Value added tax - Key principles (scope, supply, input and output tax)

Learning Outcomes

This article explains the core principles of Value Added Tax (VAT) relevant to the SQE1 assessments. After reading this material, you should be able to identify when VAT is charged, distinguish between different types of supplies (taxable, zero-rated, exempt), and understand the mechanism of accounting for VAT using input and output tax. This knowledge will enable you to apply VAT rules to scenarios involving business transactions commonly found in the SQE1 exam.

SQE1 Syllabus

For SQE1, you are required to understand the practical application of VAT principles. This includes determining VAT liability in various business scenarios and applying the essential calculations.

Your revision should focus on:

  • The conditions under which VAT is charged (scope).
  • The concept of a taxable supply and the different VAT rates.
  • The key differences between taxable supplies (including zero-rated) and exempt supplies.
  • The mechanics of input tax and output tax and how they determine VAT liability.
  • Basic VAT registration requirements.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

  1. Under VATA 1994, which of the following elements must be present for VAT to be charged?
    1. A supply of goods or services
    2. Made in the UK
    3. By a taxable person
    4. In the course or furtherance of business
    5. All of the above
  2. A VAT-registered business sells consulting services for £1,000 (exclusive of VAT). Assuming the standard rate applies, what is the output tax?
    1. £50
    2. £100
    3. £200
    4. £0

  3. True or False? A business making only exempt supplies can register for VAT voluntarily to reclaim input tax.

  4. Which VAT rate applies to children's clothing?
    1. Standard rate
    2. Reduced rate
    3. Zero rate
    4. Exempt

Introduction

Value Added Tax (VAT) is a tax levied on the consumption of most goods and services supplied within the United Kingdom. It forms a significant part of the UK tax system and understanding its fundamental principles is important for business law practitioners. This article covers the scope of VAT, the concept of supply, and the essential mechanics of input and output tax, as required for the SQE1 assessment. The primary legislation governing VAT is the Value Added Tax Act 1994 (VATA 1994).

Key Term: Value Added Tax (VAT)
A consumption tax charged at each stage of the supply chain on the 'value added' to goods and services. Registered businesses charge VAT (output tax) on their sales and can reclaim VAT (input tax) on their purchases.

Scope of VAT

VAT is chargeable under s 4 VATA 1994 if all the following conditions are met:

  1. There is a supply of goods or services.
  2. The supply is made in the UK.
  3. It is made by a taxable person.
  4. It is made in the course or furtherance of any business carried on by that person.

Taxable Person

A business (whether a sole trader, partnership, LLP, or company) becomes a 'taxable person' when it is registered, or required to be registered, for VAT.

Key Term: Taxable Person
A person (individual, firm, company, etc.) who is registered for VAT or is required to be registered because their taxable turnover exceeds the current VAT registration threshold.

Compulsory registration is required if a business's turnover from taxable supplies exceeds the statutory threshold (currently £85,000) in any rolling 12-month period. Businesses below this threshold can register voluntarily, which may be advantageous if they primarily make zero-rated supplies or wish to reclaim significant input tax.

Supply

'Supply' encompasses nearly all transactions involving goods or services provided for consideration. Goods typically involve the transfer of ownership, while services cover everything else done for consideration.

In the UK

VAT is a territorial tax. The supply must generally take place within the UK to be subject to UK VAT. Detailed rules determine the 'place of supply', which can be complex for cross-border transactions, but the basic principle for SQE1 is that the supply occurs within the UK.

Business

The supply must be made in the course or furtherance of 'business'. This term is widely interpreted and includes any trade, profession, or vocation. Regular commercial activity usually qualifies.

Taxable Supplies

For VAT to be charged, the supply must be a 'taxable supply'. A supply is taxable unless it is specifically 'exempt' or 'outside the scope' of VAT. Taxable supplies are charged at one of three rates.

Key Term: Taxable Supply
A supply of goods or services made in the UK which is liable to VAT at the standard rate (20%), reduced rate (5%), or zero rate (0%).

VAT Rates

  • Standard Rate (20%): The default rate applied to most goods and services.
  • Reduced Rate (5%): Applied to specific supplies like domestic fuel, power, and children's car seats.
  • Zero Rate (0%): Applied to certain goods and services deemed essentials or socially important. Examples include most food items (excluding restaurant meals and confectionery), books, newspapers, public transport, prescription medicines, and children's clothing.

Importantly, zero-rated supplies are taxable supplies. This distinction is essential because businesses making zero-rated supplies can reclaim the input tax they incur on related purchases.

Key Term: Zero-rated Supply
A taxable supply where the rate of VAT charged is 0%. Businesses making zero-rated supplies do not charge VAT to customers but can reclaim input tax incurred on related costs.

Worked Example 1.1

A VAT-registered bakery sells a loaf of bread for £1.50. Bread is a zero-rated item. How much VAT does the bakery charge?

Answer: The bakery charges £0 VAT. The supply is zero-rated. However, because it is still a taxable supply, the bakery can reclaim input VAT paid on its business expenses (e.g., VAT on flour, electricity, rent for the shop premises – assuming these are standard-rated supplies to the bakery).

Exempt Supplies

Certain supplies are specifically designated as exempt from VAT under Schedule 9, VATA 1994. No VAT is charged on exempt supplies.

Key Term: Exempt Supply
A supply listed in VATA 1994, Sch 9 that is not subject to VAT. Businesses making only exempt supplies cannot register for VAT and importantly, cannot recover any input tax related to making those exempt supplies.

Common examples of exempt supplies include:

  • Insurance services
  • Most financial services (e.g., provision of credit, bank charges)
  • Postal services by Royal Mail
  • Education by eligible bodies
  • Health services by registered professionals (doctors, dentists, opticians)
  • Betting and gaming

Exam Warning

Do not confuse zero-rated supplies with exempt supplies. Zero-rated supplies are taxable (at 0%) and allow input tax recovery. Exempt supplies are outside the VAT charging system, meaning no output tax is charged, but no input tax can be reclaimed on costs associated with making those exempt supplies. This difference significantly impacts a business's VAT recovery position.

Input and Output Tax

The mechanism of VAT relies on the concepts of output tax and input tax.

Output Tax

This is the VAT that a VAT-registered business charges on the taxable supplies (sales) it makes to its customers.

Key Term: Output Tax
The VAT charged by a VAT-registered business on the value of the taxable goods and services it supplies.

Input Tax

This is the VAT that a VAT-registered business pays when it buys goods or services for its business purposes.

Key Term: Input Tax
The VAT incurred by a VAT-registered business on goods and services received (purchases) for the purpose of its business, primarily for making its taxable supplies.

VAT Accounting

VAT-registered businesses must account to HM Revenue & Customs (HMRC) for the VAT they collect and pay. This is done through periodic VAT returns (usually quarterly).

The basic calculation is:

Total Output Tax (on sales) - Total Recoverable Input Tax (on purchases) = Net VAT Payable to HMRC (or Reclaimable from HMRC)

  • If output tax collected exceeds recoverable input tax paid, the business pays the difference to HMRC.
  • If recoverable input tax paid exceeds output tax collected, the business can reclaim the difference from HMRC.

Importantly, input tax is only recoverable to the extent that the purchases relate to the making of taxable supplies (including zero-rated supplies). Input tax related to making exempt supplies cannot generally be recovered. Businesses making both taxable and exempt supplies ('partially exempt' businesses) must usually apportion their input tax and can only recover the portion related to their taxable activities.

Worked Example 1.2

A VAT-registered graphic design company invoices a client £2,000 plus VAT for design services (standard-rated). In the same period, the company buys new design software for £500 plus VAT (standard-rated) and pays £100 plus VAT for printing business cards (standard-rated). Calculate the net VAT payable.

Answer:

  • Output Tax (charged to client): £2,000 x 20% = £400
  • Input Tax (on software and printing): (£500 x 20%) + (£100 x 20%) = £100 + £20 = £120
  • Net VAT Payable to HMRC = Output Tax - Input Tax = £400 - £120 = £280

Revision Tip

Remember the fundamental VAT equation: Output Tax - Recoverable Input Tax. When analysing a scenario, identify the VAT charged by the business (output) and the VAT paid by the business on relevant purchases (input), then calculate the difference to find the net amount due to or from HMRC. Always consider if input tax relates to taxable or exempt supplies.

Basic VAT Compliance

For SQE1, a basic awareness of registration and return requirements is needed.

VAT Registration

As noted, registration is compulsory if taxable turnover exceeds £85,000 in a rolling 12-month period. Businesses can register voluntarily if below this threshold. Non-UK businesses supplying goods or services in the UK may also need to register, often with no threshold.

VAT Invoices and Records

VAT-registered businesses must issue valid VAT invoices for taxable supplies made to other VAT-registered businesses. These invoices must contain specific details (e.g., VAT registration number, tax point date, description of goods/services, VAT rate, amount of VAT charged). Accurate records of sales, purchases, and VAT accounted for must be kept, typically for six years.

VAT Returns

VAT returns, detailing output and input tax for a period (usually quarterly), must be submitted electronically to HMRC, typically via Making Tax Digital (MTD) compatible software. The net VAT payable is usually due at the same time the return is submitted.

Key Point Checklist

This article has covered the following key knowledge points:

  • VAT is charged on taxable supplies of goods/services in the UK by a taxable person in the course of business.
  • Taxable persons must register if taxable turnover exceeds £85,000 per annum.
  • Taxable supplies are standard-rated (20%), reduced-rated (5%), or zero-rated (0%).
  • Exempt supplies (e.g., insurance, health, education) are not subject to VAT.
  • Output tax is VAT charged on sales; Input tax is VAT paid on purchases.
  • Input tax relating to taxable supplies (incl. zero-rated) is recoverable. Input tax relating to exempt supplies is generally not recoverable.
  • Net VAT payable/reclaimable = Output Tax - Recoverable Input Tax.
  • VAT returns are usually filed quarterly, detailing output and input tax.

Key Terms and Concepts

  • Value Added Tax (VAT)
  • Taxable Person
  • Taxable Supply
  • Zero-rated Supply
  • Exempt Supply
  • Output Tax
  • Input Tax
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