What is VAT? How it works, how much it is, how to register for VAT

VAT is a big earner for the UK government, bringing in billions every year. But what does VAT stand for, and what does it apply to? 

VAT, or value added tax, is essentially a tax on the consumption of goods and services. It’s applied at various stages within the supply chain whenever value is added.

While it’s ultimately customers who bear the cost of VAT, businesses serve as intermediaries, collecting VAT on sales and paying VAT on purchases. The difference between these amounts is either paid to HMRC or reclaimed by the business.

VAT can play a big part when running a business, but navigating this tax can be daunting. That’s where this guide comes in. We’ve pulled together the key information, tackling the question “What is VAT tax?” and explaining when you need to register for VAT, tips for managing VAT effectively, and more.

All of this is important because having an accurate understanding of things like the VAT threshold and VAT registration doesn’t just mean staying compliant with tax rules. 

It can also help you get a tighter grip on your small business finances, make smarter decisions for your enterprise, and be better equipped to implement business growth strategies.

What is VAT?

VAT is a tax that affects all kinds of businesses – from side hustle ideas like online stores which entrepreneurs run from home, right through to large brick-and-mortar establishments on the high street.

Simply put, it’s an additional cost applied to the price of goods and services, so it’s paid by your customers and clients, collected by you and then passed onto HMRC. 

Unlike income tax, VAT doesn’t directly take a bite out of your earnings. However, it can certainly impact your finances. For example, if you’re not VAT-registered yourself, you won’t be able to reclaim the VAT you pay on products and services purchased from VAT-registered businesses. 

Becoming a VAT-registered business can also require you to increase how much your charge for your own products and services, meaning that VAT is something you’ll have to factor into your pricing strategies.

How much is VAT in the UK?

The three main UK VAT rates are:

• Standard (20%) – Applies to most goods and services.

• Reduced rate (5%) – Applies to select categories including residential renovations and mobility aids for the elderly.

• Zero-rated (0%) – Applies to select categories including most foods, and children’s clothes.

Some goods and services, like insurance and credit, are exempt from VAT – in other words, they’re not taxable. A smaller selection of goods and services, such as voluntary donations to charity, are outside the scope of VAT.

Being exempt from VAT is different from being zero-rated. If your business only deals in exempt items, you can’t register for VAT.

A comprehensive list of VAT rates for different items can be found on the official government website, and serves as a handy reference guide for business owners.

How does VAT work?

Let’s look at VAT in action with a simple example.

Suppose you own a small furniture shop and you’re VAT registered. You buy a custom-made table from a local craftsman for £100. Since the craftsman is also VAT registered, they add 20% VAT (£20) to their invoice, bringing your total cost to £120.

When it’s time to sell the table, you mark it up to £150. Being VAT registered, you add £30 VAT to the selling price (20% of £150). So, your customer pays £180.

Here's how it works with HMRC:

• You paid £20 VAT when you bought the table.

• You collected £30 VAT when you sold it.

• You report both amounts to HMRC.

• The difference, which is £10 (£30 collected - £20 paid), is owed to HMRC.

Who needs to register for VAT

VAT registration depends on your taxable turnover – the total amount of money you bring in from selling VAT-rated goods and services.

VAT registration is required by law if:

• Your VAT taxable turnover for the past 12 months exceeds £90,000 (the VAT registration threshold).

• You expect it to exceed £90,000 in the next 30 days.

If turnover tops £90,000 for the past 12 months

If your VAT taxable turnover exceeds £90,000 in any rolling 12-month period, you must register for VAT within 30 days of the end of the month in which you reach this amount. Your VAT registration starts on the first day of the second month after your sales pass the threshold.

For instance, imagine that between 15 October 2023 and 14 October 2024, the VAT taxable turnover for your restaurant hits £95,000 – the first time it’s crossed the VAT registration threshold. 

In this situation, you’d need to register by 30 November 2024 and your VAT registration would start on 1 December 2024.

If turnover will top £90,000 in the next 30 days

If you realise that your VAT taxable turnover will exceed the VAT registration threshold in the next 30 days, the registration timeline is slightly shorter. In this case, you’d need to sign up by the end of that 30-day period.

For example, let’s say your events business lands an unexpected £25,000 booking on 1 November. Your customer agrees to pay in full by the end of November. This payment will see your taxable turnover go over the £90,000 threshold.

In this case, you’d need to register your business for VAT by 30 November and your effective date of registration would be 1 November – the date you realised your business would become liable for VAT.

Voluntary VAT registration

VAT registration sits outside the legal requirements for starting a small business until your taxable turnover hits the threshold. However, you can opt to register voluntarily, even if your business hasn’t yet turned over £90,000.

For example, if you’re setting up a limited company and your cash flow forecast indicates that turnover will quickly exceed the VAT threshold, it could be a good idea to register straight away. This way, managing VAT is part of your routine from the start.

Pros and cons of VAT registration

Voluntary VAT registration offers several benefits, as well as some potential drawbacks which you should take into account.

Here are some of the main perks:

• Allows you to reclaim VAT – You can start getting back the VAT you pay on business expenses.

• Boosts credibility – Having a VAT number can make your business look more credible and established. This is helpful for new businesses thinking about how to get clients on their books.

• Improves small business risk management – Entering the VAT process can foster more diligent accounting and bookkeeping practices, potentially leading to better management of finances and tax issues, and a lower risk of incurring HMRC-related penalties.

• Prepares your business for growth – VAT registration can set you up for smoother expansion, useful if you’re planning how to scale a business.

• Access to opportunities – Being VAT registered can open up new business opportunities, as many companies prefer to deal with VAT-registered businesses.

Here are some of the challenges to your business that can come with VAT registration.

• More paperwork and costs – VAT registration means more record-keeping and can lead to higher costs for things like accounting services.

• Higher prices – Charging VAT can make your products or services pricier, affecting sales to customers who can’t claim VAT back and potentially putting you at a disadvantage compared to non-VAT-registered competitors.

• Cash flow impact  – Handling VAT can sometimes complicate your cash flow, as you need to manage the VAT you collect and might wait to get back VAT you pay out.

How to register for VAT

Registering for VAT is typically done online. To begin, you’ll need a Government Gateway user ID and password. If you’ve previously completed a self-assessment return or handled PAYE as part of learning how to do a payroll, you might already have these credentials. If not, you can create them during your first sign-in.

Before getting started, you should gather some information on your enterprise. The exact requirements depend on your business entity type, and will include your company registration number if you’re a limited company, or your National Insurance number if you’re a sole trader.

There are a few common requirements too, such as annual turnover and bank account details. The HMRC website provides a complete list of what you need.

What happens when you register for VAT

After successfully registering for VAT, you’ll get several important items by post:

• A VAT registration certificate with your 9-digit VAT number

• Details on how to set up your business tax account if you don’t already have one (needed for the VAT online service)

• Instructions on when to submit your first VAT return and make your payment

• Confirmation of your business’s VAT registration date

After getting this information, you can log in to the Government Gateway and open your VAT online account. This allows you to easily manage VAT going forward.

Responsibilities of VAT-registered businesses

After you register for VAT, there are a few key rules you need to follow:

• Charge the correct VAT rate on all goods and services.

• Keep records of the VAT you charge and the VAT you pay.

• Submit VAT returns to HMRC.

• Pay any VAT due to HMRC

Charging VAT

As a VAT-registered business, you’re responsible for adding VAT at the appropriate rate to the price of the goods and services you sell. You must also issue VAT invoices that show your VAT number and how much VAT you have charged.

How is VAT calculated?

Businesses typically use software to calculate VAT, but it can be helpful to understand the maths behind it. Here’s how to add VAT to a price:

• To add VAT at 20%, multiply your selling price by 1.20.

• To add VAT at 5%, multiply your selling price by 1.05.

Keeping records

HMRC’s Making Tax Digital initiative requires VAT-registered businesses to keep digital records using approved software. VAT software records:

• The VAT you’ve charged customers – This is your output VAT and includes VAT on all the VAT-rated goods and services you’ve sold.

• The VAT you’ve paid –  This is your input VAT. It’s just like tracking your small business expenses but just for the VAT part.

Try to keep VAT records up to date as part of your regular bookkeeping for small businesses routine – it helps you file accurate VAT returns and is important if HMRC ask to check your records. Remember, if your software doesn’t scan images, you should keep original documents and receipts in case they are needed as proof later.

Submitting VAT returns

A VAT return is the form you complete to report to HMRC the amount of VAT you’ve collected and paid. Most businesses submit a VAT return every three months, which is referred to as your accounting period.

You need to file tax returns when they are due even if there is no VAT to pay or reclaim.

How to do a VAT return

Making Tax Digital has also introduced changes to VAT returns. Almost all VAT-registered companies are now required to submit returns using compatible software.

You’ll need to head into your Government Gateway account to authorise your preferred software to interact with HMRC. Then, consult your software instructions to find out how to submit a return.

Essentially, VAT software calculates the difference between your output VAT (what you’ve charged) and your input VAT (what you’ve paid) to figure out if you need to make a VAT payment to HMRC or if you’re due a refund.

Paying VAT

Most businesses pay VAT online. It’s straightforward and there are several payment methods available, including bank transfers, direct debits, and corporate credit cards. You’ll need to enter your VAT number when you pay.

As well as being able to pay VAT online, you can pay in person at your bank or building society. Standing orders are another option in some circumstances.

Payment times can vary, so make sure you leave enough time for your payment to reach HMRC. There are several same-day options if you’re cutting it fine.

If you’re due a VAT refund, you’ll usually get this within 30 days of filing your return (direct to your bank or by cheque).

VAT schemes

HMRC offers several optional VAT schemes. These schemes don’t change the VAT you charge on products and services but make working out what you owe simpler and could even reduce your VAT bill.

VAT flat rate scheme

The flat rate scheme, available to small businesses with a taxable turnover up to £150,000 (excluding VAT) is popular. It lets you pay VAT as a fixed percentage of total sales (including VAT). The percentage paid depends on your business type.

With this scheme, you usually can’t reclaim VAT (except on certain purchases) but get to keep the difference between what you charge customers and what you pay to HMRC. This could increase your net cash flow if your business pays a lower VAT rate than it charges. For example, if you’re charging 20% but only paying 12%.

If you’re thinking about how to improve cash flow, the flat rate scheme is certainly something worth considering, as long as your business is eligible.

However, the scheme might not suit every enterprise. For instance, if you primarily sell zero-rated items like children’s clothes, you won’t collect much VAT. Despite the lack of VAT money coming in, you can’t reclaim VAT on expenses like new display racks or card machines for your shop.

Alternative VAT schemes

Other VAT schemes include:

• Annual accounting scheme – Lets you complete one VAT return each year instead of four. It’s available to businesses with a VAT taxable turnover of £1.35 million or less.

• Cash accounting scheme – Allows you to pay VAT to HMRC when your customer pays you, rather than when you raise an invoice. It’s also limited to businesses with a VAT taxable turnover of £1.35 million or less.

• Margin scheme – For businesses that sell second-hand goods like art, antiques, or collectibles. It means you pay VAT only on the margin between the cost and the sale price rather than the full selling price.

• Retail schemes – There are three standard schemes designed specifically for retail businesses: point of sale, apportionment, and direct calculation. All let you calculate VAT once on each VAT return instead of on individual sales. These schemes can be used with the annual and cash accounting schemes but not with the flat rate scheme.

Smart ways to manage VAT

VAT schemes aren’t the only way to simplify how you manage VAT. Here are some tips to help things go smoothly. 

1. Get to know VAT rules

Make sure you understand the VAT rules relevant to your business, such as which goods and services are taxable, and at what rates. Keep in mind that rules can change, as seen with the temporary VAT rate reduction for hospitality and tourism in 2020-2021 and the uplift to the VAT threshold in 2024. It’s important to stay informed.

2. Stick to deadlines

Sticking to deadlines is really important when you’re dealing with HMRC, and not just when you’re paying your VAT bill. Whether you’re registering a business for VAT for the first time or filing a quarterly VAT return, it’s important to do so within the time limits. Your business may face penalties if you don’t.

3. Choose the right software

The Making Tax Digital initiative makes using software for VAT record-keeping and returns a legal requirement, but there are plenty of options available and it’s important to choose wisely. Accounting tools for small businesses often come with extra features, so take the time to compare options to find the best fit.

4. Plan ahead

Include VAT in your financial analysis and planning to avoid surprises when it’s time to pay. While some owners use VAT surplus to boost working capital at leaner times, you might also consider keeping VAT money separate, perhaps in a different bank account or even in a savings account to potentially earn some interest.

5. Get expert help

From deciding how to price products to coming up with effective customer retention schemes, you have plenty to keep you busy as a small business owner. If managing VAT becomes too time consuming or complex, you could seek advice from a VAT expert or accountant, or even consider hiring employees with the necessary skills.

6. Use technology

Beyond choosing the right accounting software, investing in the best tech for your business can really pay off. For instance, SumUp’s self-service kiosks and point-of-sale systems can automatically apply the right VAT rate to your products and services when you sell them, making your VAT work a lot simpler and more accurate.

Disclaimer: The contents of this page are intended for informational purposes only and should not be construed as professional advice. For matters requiring legal or financial expertise, it’s recommended to seek guidance from qualified professionals.