What is VAT? A Comprehensive Guide

Value Added Tax (VAT) is a consumption-based tax placed on certain goods and services. The amount of VAT charged depends on the type of service or goods, the country of residence, and what the goods or services are.

It sounds complicated, but this guide will take you through how VAT works, what you need to know as a business owner, the importance of understanding VAT, and how to stay on top of your VAT admin.

First – why is it important to understand VAT?

The cost of VAT, which is 20% in the United Kingdom, is determined by the government and applied across the board to all companies and consumers. As a business, you need to know what VAT you’ve paid and what VAT you must charge so you are always up to date with your VAT returns. If you know your VAT costs and expenditures, you can get a VAT refund which can make a difference to your cash flow.

The International Monetary Fund (IMF) believes that VAT is significantly contributing to global revenue and to the more than 160 countries that currently impose it.

What is VAT?

VAT is applied to specific goods and services throughout the supply chain. There are some goods, like food and services, that are exempt. You can see a complete list here for HMRC, but it includes services like insurance and education. While food and drink are usually zero-rated, there are some exceptions, like alcohol. 

VAT is a location-based tax, so the country where the items are purchased determines the price of the VAT.

VAT is different from other tax systems, such as sales tax (see below), in that VAT is a set fee, whereas other tax forms tend to differ depending on the cost of an item or its use. HMRC also expects the business to submit a VAT return regularly as you will need to pay any VAT you have charged your customers to the tax authority. You will also be reimbursed for any VAT you paid as a business which is not an option with other forms of tax.

VAT vs. Sales Tax

VAT is not sales tax. VAT is collected at every step along the route of a product’s development and sale. Sales tax is only paid at the point of purchase.

For example: VAT is paid along a product’s route to its final destination, from the base products that make up its components (such as the fabric) to the plastic parts product (the curtain hooks or plastic hooks) to the final consumer purchase of a complete curtain set. Each stage has a VAT charge. With sales tax, the consumer only pays tax on the complete curtain set.

For many, the benefit of sales tax is that it is only paid once at the time of the transaction and only customers pay the cost when they make a purchase. The disadvantage is that there is a risk that the retailer won’t charge sales tax, so the funds are lost to the government.

On the other hand, VAT has an amount added at every point along the value chain, so there are always funds going back to the government. However, it does add a lot of admin to the business as you need to keep accurate records and ensure your VAT returns are always filed on time, or you run the risk of a fine.

When it comes to cross-border transactions, every country has a VAT Identification Number (VAT ID) that you will need to use when doing business in other countries. If you provide goods and services in another country, then the VAT is determined by that country. This is known as the destination principle. There are also specific rules around doing business with countries in Northern Ireland and the European Union that you should read to ensure you stay on top of your VAT.

VAT Components and Structure

VAT is made up of a variety of different components, each one serving a specific purpose, and it is structured differently in different countries and regions. In the UK, the standard VAT rate is 20%, with a reduced rate of 5% on some goods and services, such as children’s items and home energy. There is also a zero rate for certain foods and children’s clothing.

You also need to consider input VAT and output VAT. Output VAT is the amount you need to pay the tax authority based on the amount of VAT you have charged for VAT on your invoices for your services and products. It has to be accurately calculated and submitted as part of your VAT return. Input VAT is the amount of VAT you’ve paid on goods and services as a business – you can claim this VAT back from the tax authority. Both input VAT and output VAT require that all your invoices and receipts are accurately stored and managed so your VAT return is accurate and you receive the correct input VAT back from the tax authority.

The point at which your company becomes eligible for paying VAT is determined by the income your business makes over a 12-month period. If your taxable turnover is more than £85,000 then you have exceeded the VAT threshold and need to register. If you don’t register for VAT and your turnover exceeds the VAT threshold determined by HMRC, then you are liable for a fine from the tax authority.

VAT Compliance and Responsibilities

VAT due date deadlines are non-negotiable – from the moment you register your company for VAT, you must complete a VAT return regularly and ensure that HMRC receives that return on time. You can log into your HMRC VAT Online Account to find out when you need to submit your VAT returns and ensure that your payments are up to date.

Late VAT returns and payments are now subject to a penalty points system designed to make it easier for companies to manage their VAT returns. The penalty point system issues one point to your company for every missed deadline. These points will expire after two years if you’ve not exceeded the penalty threshold. After that, you will have to submit your VAT returns and payments on time for a set period of time before your points are reset to zero.

You need to keep accurate records to avoid penalties for submitting incorrect information on your VAT return. You should maintain records of all your VAT-relevant transactions in a digital format that’s secure and accessible so you can find the information you need. If you don’t record your VAT output and VAT input, you could be liable for fines or lose out on being reimbursed for the VAT you’ve spent as a business.

It is easy to see why you can fall behind on VAT returns and paperwork, but consider investing in a solution to help you navigate the common challenges and pitfalls that can impact VAT compliance.

VAT on International Trade

The challenge with VAT on international trade and cross-border transactions is managing your compliance and ensuring that you pay VAT into the correct country in the right amounts. A global reporting tool will help you to simplify and digitise your VAT across local and international areas of your business, and it can help you automate your processes so you don’t need to do everything manually.

Staying on top of different VAT amounts, regulations, deadlines and expectations can be quite complex. In addition, you also need to manage VAT refund mechanisms and VAT treatments for international services. You can manage your VAT refunds for EU countries by submitting your VAT claim via HMRC, as they then send it on to the relevant tax authority and country.

Top tip: You earn interest if your VAT refund is late.

There are quite a few complex hoops and exemptions to navigate regarding VAT across borders, so your best bet is to use a smart tool with global capabilities, hire a VAT expert, or spend time reading up on the varied VAT exemptions.

VAT Developments and Updates in 2023

There are several different VAT developments and updates in 2023. This is a by no means exhaustive list:

• The VAT period starting after 01 January 2023 will be subject to the new penalty scheme that runs a points-based system for late filing, incorrect filing, and outstanding payments.
• The EU has launched VAT in the Digital Age, also known as ViDA, which covers various challenges around digital reporting, e-invoicing, single VAT registration, and more. It is still undergoing changes and ratification by different members states.
• As of 01 February 2023, HMRC no longer sends tax notification letters to respond to taxpayer submissions and is not processing requests to confirm the existence of an option to tax. As always, there are exceptions.
• The Spring Budget saw a variety of changes to VAT that are fully unpacked and explained here.
• The sale of used cars between the EU and Northern Ireland saw the arrival of a VAT-related payment scheme alongside changes to energy-saving materials in the latter country.  

Blue dot and VAT

There is a lot to know and learn about VAT and it can seem intimidating, but technology and expertise are here to help you transform your VAT compliance and understanding. You don’t need to navigate this landscape while feeling overwhelmed or confused.

First there is Blue dot’s VATBox that’s designed to identify and calculate any eligible and qualified VAT spend across multiple countries and legislations. It helps you optimise, manage and analyse your company’s global and local VAT processes while identifying unclaimed returns and avoidable costs. Not sure if this is the right route for you? Watch our customer success story where a company used VATBox to save millions of Euros through VAT recovery. We also have an artificial intelligence (AI) driven application designed to help you customise the taxation rules to suit your needs. It analyses your spend to help you remain compliant and ahead of the VAT game.