A value-added tax (VAT) return is a document that businesses in the United Kingdom submit to His Majesty’s Revenue and Customs (HMRC) to report the VAT they’ve charged on sales and the VAT they’ve paid on purchases within a specific period, usually quarterly. The purpose of a VAT return is to calculate the difference between the VAT collected from customers and the VAT paid to suppliers. If a business has collected more VAT than it has paid, it must pay the difference to HMRC. Conversely, if it has paid more VAT than it has collected, it can reclaim the difference.

Below, we’ll explain what businesses should know about VAT returns in the UK, including current rates and exemptions, how to apply VAT rates, and common VAT return mistakes and challenges.

What’s in this article?

• How VAT rates impact businesses
  
• Current UK VAT rates and classifications
  
• VAT exemptions and special cases
  
• How to apply VAT rates to goods and services
  
• Common VAT return mistakes and challenges
  

How VAT rates impact businesses

VAT is an important consideration for businesses that operate in the UK. Here’s how VAT rates can impact them:

• Cash flow: Businesses collect VAT on sales and pay it on purchases. This affects liquidity and requires precise timing to refine cash availability.

• Pricing strategy: Businesses must decide how much of the VAT burden to pass to customers and how much to absorb themselves. This decision impacts competitiveness and profitability and requires a nuanced approach to maintain market position without diminishing margins.

• Compliance and overhead: Adhering to VAT regulations requires substantial administrative effort. This can be particularly challenging for smaller businesses that don’t have dedicated finance teams.

• VAT registration decision: The threshold for mandatory VAT registration is an annual taxable turnover of £90,000, but businesses below this threshold can choose to register as well. Businesses must weigh the benefits of reclaiming VAT against the added work of filing returns.

• Variable VAT rates: Businesses need to understand how different VAT rates apply to different products and services. This informs financial planning and impacts various aspects from cost management to sales tactics.

• International trade considerations: Brexit changed the VAT landscape for transactions between the UK and European Union. Businesses engaged in international trade must address these changes to manage costs effectively and remain compliant.

Current UK VAT rates and classifications

As of 2024, there are three VAT rates in the UK:

• Standard rate (20%): This is the most common rate and applies to most goods and services.

• Reduced rate (5%): This applies to goods and services such as domestic fuel and power, energy-saving materials, and children’s car seats.

• Zero rate (0%): This applies to certain goods and services considered essential, such as most food and drink, books and newspapers, and children’s clothing.

VAT exemptions and special cases

Some goods and services are exempt from VAT or classified as “out of scope.” Businesses cannot charge VAT on these. Here’s a closer look:

• Exempt: Exempt goods and services include most insurance, financial services, education, healthcare, and subscriptions to membership organizations. Exempting these services supports accessibility and affordability by keeping costs lower than they would be with added VAT.

• Out of scope: Goods and services that are outside the scope of VAT include those bought and used outside of the UK, statutory fees (e.g., congestion charges), and goods sold as part of a hobby.

How to apply VAT rates to goods and services

Applying VAT rates is a multistep process. Here’s a rundown of what’s involved:

• Determine VAT liability: Ascertain whether the goods or services your business provides are liable for VAT and at what rate (e.g., standard, reduced).

• Register for VAT: If your business’s annual taxable turnover exceeds £90,000, you must register for VAT. You can also register voluntarily if it benefits your business.

• Classify your goods or services: Classify each product or service according to the correct VAT rate.

• Calculate VAT: For each product or service, calculate how much VAT should be collected. Follow the formula of VAT Amount = Price x (VAT Rate / 100). For example, if a retailer plans to sell an item for £100 and the standard 20% VAT rate applies, they would multiply 100 by 0.2 and get £20 VAT.

• Set prices: Decide how to display prices to customers. Prices can either include or exclude VAT. For customer-facing businesses, prices typically include VAT, whereas business-to-business (B2B) transactions often show prices excluding VAT.

• Issue invoices: Ensure that your invoices are VAT compliant. They should include:

  • The date of the invoice
    
  • A unique invoice number
    
  • Your business VAT number
    
  • Your business name and address
    
  • The customer’s name and address
    
  • A description of the goods or services provided
    
  • The quantity of each item sold
    
  • The amount(s) being charged before VAT
    
  • VAT amount (if applicable)
    
  • The total amount including VAT
    

• File VAT returns: File your VAT returns quarterly or annually, depending on your VAT scheme. Report the total VAT charged to customers and the total VAT paid on your business expenses. The difference between these amounts is what you will either pay to or reclaim from HMRC.

• Keep records: Maintain detailed records of all transactions related to VAT for at least six years. These records should support the amounts claimed on your VAT returns and must be available if HMRC requests them.

Common VAT return mistakes and challenges

Mistakes with handling VAT can have serious financial and operational consequences. Here are some common mistakes businesses make and how to solve them.

VAT rates

Using the wrong VAT rate can negatively affect your pricing, impact your competitiveness, and create compliance issues. For example, if you charge the standard rate on zero-rated items such as children’s clothing, you risk overcharging customers. This can lead to refunds, loss of trust, and potential penalties.

• Solution: Regularly review the VAT rates relevant to your products and services. Create a VAT rate matrix that aligns with HMRC’s guidelines and update it whenever there are changes in tax laws or your product line. Use accounting software that allows you to customize VAT rates for different categories to automate the process and minimize human error.
  

VAT expenses

Many businesses mistakenly reclaim VAT on ineligible expenses such as client entertainment and personal-use items. This could flag your business for an HMRC audit. Reclaiming VAT incorrectly doesn’t just mean repaying it; it can lead to fines, interest charges, and a closer look at all your records.

• Solution: Understand what VAT you can reclaim. Develop a list of eligible and ineligible expenses and train your team to cross-check before submitting expenses. Assure that your accounting system has clearly defined categories.
  

Recordkeeping

Without accurate records, proving the VAT you’ve charged or claimed becomes nearly impossible. Poor records can result in denied claims and fines.

• Solution: Invest in digital accounting tools that automatically log transactions. Keep digital copies of receipts and invoices. Develop a clear filing and tagging system within your software so you can easily access records when needed. Schedule regular internal audits to catch and correct errors early.
  

VAT returns

Late VAT returns or inaccurate submissions can result in penalties and interest charges, which reduce profits and can attract more scrutiny from HMRC.

• Solution: Set internal deadlines well ahead of the HMRC deadlines to allow time for review and correction of any errors. Use accounting software that integrates with HMRC’s Making Tax Digital (MTD) system to make the submission process easier. Consider working with a VAT adviser to review returns before submission, especially if your VAT situation is complex.
  

Challenges with partial exemptions

If your business provides both taxable and exempt goods or services, getting the partial exemption calculation right can be tricky. Getting this calculation wrong can lead to overpayment or underpayment.

• Solution: Develop a comprehensive method for tracking and calculating VAT on mixed supplies, which might involve using VAT schemes or hiring a VAT specialist. Regularly review your method and calculations to ensure they are still compliant and accurate as your business develops.
  

Reverse charges

A reverse charge is when the customer receiving the service accounts for the VAT, rather than the supplier. Reverse charges are required for certain goods and services, such as building and construction services. If reverse charges are handled incorrectly, your business might underpay or overpay VAT.

• Solution: Stay informed about when the reverse charge applies. Regular training sessions for your finance team can help them stay up-to-date. Ensure your accounting software can handle reverse charges correctly and flag these transactions for additional review.
  

Bad debts

When customers don’t pay, you’re still entitled to reclaim the VAT on those bad debts. Many businesses miss this opportunity.

• Solution: Stay vigilant over your accounts receivable and establish a process to identify bad debts once they reach the six-month threshold. Automate reminders in your accounting software to flag these opportunities for VAT reclamation so they’re not overlooked.
  

Accounting systems

Using outdated or insufficient accounting systems increases the risk of VAT errors across the board, from misapplied rates to missed filings. This also makes it more difficult to adapt to new regulations or VAT rate changes.

• Solution: Upgrade to a modern, cloud-based accounting system that supports MTD and enables easy updates as VAT rules change. These systems often have built-in compliance checks and automated VAT calculation features.