Taxation in business - Value Added Tax (VAT)

Learning Outcomes

This article covers the application of VAT to business transactions, including:

• What constitutes a taxable supply and who qualifies as a taxable person, with reference to business activity and consideration
• The distinction between input tax and output tax and the core calculation of VAT payable or repayable
• Registration triggers and timing (rolling 12‑month threshold and future 30‑day test), effective dates, and when voluntary registration is advantageous
• The treatment of standard‑rated, reduced‑rated, zero‑rated and exempt supplies, and how this affects input tax recovery and eligibility to register
• VAT invoices, tax points, returns (quarterly, monthly, annual accounting), and digital record‑keeping obligations
• Practical and commercial consequences for businesses and legal practice, including pricing (VAT‑inclusive assumptions), cash flow planning, and evidential requirements for input tax
• Common compliance risks and penalties, such as late registration, incorrect or missing invoices, and misclassifying exempt supplies as zero‑rated
• Application of these rules to realistic SQE2 scenarios, enabling clear advice on registration, invoicing, reporting, and penalty exposure

SQE2 Syllabus

For SQE2, you are required to understand VAT as it applies to common business scenarios, with a focus on the following syllabus points:

• understanding the meaning and scope of VAT in business, including what counts as a taxable supply
• distinguishing between input tax and output tax
• understanding when VAT registration is compulsory and the consequences
• completing VAT invoices and returns, and understanding payment and record-keeping obligations
• applying VAT rules to realistic legal and business situations likely to appear in SQE2 practical assessments
• understanding the difference between zero-rated and exempt supplies and the impact on input tax recovery and registration

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. What is a taxable supply for the purposes of VAT, and when must a business register for VAT?
2. Briefly describe the difference between input tax and output tax for VAT.
3. Does a sole trader making only exempt supplies need to register for VAT?
4. What general documents must VAT-registered businesses provide to customers and HMRC?

Introduction

VAT is a widely applicable tax in business law and practice. For SQE2, you must advise clients on when VAT applies, their responsibilities, and the results of failing to comply. This section explains the scope of VAT for businesses, focusing on the most examinable features.

The Scope of VAT

VAT is a tax levied on supplies of goods and services in the UK. The general rule is that VAT applies to taxable supplies made by taxable persons in the course or furtherance of a business.

Key Term: Value Added Tax (VAT)
A tax on the value added to most goods and services supplied by VAT-registered businesses in the UK.

Key Term: Taxable supply
A supply of goods or services, other than those that are exempt, made in the UK by a taxable person during business activities, on which VAT is chargeable.

Key Term: Taxable person
Any individual, partnership, company, or other organisation that is, or is required to be, registered for VAT because of making or intending to make taxable supplies above the registration threshold.

VAT is charged by reference to the Value Added Tax Act 1994 (VATA). Under s 4 VATA, VAT is chargeable where there is a taxable supply by a taxable person in the course or furtherance of any business. “Business” is broadly defined to include any trade, profession or vocation, and it generally captures continuous or regular activity carried on with a commercial aim (s 94 VATA). VAT applies to supplies made for consideration; gifts and gratuitous acts are outside the scope unless specific rules apply.

Key Term: Business (for VAT)
Includes any trade, profession or vocation. Business activities generally involve making supplies for consideration on a continuing basis.

Key Term: Value of supply
The amount on which VAT is calculated, typically the net price before VAT. Unless stated otherwise, an advertised price is deemed to include VAT.

Types of Supplies

Most supplies are standard-rated (the normal rate is 20%), but some are zero-rated or reduced-rated (5%). Other supplies are exempt (such as education, medical services, certain land transactions, and insurance). VAT does not apply to exempt or non-business supplies.

Key Term: Zero-rated supply
A taxable supply charged at 0% (e.g., most books, children’s clothing, most food). Zero rating keeps the supply taxable, so input tax attributable to it is generally recoverable.

Key Term: Exempt supply
A supply on which no VAT is charged and which is not taxable (e.g., insurance, most health and education, and residential land). Input tax directly attributable to exempt supplies is not recoverable.

Zero-rated and exempt are not the same. Zero-rated supplies count as taxable supplies and support input tax recovery (if attributable to them), whereas exempt supplies do not. This distinction is frequently examinable and critical in practice for both pricing and cash flow.

VAT Registration

You must register for VAT if your taxable turnover in the previous 12 months exceeds the statutory threshold (currently £85,000), or if there are reasonable grounds to expect it will do so in the next 30 days. Registration is with HMRC. Voluntary registration is permitted for businesses below the threshold, but only those making taxable (not exempt) supplies.

Key Term: Taxable turnover
The total value of taxable supplies (standard-rated, reduced-rated and zero-rated) made in the UK, excluding VAT. It excludes exempt and non-business supplies.

Key registration tests and timing points:

• Historic turnover test: monitor on a rolling 12-month basis. If the threshold is exceeded at the end of any month, HMRC must be notified—late registration can lead to penalties and an obligation to account for VAT from the effective date.
• Future 30-day test: if at any time there are reasonable grounds to expect that taxable turnover alone in the next 30 days will exceed the threshold, registration is required immediately.
• Voluntary registration: often considered by start-ups or B2B suppliers to recover input tax, but it can make prices less competitive for consumers (who cannot reclaim VAT). Partnerships can register in the partnership name.

Sole traders or entities making only exempt supplies cannot register and cannot issue VAT invoices.

VAT Invoices, Returns, and Record Keeping

A VAT-registered business must issue VAT invoices showing the VAT number and the VAT charged on each supply. Returns must be submitted, typically quarterly, to HMRC. Records must be complete and accurate for at least six years.

Key Term: VAT invoice
An invoice issued for a taxable supply, showing the supplier’s VAT number, the value of the supply, the VAT rate and amount charged, and core identifying details.

Key Term: VAT return
The periodic report to HMRC (commonly quarterly) showing output tax due and input tax recoverable for the period, with a resulting payment to or repayment from HMRC.

VAT-registered businesses charge VAT on their supplies (output tax) and recover VAT on business purchases (input tax) where conditions are met. The timing of VAT liability generally aligns with the time goods are delivered or services performed, though specific tax point rules can apply. Most businesses submit quarterly returns; monthly returns can be permitted (often useful if the business is regularly in a repayment position, for example where sales are largely zero-rated). Annual accounting options also exist. Digital record-keeping and electronic filing are now the norm, and accurate, contemporaneous records must be retained.

Key Term: Input tax
VAT paid by a business on goods and services purchased for use in its business, which it may be able to recover from HMRC.

Key Term: Output tax
VAT charged by a business on goods and services it supplies to customers.

The VAT Calculation

The basic formula is: VAT payable to HMRC = output tax (collected from customers) minus input tax (paid to suppliers). Where input tax exceeds output tax, the business can claim a repayment from HMRC.

Businesses making only exempt supplies cannot recover input tax attributed to those supplies. Where both taxable and exempt supplies are made (mixed supplies), input tax recovery becomes more complex and may require an apportionment approach to ensure only the attributable portion to taxable supplies is reclaimed.

Worked Example 1.1

Sarah operates a small graphic design business. Her VAT-taxable turnover for the previous 12 months is £90,000. She buys stationery for £600 plus £120 VAT and invoices a client £1,000 plus £200 VAT. Under her VAT obligations, what does Sarah owe to HMRC for this transaction?

Answer:
Sarah is required to be VAT-registered as her taxable turnover exceeds the threshold. For this transaction, she collects £200 output tax from the client and pays £120 input tax on supplies. The VAT payable to HMRC is output tax (£200) minus input tax (£120), resulting in £80 due.

Worked Example 1.2

James is a sole trader making only private medical supplies, which are VAT-exempt. His turnover is £120,000. Does he need to register for VAT or issue VAT invoices?

Answer:
No, because all his income is from exempt supplies. He is not required (or permitted) to register for VAT and cannot issue VAT invoices.

Registration Triggers and Effective Dates

A business must monitor turnover continually. If the rolling 12-month taxable turnover exceeds the threshold at the end of any month, HMRC must be notified within the required time, and the business will have an effective date of registration. Under the future 30-day test, if there are reasonable grounds to expect that taxable turnover in the next 30 days alone will exceed the threshold, registration is required immediately and the effective date will be tied to that expectation. Late notification can trigger assessments, interest and penalties.

Voluntary registration can be advantageous for businesses incurring substantial VAT-bearing costs before revenue builds, enabling input tax recovery. However, for B2C traders, pricing may become less competitive because customers cannot reclaim VAT.

Worked Example 1.3

Delta Carpentry’s rolling 12-month taxable turnover reaches £86,000 on 31 August. The business had not previously been VAT-registered. What are the consequences?

Answer:
Delta must notify HMRC because the historic 12-month taxable turnover now exceeds the £85,000 threshold. Registration will take effect from the appropriate registration date set by the rules for the historic test. Delta will need to charge VAT on taxable supplies from the effective date and account for the VAT (even if invoices were initially issued without VAT), and may face penalties and interest if it fails to notify or account on time.

Zero-Rated vs Exempt: Commercial Impact

Businesses selling mainly zero-rated items (for example, retailers of zero-rated children’s clothing) often find themselves in a regular repayment position because they charge 0% VAT on sales while still incurring input VAT on overheads. They can register and recover input tax. Conversely, businesses making exempt supplies cannot recover input VAT on costs attributable to those supplies, increasing their cost base. This distinction affects pricing strategy, margins, and the desirability of voluntary registration.

Worked Example 1.4

PurePages sells only printed books (zero-rated). In a quarter it sells £100,000 of books (0% VAT) and incurs £10,000 plus £2,000 VAT on overheads. What is the VAT return position?

Answer:
Output tax is £0 because sales are zero-rated. Input tax is £2,000 and is recoverable because the sales are taxable (albeit at 0%). The return will show a £2,000 repayment due from HMRC.

Invoicing and Documentation

VAT invoices must show the supplier’s name and address, a unique invoice number, the date, the customer’s details (for business customers), the supplier’s VAT registration number, a description of the goods or services, the net amount, the VAT rate and the VAT amount. A person charging VAT must hold valid purchase tax invoices to support input tax recovery. Prices are generally treated as VAT-inclusive unless explicitly stated as “plus VAT”.

Legal practice note: professional fees for legal services are usually standard-rated. Recharges to clients are generally treated as part of the firm’s supply unless very specific criteria for disbursements are met (for example, the firm acts as agent and the liability is the client’s). Always ensure engagement letters and invoicing practices align with VAT rules on recharges.

Returns, Payment and Records

VAT returns are typically quarterly, with payment due one month after the end of the period. HMRC may allow or require monthly returns in some circumstances (e.g., frequent repayment cases), and an annual accounting scheme may be available for suitable businesses. VAT is a self-assessed tax; proper records must be retained for at least six years, including sales and purchase invoices, VAT account summaries, and supporting documentation. Where digital record-keeping is required, compatible software must be used to keep and submit returns.

Practical Consequences and Compliance

VAT is self-assessed; businesses must accurately account for VAT. Penalties can arise for late registration, incorrect returns, or late payments. Record keeping is essential, both for returns and for surviving possible HMRC inspection.

Common practical points include:

• Pricing: if prices are quoted without stating “plus VAT”, the price may be treated as VAT-inclusive, reducing net margin for the supplier.
• Cash flow: VAT is commonly paid quarterly; planning for payment dates and considering return frequency can help manage cash flow, especially for seasonal businesses.
• Input tax evidence: recovery requires valid VAT invoices and a clear business purpose. VAT incurred on non-business use or related to exempt supplies is not generally recoverable.
• Partnerships: can register in the partnership name and must account for VAT on partnership supplies.

Worked Example 1.5

A start-up marketing agency sells mainly to VAT-registered businesses (B2B). Its taxable turnover is £60,000 in year one. It incurs £24,000 plus £4,800 VAT in costs. Should it register voluntarily?

Answer:
Voluntary registration would allow the agency to recover £4,800 input tax. As its customers are VAT-registered, charging VAT is unlikely to harm competitiveness because clients can usually recover it. Voluntary registration is therefore commercially sensible, subject to compliance costs and administration.

Exam Warning

Failure to register for VAT when required, or issuing VAT invoices without being registered, is a common exam scenario. Penalties range from surcharges to criminal prosecution. Always check if a business exceeds, or is likely to exceed, the threshold.

Other frequent pitfalls:

• Treating exempt supplies as zero-rated and reclaiming input tax incorrectly.
• Failing to treat a quoted price as VAT-inclusive where “plus VAT” is not stated.
• Attempting to reclaim input VAT without valid tax invoices or for non-business expenditure.

Revision Tip

For SQE2, memorise the current registration threshold and the main types of exempt and zero-rated supplies. Practice scenarios that require distinguishing input tax from output tax. Be ready to advise on the commercial impact of zero-rated versus exempt supplies and on the consequences of late registration, including backdating and penalties.

Key Point Checklist

This article has covered the following key knowledge points:

• The definition and purpose of VAT, taxable supplies, and taxable persons
• Registration for VAT: compulsory, voluntary, and exemptions
• Differences between input tax and output tax in VAT accounting
• VAT invoices, returns, and record-keeping duties for registered businesses
• Consequences of late, incomplete, or false VAT filings
• Examinable distinctions between zero-rated, exempt, and non-business supplies for VAT
• The calculation of VAT payable or repayable and its cash flow impact
• Practical considerations for legal practice, including VAT on professional fees and the importance of valid tax invoices

Key Terms and Concepts

• Value Added Tax (VAT)
• Taxable supply
• Taxable person
• Business (for VAT)
• Value of supply
• Taxable turnover
• Zero-rated supply
• Exempt supply
• VAT invoice
• VAT return
• Input tax
• Output tax