Are you wondering how VAT works? Well, in this article, I’m going to give you a brief overview of how it works and why it might be a good idea for your business.

Now, VAT is not a particularly well-understood topic, even among accountants. It’s one of the more difficult taxes to deal with due to its many rules and complexity. However, I want to share some key concepts with you today.

Before we dive in, if you enjoy this type of content, be sure to click the subscribe button below so you can get notified whenever we release another video. Let’s start with the basics.

Understand How VAT works in Paris

Understanding VAT

VAT, or Value Added Tax, is a consumer tax, also known as an indirect tax. This means it’s paid by the people buying products and services. VAT-registered businesses in the supply chain act as tax collectors for the government. Ultimately, it’s the end user who ends up paying VAT.

Something interesting is that people pay VAT every day without even realizing it. It’s there when you go shopping, buy a TV, or use various services. However, it’s often when VAT is displayed on invoices for larger purchases, like a new boiler or hiring a builder, that people start to take notice and get concerned.

In the UK, we have a relatively high threshold for VAT registration. Businesses don’t have to register for VAT until they reach at least £85,000 in a 12-month period. However, reaching this threshold can catch you off guard if you’re not careful.

It’s worth noting that you can register for VAT even if your turnover is less than £85,000. In some cases, it can be beneficial to register from day one, especially if you’re dealing with larger VAT-registered businesses that don’t mind the VAT you charge. However, if you primarily deal with the public, registering from day one may not be a good idea.

How VAT Works?

Imagine you as a consumer paying all this extra VAT to businesses. Let’s take an example of a £120 TV. Every £20 that the business collects, they will hand over to the revenue and customs authorities on a quarterly, monthly, or yearly basis, depending on their VAT schedule.

However, businesses can offset any VAT they’ve paid out before handing it over. They get to reclaim the VAT they’ve incurred on their expenses. While it may not feel like a reclaim since they’re still giving money to the government, it’s significantly less than the money they’ve collected on behalf of the government.

This concept is why it can be beneficial to register for VAT. You can reclaim the VAT you’ve incurred on expenses like mobile phone bills, accountants’ fees, rent, and building materials if you’re in the construction industry.

It’s important to note that not all goods and services are subject to VAT. The government sets some as zero-rated, meaning there’s a 0% VAT rate on them. Additionally, some goods and services are outside the scope of VAT or exempt from it, meaning VAT is not charged on them. The distinction between zero-rated, exempt, and outside the scope can be complex, so consulting with a professional is recommended.

When you approach the £85,000 threshold, it’s crucial to review your figures and pricing to ensure compliance. You have 30 days to register for VAT once you reach the threshold. Taking the time to understand VAT and its implications for your business can help you navigate this tax efficiently.

Keep in mind that VAT regulations may vary in different countries, so it’s essential to familiarize yourself with the specific requirements of your jurisdiction.

I hope this overview has provided you with valuable insights into VAT. If you have any further questions or need assistance, don’t hesitate to consult with a tax professional.

Understanding VAT: A Practical Example

Let’s dive into a real-life example to see how VAT works in practice. Imagine a small business that handcrafts beautiful chairs. These chairs typically sell for £100 each, and the cost of the materials, specifically the wood used to make the chairs, is £60.

Now, let’s take a closer look at the receipts to see the breakdown. The receipt shows that the wood for the chair costs £50. So, the business is paying £60 for the wood, which means they are making £40 from each chair (£100 – £60).

If this business decides to register for VAT, the price of the chair will increase to £120, while the cost of the wood remains at £60. Here’s where it gets interesting. The business will receive an extra £20 from the customer due to the higher price, but they won’t have to hand over the entire £20 to the taxman. This is because they can offset the VAT they’ve paid on the wood (£10) against the VAT they’ve collected.

In this case, the business keeps £50 (£120 – £60 – £10), which is significantly more than the £40 they were making without VAT registration. They’ve effectively made an additional £10 in profit.

However, there’s a catch. If the business primarily sells to the general public, customers may not be thrilled about paying £120 for a chair when they can find a similar one for £100 elsewhere. This pricing difference can lead to customers questioning whether they should buy from the VAT-registered business or the non-registered one.

To address this challenge, the business has to find ways to differentiate itself beyond just price. Providing exceptional quality, unique designs, or excellent customer service can be crucial in attracting customers despite the higher price.

Alternatively, the business can still sell the chair for £100, but in this case, the taxman will take a portion of that amount as VAT. Working backward, if the chair is priced at £100, approximately £16.67 will be paid to the taxman (£100 / 1.2 * 0.2). The business can still offset the VAT they’ve paid on the wood (£10), which means they will only hand over £6.67 to the taxman (£16.67 – £10).

However, with a price of £100, the business is now left with £83.33 (£100 – £16.67) as their total revenue. After deducting the cost of the wood (£60), they’re left with a profit of £23.33 instead of the original £40.

This example highlights the complexities of pricing when it comes to VAT. It’s essential to consider various factors, including the target market, competition, and value proposition when setting prices.

Now, let’s touch on a few additional points. In the case of businesses that primarily sell to VAT-registered customers, like larger retailers, charging the higher price of £120 doesn’t deter customers because they can reclaim the VAT they’ve paid. In this scenario, registering for VAT from day one can be advantageous.

It’s worth mentioning that VAT requirements have become more stringent with the introduction of Making Tax Digital (MTD) by revenue and customs authorities. MTD mandates the use of software for submitting VAT returns and keeping digital records of transactions. While you can still use a spreadsheet, you’ll need software that integrates with it to transmit your VAT return.

Lastly, it’s important to note that VAT refunds are possible if you end up buying more goods and incurring more VAT than you collect from your sales. This can happen during startup phases or times when you’re stocking up on inventory. The process and frequency of VAT refunds depend on how you pay your VAT.

That covers the basics of VAT for your business. By understanding how VAT works, considering pricing strategies, and staying compliant with VAT regulations, you can navigate the complexities and make informed decisions to support your business’s financial success.