Managing VAT: How to overcome the challenges of dealing with tax

There’s no getting away from Value Added Tax, or VAT. As consumers, we pay VAT on most things we buy.

Managing VAT is a requirement for businesses because the government requires organisations whose turnover is above a certain threshold (currently £85,000), and that make VAT-eligible sales, to register for VAT.

They must collect and account for VAT, and send the money to HMRC.

Not all businesses need to register, though – if all the sales you make are exempt from VAT, you’re exempt from the registration requirement.

The good news is that businesses can deduct the VAT on goods or services they purchase from the VAT bill they have to pay. And smaller businesses hold the VAT cash collected until it’s due (typically every three months).

This means it can earn interest in a bank account or be used for short-term credit to fund purchases or pay bills, aiding cash flow and enabling growth.

Keeping on top of VAT accounting and payments is vital because HMRC can impose penalties for getting it wrong. This isn’t just for wilful attempts to cheat the system but also for mistakes caused by ignorance of the rules and failing to keep records.

While speaking to an accountant or other tax expert about VAT is vital, below we take a look at what you need to know about VAT when running a business – and how to overcome the challenges it presents.

• What is VAT?
• Why managing VAT can be challenging for businesses
• How to start with VAT accounting
• VAT schemes offered by HMRC
• Dealing with VAT rate changes
• What does Brexit mean for VAT?
• Tips to overcome the challenge of managing VAT
• Quick VAT glossary

What is VAT?

VAT is a form of tax that’s applied by VAT-registered businesses to sales they make that are VAT-eligible.

In an average business, this is typically for goods or services. But VAT can also be applied to things such as commission or the fee for hiring or loaning goods.

If you’re VAT registered and want to sell a mobile phone so you keep £100 of the sale price, for example, then you’ll need to charge your customer £120.

You’re liable to pass that additional £20, along with the rest of the VAT you collect, to HMRC.

If a mechanic spends three hours fixing a car, for a total of £90, then they charge £108 to the customer and are liable to pass £18 to HMRC along with the rest of the VAT they’ve charged customers.

But it’s never this clear cut.

As mentioned earlier, you offset the VAT you collect against what VAT payable on purchases.

In practice, you calculate the VAT you have to hand over to HMRC based on the difference between VAT charged on sales invoices, and VAT you’ve been charged on purchase invoices.

The total VAT you’ve collected on sales might be £20,000, for example, but it might transpire £5,000 was paid as VAT for your purchases. Therefore, HMRC requires you to pay just £15,000 in your VAT Return.

Often this is referred to as “getting the VAT back”.

If you end up with a negative figure in your calculations – that is, you paid more VAT on purchases than you charged on sales – the government will pay you that cash.

This is known as net repayment, but it’s not common.

While the standard rate of VAT is 20%, there’s also a reduced rate of 5% and a zero rate of 0%. The rate you apply depends on what’s being sold – and sometimes even where and how it’s sold.

Some sales are out of scope of the VAT system, typically because they’re exempt from VAT – although it’s important to note that the zero rate of VAT isn’t the same as something being exempt, because zero-rated sales must still be accounted for (and so the business will still need to be registered for VAT).

Most businesses have to electronically file a VAT Return every quarter, which tells HMRC basic facts about the VAT they’ve collected and the VAT they’ve been charged on things they’ve bought.

VAT returns must be sent to HMRC one month and seven days after the end of the VAT period.

Businesses typically pay their VAT bill quarterly too, as the payment is due when the VAT is reported. Your VAT accounting must be kept for six years in most cases, in case HMRC want to take a look in the future.

Some businesses pay VAT monthly, because that works best for their cash flow. But this requires permission from HMRC.

Why managing VAT can be challenging for businesses

VAT accounting can be tricky, especially if you’ve only just registered for VAT. However, once you have the processes in place – such as the right kind of invoices and accounting system – things typically run smoothly.

Firstly, you need to know what VAT rate applies to the sales you make.

There are look-up tables that show which rate of VAT you should apply to sales.

You shouldn’t assume the standard rate of 20% applies at all times, and you’ll need to keep an eye on the look-up tables because VAT rates sometimes change, especially following a budget announcement from the government.

Sometimes you might make a sale that includes elements with different VAT rates. This is known as making a mixed supply, and can be especially difficult to get right.

Secondly, VAT has its own terminology that you need to understand.

For example, when you make a sale eligible for VAT, it’s known as making a taxable supply. When it comes to your accounting, the VAT you charge on your sales is known as the output tax.

VAT you’re charged on purchases from other suppliers is known as your input tax. See our glossary at the bottom of this article for some basic terms.

Thirdly, the devil is truly in the details with VAT accounting and it’s very easy to be innocently caught out.

For example, the reduced rate of VAT (5%) can apply not only to the sale of the goods, but to where the sale is made.

Sales of mobility aids for older people have the reduced VAT rate applied – but only if the goods are installed in the consumer’s home.

Getting expert help is a must.

How to start with VAT accounting

The law says VAT-registered businesses must keep not only a VAT account but also keep a VAT Bad Debt account. These accounts should be separate from your main accounting ledgers, although obviously they will share data.

The law also says your VAT accounting must be kept using software.

In other words, you can’t keep it scribbled down on a paper ledger. Spreadsheets can be used for VAT accounting, although you’ll need bridging software to communicate with HMRC’s computers to file and pay returns.

Most businesses simply use their accounting software to handle VAT. This makes the process of creating a VAT Return as easy as clicking a button, and keeps your VAT accounting alongside your main profit and loss.

The VAT account should track the VAT you charge, and the VAT on purchases. It should detail the VAT you owe HMRC, and the VAT you can reclaim. If you sell or purchase to businesses outside the UK but in the European Union (EU) VAT area (known as making acquisitions or dispatches), then it should track these too.

The Bad Debt account is required because VAT must be accounted for regardless of whether it’s been paid to you, or not.

If the invoice doesn’t get paid – your customer goes bust, for example, or there’s a dispute – then you write-off the VAT owed by transferring it into the Bad Debt account, with the hope of claiming it back from HMRC after six months.

This method of handling bad debts can be problematic, and not just from a cash flow perspective.

Bad Debt Relief rules must be followed, which include requirements for accounting and informing the customer of what you’re doing.

There are also special rules for invoices for which VAT is applied, and it must contain details such as the tax point (see glossary below), and the VAT number you’re issued when you register.

Additionally, VAT invoices must be kept as part of your VAT accounting, including purchase invoices and even any VAT invoices that you issue by mistake and cancel.

VAT schemes offered by HMRC

One way to overcome the difficulties of VAT accounting is to use one of the special VAT schemes offered by HMRC.

These simplify things but potentially at the expense of you paying more VAT than you would using the standard VAT scheme, or having your cash flow adversely affected.

It’s vital to speak to an expert and undertake profit and loss projections to ensure the scheme is beneficial.

The schemes have minimum lengths before you can switch to another scheme or back to standard VAT payments, so it’s not really possible to try a scheme for the short term to see how well it works for you.

Flat rate

Using this scheme, you simply apply a percentage to your turnover and pay that amount as VAT.

Typically, this is around the 10% mark for many business types. There’s no need to concern yourself with periodic input and output VAT calculations, although you can still offset VAT when purchasing certain capital assets costing more than £2,000.

The percentage you hand over to HMRC as your VAT payment depends on the industry you work in, but an exception is made for what HMRC calls limited cost businesses whose purchases are only 2% of turnover, or less than £1,000.

Limited cost businesses pay a higher rate of 16.5%. You must apply to HMRC to use the flat rate scheme. VAT Notice 733 from HMRC details this scheme.

Cash accounting

Smaller businesses with VAT taxable turnovers of £1.35m or less can use the cash accounting scheme.

This simplifies things by altering the point at which the VAT is due, so it becomes when you’re paid, or when you pay a supplier.

It’s useful because it inherently avoids worrying about accounting for VAT for bad debts, and it also means you can give customers extended credit without worrying about VAT implications.

However, cash accounting has significant limitations, perhaps the biggest being it can’t be used if you import goods from the EU.

And if your VAT-eligible turnover goes over £1.6m, you must leave the scheme.

You can switch to cash accounting if you’re eligible without telling HMRC first, but it must be at the beginning of a VAT accounting period. VAT Notice 731 from HMRC details this scheme.

Annual accounting

As the name suggests, this simplifies VAT by asking you to submit just one VAT Return each year.

But HMRC still wants that VAT money, so you’re required to make either three or nine instalments throughout the year on account, based on the previous year’s VAT figures.

Then, at the end of the year when you submit your VAT Return, you might need to make a top-up payment or you might be due a refund.

As with cash accounting, this scheme can only be used by businesses with VAT taxable turnovers of £1.35m or less, and you must leave the scheme if VAT-eligible turnover goes above £1.6m.

You need to apply with HMRC to join the annual accounting scheme. VAT Notice 732 from HMRC details this scheme.

Dealing with VAT rate changes

Occasionally, the VAT rates are temporarily reduced. Alternatively, goods and services are reclassified so the VAT rate that applies to them changes.

The standard VAT rate was changed to 17.5% a decade ago in order to stimulate the economy, for example. And in 2020, the VAT rate for hospitality, holiday accommodation, and attractions sectors was reclassified to 5% (temporarily), as part of government measures to alleviate coronavirus disruption.

Using cloud accounting software alleviates much of the struggle when rate changes occur because it will be updated automatically.

However, you may need to manually change the VAT rate for product or service entries within your accounting software and potentially change your invoice templates.

What does Brexit mean for VAT?

Although Brexit occurred on 31 January 2020, the UK remains in the EU VAT system until the end of the transition period (31 December 2020).

Brexit should make no difference to businesses making VAT eligible supplies within the UK. But it may affect how you sell VAT-eligible goods or services to businesses and consumers in the EU, or receive VAT-eligible services or goods from businesses in the EU.

In short, there’s two paths that most experts believe might be followed.

The UK might remain within the EU’s VAT system, which will mean we continue to follow the same old rules to some degree.

Alternatively, the UK may leave the EU’s VAT system, in which case selling or buying VAT-eligible goods from EU countries will be considered importing/exporting, and the same rules will apply for VAT as currently apply for non-EU countries.

This will mean you don’t account for VAT on exports, but VAT will be charged on imports.

The UK government has announced that postponed accounting will be implemented for the VAT due on imports, which will mean it won’t be due immediately when the goods enter the UK, but will instead be declared on VAT Returns as input VAT.

This will ease cash flow by removing that immediate need to pay VAT when goods enter the UK.

However, import and exporting in this way is administratively complicated. UK businesses will need an EORI number, for example, and will need to know what import or export documentation is required for each country they sell to or import from. This is likely to require specialist help from a customs broker.

Tips to overcome the challenge of managing VAT

Getting your VAT accounting right is tough. Here are some tips.

1. Consider using one of the VAT schemes. These were created to make life easier when it comes to accounting, and many businesses across the UK significantly reduce their admin requirements thanks to them. These schemes are of particular benefit to small businesses.
2. Work with an accountant or VAT expert. VAT is inherently complicated, and this shows no sign of changing any time soon. Although it’s useful to know the basics, a good accountant will know everything there is about VAT – from what rate you should apply to your business, to what HMRC will expect from your kind of business in terms of total VAT payments. This can help avoid all kinds of problems.
3. Use software. Software is a legal requirement for VAT accounting due to Making Tax Digital legislation – but it’s also one of the best investments your business can make in terms of dramatically reducing admin in all regards, although especially when it comes to VAT. Businesses have long suffered under the requirement to create VAT Returns. But with accounting software, the data is already there. So producing a VAT Return is simply the matter of clicking a button, checking the figures, and then sending it to HMRC.
4. Keep your accounting up to date. VAT accounting brings with it legal requirements to note and retain information, and HMRC has a whole team of VAT inspectors (officially known as Assurance Officers) who can request to see your books at any time. But there’s more to it than this. Keeping your VAT accounting up to date lets you see what your financial position is, and how much you owe to HMRC. Businesses have gone bust because the neglected to put enough aside for the VAT bill. Don’t let your business be one of them.

Quick VAT glossary

Here’s a basic rundown of VAT terms the average business is likely to encounter.

Acquisition

VAT-liable purchases from businesses outside the UK but within the EU VAT area.

Bad Debt relief

The rules surrounding how you reclaim the VAT you’ve accounted for, but that wasn’t paid to you because the invoice was defaulted on (e.g. when a customer goes out of business).

Dispatches

VAT-liable sales to businesses or consumers outside the UK but within the EU VAT area.

Distance selling rules

The rules that define how VAT eligible sales from the UK to end customers (business to consumer, B2C) in EU countries are handled.

Below the threshold (which varies by country) VAT is charged as it would be if supplying a customer in the UK.

Once the value of VATable sales into a country goes above the threshold, the VAT must be calculated as if the supplier was based in the customer’s country (using the local VAT rate and reported using local VAT returns in the local language).

Exempt

Sales for which VAT doesn’t apply. If these are the only sales your business makes, your business is also exempt from VAT registration.

Exempt is not the same as zero-rated.

Export

In VAT terminology, this describes sales eligible for VAT to countries outside the EU VAT treaty areas. No VAT is charged on exports.

Import

In VAT terminology, VAT-eligible supplies imported from countries outside the EU are called imports rather than supplies.

Once the supplies arrive in the UK, VAT becomes due.

Input VAT

The total VAT you’re charged by your suppliers – and that’s typically detailed on purchase invoices. This is offset against the total output VAT, and the difference is paid to HMRC.

If the figure is negative, a net repayment situation arises, and HMRC will pay you the money.

Making Tax Digital

The government’s plan to make all tax record-keeping and submission digital. The first implementation is Making Tax Digital for VAT, which means eligible businesses have had to keep VAT accounts digitally and submit VAT Returns using software since April 2019.

Out of scope

Any sale that falls outside the VAT system. Mostly this refers to sales that aren’t eligible for VAT, but it can include things like sales or purchases made from outside the EU.

Output VAT

The VAT you apply to your sales and is detailed on sales invoices.

Reduced rate

The lower rate of VAT applied to some eligible sales (currently 5%).

Standard rate

The rate of VAT applied to most VAT-eligible sales (currently 20%).

Supply

Transactions involving goods or services that are eligible for VAT. In other words, if you sell something or provide a service that’s eligible for VAT then you’re making a supply.

Tax point/time of supply

The date a sale or purchase occurs as far as VAT record-keeping is concerned. It doesn’t always correspond with the actual date of supply.

It can be the date of the invoice, for example, but if the invoice is issued 15 or more days after the supply is made then it must be the date the supply took place (e.g. when goods were delivered).

If the invoice is issued in advance, and paid in advance, the date of receipt of payment becomes the tax point (but if payment is received even before the invoice is issued, that must be the tax point).

VAT account

You must keep a separate record of the VAT you charge and the VAT you pay on purchases. This is called a VAT account. It must include a separate VAT Bad Debt account.

VAT Return

The tax return VAT-registered businesses have to provide to HMRC, typically quarterly. This now must be done digitally via software.

Zero rate

Sales that are eligible for 0% VAT applied. These must still be included in your VAT accounting. Zero rate is not the same as exempt.