This is the fifth blog in a series offering advice and guidance to anyone considering starting a new business. We’ll be publishing further blogs over the coming months.
Value Added Tax (VAT) is something all business owners need to understand. In this blog, we’ll look at how VAT works and explain the responsibilities it entails. As we’ll see, VAT registration becomes mandatory for businesses when they reach a certain level of turnover, but voluntary registration is open to all businesses and, depending on circumstances, may well be beneficial.
What is VAT?
VAT is a consumption tax levied on the value added to goods and services at each stage of production or distribution. It’s an indirect tax, meaning that businesses collect the tax on behalf of the government and then remit it to HMRC.
There are three standard VAT rates:
- Standard Rate (20%): This is the most common Rate and applies to most goods and services.
- Reduced Rate (5%): This lower Rate is applied to specific goods and services, such as children’s car seats and energy-saving materials.
- Zero Rate (0%): Certain items, like most food items, books, and children’s clothing, are subject to a 0% VAT rate.
Once a business is VAT registered, it must charge VAT on taxable sales (VAT cannot be charged until registration is complete and certification issued). The VAT collected should be kept separate from business funds until it is reported and paid to HMRC.
Here at Inca, we always recommend using digital accounting software for the time-saving and performance insights it delivers, but for VAT-registered businesses, it’s a legal requirement. Regular (usually quarterly) VAT returns must be submitted using electronic software compliant with Making Tax Digital, reporting VAT collected and paid.
Businesses must maintain accurate records of all sales and purchases, including invoices, receipts, and accounting records, as HMRC may request these in the event of an inspection.
Unless you pay yourself through PAYE and receive no income from other sources, you’ll have to complete a Self-Assessment tax return declaring any income you’ve received in the form of salary and dividends – together with any additional income you may have received from other sources.
Each year, you’ll have to complete and file an online Self-Assessment tax return to HMRC by midnight on 31st January following the end of the tax year: this is also the date by which you’ll have to settle your tax bill.
Compulsory VAT registration
If your taxable turnover exceeds the VAT registration threshold – currently £85k, you must register for VAT. Many businesses get caught out because the threshold is calculated on a rolling 12 months – not based on turnover achieved within a tax year or financial period.
If your businesses getting close to the compulsory turnover figure or experiencing a growth phase, you need to be especially vigilant. When quoting for work, you’ll need to ensure you allow for the fact that, from the point you become registered, your business will need to either pass on or absorb the cost of any VAT you pay.
If you’re already using accounting software, it should be easy to keep track of your rolling 12-month sales figure; if not, we suggest keeping a simple manual record so you can see when you will hit the threshold for compulsory registration.
Once registered, you’ll have two decisions to make:
1. Whether to record VAT based on accruals or cash
Usually, the amount of VAT you pay HMRC is based on accruals: this means you will be required to report the difference between your sales and purchase invoices and pay any money to HMRC – even if the invoices have not been paid.
However, as long as the turnover of your business is less than £1.35 m, you can choose to report VAT based on when things get paid rather than when they’re invoiced. Selecting this option can help cash flow. For example, if your business deals with larger customers who take more than 30 days to pay, reporting on an accrual basis might mean you have to pay VAT before you receive money from your customer. But if you report on a cash basis, VAT won’t become due until your business gets paid.
It’s important to note that whichever reporting option you choose, you must apply it consistently to all your sales and purchases.
Find out more about HMRC’s Cash Accounting Scheme.
2. Whether or not to use the flat rate scheme for reporting VAT
Small businesses with a turnover of up to £150k can benefit from the VAT Flat Rate Scheme. This simplified scheme allows you to pay a fixed percentage of your turnover as VAT, which can be less than the standard VAT rate.
Under the scheme, you can choose to report VAT based on paying a fixed rate of VAT based on the type of business you operate. If you register for flat rate VAT, you can keep the difference between what you charge your customers and the fixed Rate you pay to HMRC. You cannot reclaim the VAT on your purchases – except for certain capital assets over £2k.
While the flat rate scheme will not be financially attractive for many businesses, it may be worth looking into – especially when cost savings in terms of preparing and maintaining records are taken into consideration.
Find out more about HMRC’s flat rate scheme and work out what you will have to pay if you register.
Which reporting solution to use and whether the flat rate scheme benefits you will depend on your circumstances, and you should seek the advice of your accountant or financial advisor.
Voluntary VAT registration
Even if your turnover is below the compulsory threshold, you can voluntarily register for VAT.
If your customers are the general public, it’s usually better to wait until you have to register because adding VAT will either make you more expensive than you otherwise would be (your customers won’t be able to reclaim the VAT you charge) or, if you choose to absorb some or all of the VAT yourself, you’ll reduce your profit margin.
If your customers are businesses however – particularly bigger organisations, there’s a good chance they will be VAT registered. If this is the case, it may well be financially advantageous for you to register sooner than you have to. Your customers will be able to recover any VAT you charge them, and in turn, you can reclaim any VAT you have to pay on chargeable products and services.
Ultimately, deciding whether to register voluntarily means balancing the time and cost of record-keeping against the value of any VAT you can recover.
Even if registering for VAT is not financially advantageous, it might make commercial sense. Being registered can add credibility and make your business appear larger and more established than perhaps it is, and some large organisations expect their suppliers to be VAT-registered.
Are you considering starting your own business? For more than 20 years, Inca has specialised in working with the owners of micro to small start-ups, helping them build and grow successful, sustainable businesses. 63.9% of the new start-ups we work with get to celebrate their fifth birthday – a success rate more than 300% higher than the national average!