Back to Basics: Value-added tax
Value Added Tax is an indirect tax - a tax on spending. In the UK, the price displayed on an item normally already incorporates the VAT, but in other countries, you'll often find the equivalent tax referred to as a sales tax and you’ll see it being added to the price when you pay.
In any VAT question or scenario, whether a simple sale of chocolate biscuits for 64p or the purchase of a new factory building for £4m, the first step is to go right back to basics.
Put yourself in the shoes of the trader (it could be a sole trade, a partnership or a company) and examine the transactions using proper VAT terminology of outputs and inputs. I always scribble out the following diagram in any VAT question.
If you're being asked about a sale (in VAT language, a “supply of goods or services”) you're dealing with an output and need to calculate the output tax. Every supply will be taxable or exempt. “Taxable” incorporates three different rates – standard rate (20%), reduced rate (5%) and zero rate (0%). Exempt means there will be no tax on the sale.
There are Schedules (appendices) to the VAT Act which list the supplies subject to different rates. If a good or service is not listed, then the default position is that it is standard-rated and 20% will apply to the net price. A trader wishing to sell an item for £60 will have to charge a further £12 (20%) VAT, resulting in a gross price of £72.
The output VAT is charged as part of the selling price, and is collected by the trader, but never forms part of their profit. The trader is simply acting as a tax collector and the output VAT must be paid over to HMRC, normally quarterly.
If you’re being asked about a purchase, this is an “input” in VAT terminology. Refer back to the diagram, and remember that an input of our business is an output of business X, the supplier.
Business X will have checked the rate of VAT and added any appropriate output VAT to the selling price. This ‘input VAT’ of our business must be paid to the supplier (business X).
The important point of VAT, and where most VAT planning is focused, is whether or not our business can recover the input VAT paid on our purchases.
The rule relating to this is one of the key concepts of VAT: input VAT can be recovered if, and only if, the input helps the business with the supply of taxable outputs. Remember that ‘taxable’ includes standard-rated, reduced-rated and zero-rated supplies.
When you are dealing with more complex areas of VAT, it is a good idea to go right back to basics. In your course, you may deal with land and buildings, partial exemption and transfer of going concern.
Most students find that they can deal with these topics if they use the basic diagram above to consider the outputs and inputs of a business.
Remeber: Always put yourself in the shoes of the supplier to determine what is being supplied and if VAT will be charged.