The reverse charge places the responsibility of reporting and calculating the VAT due on a transaction to the buyer. They then have to declare it as output tax, as if they had sold the item, and also input tax, as if they had purchased the item.
If the purchaser qualifies for reclaiming the VAT, this means the output tax and the input tax may well cancel themselves out, so no VAT bill. If the purchaser isn't VAT registered, or only partially exempt, then they may face a VAT bill with no means of reclaiming it.
Firstly, you need to know the VAT registration threshold and whether you should be registered. Thresholds can vary by country, something to consider carefully if you export, so be sure to keep up-to-date with cross border regulations. If registered, you have to apply VAT on all your taxable supplies, so record this carefully in order to submit the required quarterly VAT returns.
The returns provide a comprehensive account of the VAT you've collected from customers and the VAT you've paid to other businesses. You can see why good record keeping is the backbone of VAT compliance. They provide the transparency and traceability needed in the event of a HMRC investigation.
This all means you need to keep track of all sales and purchase invoices, credit notes, VAT invoices, and import/export documentation. Accounting software can ease this burden by potentially helping to automate and streamline much of the record-keeping process, ensuring that all the necessary data is captured and stored securely.
VAT compliance can also offer some benefits to your business. Being VAT-compliant enhances your credibility with suppliers and customers, as it demonstrates a commitment to legal and fiscal responsibilities. Additionally, meticulous VAT record keeping can help provide valuable insights into your business's financial health and how you can use your financial situation and performance to help drive future growth.
VAT Issues we often come across with SMEs
1. VAT registration confusion
Many start-ups and small businesses don't realise, or fail to understand that they need to register for VAT. This can then lead to late registration with the potential for penalties.
How to avoid this: Monitor your taxable turnover regularly so that you're in a position to register when you meet or breach the threshold. Another option could be to consider voluntary registration if it benefits your business, such as improving cash flow through reclaiming input VAT.
2. Incorrect application of the VAT Rate
Countless SMEs have got caught in the complex error web that is applying the wrong VAT rate to the goods and services in question. This can then result in complexity and confusion through underpayment or over-payment of the tax amount due.
How to avoid this: Research and familiarise yourself with the different VAT rates and their varying application to goods and services. Keep up to date with regular training and updates on VAT legislation, or hire an accountant and tax advisor to handle all this on your behalf.
3. Poor record keeping
Inadequate documentation can lead to errors in VAT returns and difficulties during HMRC investigations.
How to avoid this: Put in place a system of robust record-keeping practices and checks. Use accounting software to maintain accurate and organised records of all transactions, invoices, and receipts.
4. Errors in your VAT Returns:
Making errors in your calculations of input and output VAT (see below for definition of these terms). This can result in incorrect VAT returns, leading to potential fines.
How to avoid this: Check your calculations carefully. If feasible, consider using accounting software to automate VAT return preparation. Engaging a professional accountant can also help check your calculations, application of rates, and therefore accuracy of your records.
5. Cash flow issues resulting from VAT payments
A common scenario is where SMEs haven't received payment from their customers yet but their own VAT payments are due. This can lead to an inevitable cash flow crisis if not managed carefully.
How to avoid this: An option, if applicable, could be to make use of the VAT Cash Accounting Scheme (see the different schemes earlier in this post). This works whereby you only account for VAT when cash has been received and paid, as opposed to when invoices are issued and received. The cash based scheme can help align your VAT payments to your actual cash flow.
6. Lack of awareness of the different VAT Schemes
Many SMEs are unaware of the various VAT schemes available that could simplify their VAT accounting, potentially making payment and collection a simpler and more effective business process.
How to avoid this: Where relevant, discuss this carefully with your accountant. Consider the pros, cons, and application of the different VAT schemes relative to your business circumstances. Determine which you select based on your business model and cash flow needs.
The content of this post was created on 03/06/2025.
Please be aware that information provided by this blog is subject to regular legal and regulatory change. We recommend that you do not take any information held within our website or guides (eBooks) as a definitive guide to the law on the relevant matter being discussed. We suggest your course of action should be to seek legal or professional advice where necessary rather than relying on the content supplied by the author(s) of this blog.
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