What is VAT?

How does VAT work?

VAT is paid by the final consumer and collected by every business in the chain. A registered business adds VAT to its sales — output VAT — and is charged VAT on its purchases — input VAT. Each quarter it pays HMRC the output VAT less the input VAT. If input exceeds output, HMRC pays the business.

For the business, the VAT it collects is never its money. It sits in the bank account looking like turnover, and it is owed to HMRC. Businesses that treat it as their own are the ones that cannot pay the quarterly bill.

Registration is compulsory once taxable turnover in any rolling twelve months passes the threshold on gov.uk, and voluntary below it. Most goods and services are standard-rated; some are reduced-rated, zero-rated or exempt, and which is which is a matter of law rather than judgement.

A worked example

A VAT-registered electrician's quarter. He invoices £30,000 of work before VAT, so he charges £6,000 of output VAT and his customers pay £36,000. He buys £12,000 of materials and van costs before VAT, paying £2,400 of input VAT on top.

His VAT return shows output VAT £6,000, input VAT £2,400, and £3,600 payable to HMRC. Of the £36,000 that came in, £30,000 was his; the £6,000 of VAT was passed through, less the £2,400 the system let him recover on his costs.

What is the difference between zero-rated and exempt?

Both mean no VAT on the sale, and the difference is entirely about the seller. A zero-rated sale is a taxable sale at 0%, so the business can still reclaim input VAT on the costs behind it. An exempt sale is outside the system, and the input VAT relating to it cannot be reclaimed. Books are zero-rated; insurance is exempt. The distinction is why a business making only exempt supplies cannot register at all.