What is value added tax (VAT) and how is it calculated?
By Indeed Editorial Team
Published 24 May 2022
The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.
Value added tax (VAT) is a common part of everyday life. It's applied to the price of everything, from fuel to clothes and services such as takeaway deliveries. This means it's important you fully understand how it works. In this article, we discuss what VAT is, what its benefits are and how you calculate it, with some practical examples.
What is value added tax?
So what is value added tax? VAT is a tax that applies both to the supply of services and the sale of goods, meaning that it's likely to factor into the bill at a restaurant or the price of a brand new jumper. It's commonly referred to as a type of ‘consumption tax' or ‘indirect tax' because it's placed onto items that consumers buy from sellers for collection on behalf of the government.
While it's a form of tax that's used across the world, many countries charge VAT differently, but locally, it's already incorporated into the price of most goods, so individuals aren't required to calculate it themselves when purchasing an item or service. This is convenient, as the rate of VAT can vary according to the government's economic priorities, which has been the case since it was first introduced in 1973, when it replaced the Purchase Tax. While not necessary in most cases, you can use online VAT calculators to work out the exact amount yourself if you wish.
What is the rate of value added tax?
Since January 2011, the rate of value added tax has been 20%. When it was first introduced, the standard rate was 10%, but this has steadily fluctuated over time. For example, in 1991, the rate was increased from 15% to 17.5%, but it returned to 15% in 2008 before increasing once more in 2010.
What is value added tax added to?
Value added tax is traditionally charged in a variety of settings. The most common occurrence of VAT comes from business sales through goods and services, but it's also applicable when you hire or loan goods to a consumer, sell business assets, take commissions or sell items to staff at their place of work, such as food within a canteen.
VAT is even applicable on non-sale items, which includes bartering, part-exchanging or gifts. VAT doesn't apply to charities and isn't added to children's clothing, food, postage stamps, financial transactions or property transactions. Some goods and services are also subject to VAT at a reduced rate of 5%, such as domestic fuel.
What are the benefits of value added tax?
Value added tax registration isn't compulsory for everyone. While some businesses are required to register for VAT, it's optional for many entrepreneurs, freelancers and small companies. But what are the advantages of paying VAT? Here are a few:
Businesses can claim back VAT placed on goods and/or services from the Her Majesty's Revenue and Customs (HMRC), meaning they can adjust their prices to remain competitive with similar businesses.
Smaller businesses who register for VAT appear more credible and trustworthy, making them more attractive to larger businesses, investors, customers and suppliers. All VAT-registered businesses receive a VAT number they can print onto letterheads, websites and stationery.
Businesses who register can claim the VAT back on any items purchased in the past four years that they are still using. To make a successful application, they require all VAT invoices and records for this time period.
Voluntarily registering for VAT forces businesses to keep an accurate set of records. Without regular pressure from the HMRC, standards in this area can start to slip.
Who has to pay value added tax?
Consumers pay value added tax on almost everything they purchase, but for businesses that supply the goods or perform the services that customers are paying for, the requirements are different. For example, businesses only pay VAT once their company reaches a turnover rate of £85,000. Once a business reaches this, the company in question registers with the HMRC so that they can both pay and charge VAT on the products they sell and the services they provide. Although not a legal requirement, businesses that don't hit this turnover rate can choose to register for value added tax voluntarily.
How is value added tax collected?
Businesses collect value added tax by adding it to their products and services. They then pass this on to the government via the HMRC. A business charges VAT at the point of sale, ensuring an accurate filing on their tax returns to the HMRC. The HMRC then collects VAT through invoices. This means that an invoice has to be accurate and include:
an invoice number
the invoice date
the date of the sale or service
the business's name and address
the customer's name and address
the business's VAT registration number
a description of the item purchased/the services performed for each item purchased or service performed (if relevant)
the quantity purchased
the rate of VAT
the price of the item before VAT gets added
the total to pay (without the addition of VAT)
the amount of VAT added to a particular item
any discount that applies to an item
Examples of value added tax
Consumers pay value added tax as part of the overall price for goods or services, rather than on top of it, as in other countries. One example of this would be if a business sold a laptop to a consumer for £660. With a VAT rate of 20%, the taxation on this transaction is £110. The laptop alone costs the consumer £550, but because VAT is already included as part of the final price, the advertised price tag of the laptop is £660.
The rate of value added tax has been 20% since 2011, but this could change. Whether it increases or decreases, the process of calculating VAT won't change. For example, if the price of a dress before VAT was £50 and the rate increased to 22%, you would simply multiply the price of the dress by 1.22 to get a total price of £61. This means that the VAT on this sale is £11.
How much VAT does a business pay to the HMRC?
When a business pays the HMRC what they owe in value added tax, they do so by calculating the difference between their sales invoices on goods and services (output VAT) and the value added tax they have paid to provide these goods/services (input VAT). This means that if a business charged £10,000 on output VAT, but it paid £1,000 in input VAT, the calculation would be £10,000 - £1,000 = £9,000. This leaves £9,000 in VAT to pay to the HMRC.
What happens if a business doesn't pay its value added tax?
If a business's turnover surpasses the £85,000 threshold, value added tax becomes a legal obligation. If a business refuses to pay this tax or is late with their payment, they could get a fine or may even receive a custodial sentence. If they receive a penalty, this is likely to include a fixed penalty percentage added on top of the initial payment.
This penalty increases from the date that the business was meant to have sent the initial report to the HMRC. It stops only when the HMRC becomes aware that the business has registered for this tax. For example, if a business is less than nine months late registering for value added tax, they pay a 5% penalty rate. If a business is over nine months but under 18 months late with their registration, they are liable to a 10% fixed penalty rate. Those that exceed 18 months pay a 15% fixed penalty rate.
What happens if a business reports an inaccuracy?
If a business's value added tax registration is inaccurate, the HMRC could potentially serve a penalty rate of up to 100% of any tax that has been either understated or overclaimed on their invoice. This means it pays to ensure that registration invoices are accurate before sending them off, but penalties vary according to individual circumstances. To avoid making mistakes on returns and paying penalties, many businesses choose to work with an accountant so they can confidently submit a correct VAT registration.
Please note that none of the companies mentioned in this article are affiliated with Indeed.
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