We sometimes receive calls from clients, who might not know what VAT is, or how it works. This is normal for many people as they might not have dealt with VAT procedures until they thought about starting a business.
Many people from countries that don’t have a VAT system will naturally be curious when VAT is mentioned. For example some countries in the middle east including: Bahrain, UAE, Kuwait and Saudi Arabia, have 0% VAT. This article is aimed at giving you an introduction to VAT, how it’s applied and what you may have to do.
VAT is short for value added tax and it is a tax applied when most goods and services are sold. It is a government tax and most consumers/customers buying goods and services will be charged VAT, when they might not be aware of it. With VAT there is value added at each stage of a product, or sometimes even in a service and the VAT is taxed at each stage, but the remuneration paid to government is for the total VAT. The government receives the percentage for the final sale, and each individual pays towards this at each stage where ‘value is added’.
VAT registered businesses have to charge VAT to other businesses and consumers once they reach certain thresholds, most commonly the domestic selling threshold of their particular country. For instance this is £85,000 in the UK.
When you are near to this threshold, or you have crossed it, then you must register for VAT purposes. The difference of a company’s VAT charges and VAT purchases are sent to the tax office e.g. If a company charged £10 of VAT on sales in a period and paid £5 VAT on purchases, they would send £5 to HMRC. VAT registered companies have the right to reclaim VAT from the tax office if their charges exceed their purchases. This is essentially when your business gets a negative difference.
Depending on the type of goods or services you provide, you will have to charge VAT on your invoices if you are VAT registered. There are three different rates in the UK: 20%, 5% and 0%. The 20% rate is applied to most goods sold within the country. The lower rates are for some goods and services. Some goods/services are VAT exempt including: Financial services, import/export services and some transport services.
Examples of how VAT works
Example 1: Basic using GBP £
A company makes t-shirts in a country that has a 10% VAT rate
The company buys the raw materials needed for £1.00 plus VAT of 10p because of the 10% VAT. The total cost is £1.10, with 10p being paid to the government by the raw material supplier.
Once the T-shirts are manufactured, the manufacturer sells them to a retailer for £8.00 plus VAT of 80p. The retailer pays £8.80 to the manufacturer but the manufacturer only renders 70p to the government for VAT, as they have already paid VAT of 10p on their purchase of raw materials.
The retailer sells the T-shirts for £20 to consumers, plus VAT of £2.00 for a total cost of £22.00. The retailer renders £1.20 to the government as they have already paid VAT of 80p on their purchase from the manufacturer.
The government receives £2.00 from VAT payments, which is the appropriate amount of VAT for the £20.00 sale (10p paid by the raw material supplier + 70p paid by the manufacturer + £1.20 paid by the retailer).
The case above does however rely on each party being VAT registered, apart from the end consumer of course.
Example 2: More realistic using Euro € and VAT rate of 20%
A small fishery sells their catch to a supermarket. The cost of the sale is €2000, but because the VAT rate is 20%, the fishery charges the supermarket €2400. Ordinarily the fishery would pay €400 to the government, but in the same period it has bought €480 worth of fishing equipment, which included €80 of VAT. The fishery is therefore only required to pay €320 to the government (€400 – €80). The government has received the €80 and now receives the €320 totalling €400, which is the appropriate amount of VAT due from the sale of fish.
Breakdown – Fishery
Value of sale: € 2000
VAT charged on sale: €400
VAT paid on purchases: €80
Net VAT (payable to government): €320
The supermarket has now paid €400 VAT to the fishery, as part of the purchase. The supermarket also paid €40 of VAT on other purchases such as packaging supplies. The supermarket sells the processed and packaged fish for €4800 (including €800 VAT). The value of the sale is €4000. The supermarket pays €360 to the government, deducting the €440 it has already paid on purchases (VAT to fishery = €400 + packaging supplies = €40). The government receives the €360 from the supermarket and the €320 from the fishery, plus €80 paid by the supplier of equipment to the fishery, plus €40 paid by the supplier of packaging to the supermarket. This means the government receives €800 on the sale worth €4000, which is the appropriate amount of VAT due from the sale of the packaged fish.
Breakdown – Supermarket
Value of sale: €4000
Vat charged on sale: €800
VAT paid on purchases: €440
Net VAT (payable to government) : €360
For more information visit the European Commissions guidelines.
|Exempt||Free from or not subject to e.g. these products are VAT exempt.|
|Fishery||An entity that raises or harvests fish, in this case to sell commercially.|
|HMRC||Her Majesty’s Revenue and Customs – Government body responsible for the collection of taxes (including VAT) and NI.|
|Raw material||Basic, starting material that a product is made from e.g. iron ore is a raw material of steel.|
|Threshold||A benchmark or limit beyond or below which a different state of affairs exists. E.g. Going beyond the limit of the distance selling threshold, requires registration for VAT.|