Value Added Tax – a basic guide to the indirect tax for sole traders

When many people think of VAT, they think of the extra charge on clothes, petrol and everyday items. However, those that are self-employed and/or run a business, may be required to get involved with VAT more than they would otherwise expect.

What is VAT?

Value Added Tax (or VAT) is in indirect tax applied to goods and services. It is charged when a taxable individual makes taxable supplies. A taxable individual is any sole trader, partnership, limited company, or other organisation that makes taxable supplies.

A taxable supply is one that is within the scope of VAT, even if the rate of VAT is 0% (known as zero rated). Many things are exempt or outside the scope of VAT such as insurance products. If a taxable individual, makes taxable supplies then they must charge VAT on the taxable goods and services they produce and sell to customers/clients. This VAT is known as output VAT as it the VAT charged on the output of goods and services. This output VAT is paid over to HMRC.

But it’s not all bad news because a taxable individual making taxable supplies can also reclaim VAT on the supplies and goods it purchases for the business. The VAT on the goods or services used within the business is known as input VAT and can be reclaimed back from HMRC.  The net VAT (output VAT less input VAT) is  paid over to HMRC or repaid if a repayment is due from HMRC via the VAT return.

The above process is VAT in its most simple form. VAT can get very complicated when looking at overseas elements and other very complex and niche circumstances that require VAT advisory specialists. However, for a lot of people VAT is mostly compliance based and it is this VAT compliance that will be the focus of this article.

What is a VAT return & do I need to do one?

If you are a taxable individual making taxable supplies, then you will need to do a VAT return if your turnover exceeds £85,000 over a 12-month period or will exceed £85,000 within the next 30 days. You can find further details of when to register on HMRC’s Website. If you are below this threshold, there is no need to register for VAT, however you can voluntarily register which  may be good for individuals who know they will exceed the threshold in the near future or those whose input VAT is frequently greater than their output VAT and wish to receive a repayment.

If you need to register for VAT this can be completed on HMRC’s Website. Upon registration you will be issued with a 9-digit VAT registration number which must be included on all invoices and from the date you receive it and you must then charge VAT on your invoices. There may be a gap between the effective date of registration (i.e. the day you exceed the £85,000 annual threshold) and receiving the VAT number. If this happens you can increase your prices to account for the VAT and then re-issue an invoice at a later date showing the VAT due (make sure to tell the client or customer that they do not have to pay twice though!)

In order to register for VAT, you need to set-up an online government gateway account with HMRC. Alternatively, you can also write to HMRC, however VAT returns must be filed online with MTD compliant software (discussed later on), therefore it is probably best to be as digital as possible to keep well up to date with HMRC’s processes.

Once registered for VAT, a VAT return must be completed. VAT returns can be completed monthly, quarterly, or annually depending on the individual’s preference. Most people choose the option to have quarterly VAT returns as it is a good balance between reducing the compliance burden of having to file each month, but also avoiding a possible huge VAT bill from HMRC under an annual return, as under the annual accounting scheme you make monthly payments in advance based on the previous VAT return and then make a final payment once the annual return is submitted.

The VAT return must be submitted, and any VAT paid, one month and seven days after the VAT period. For example, if a VAT period ended 31 August 2023 (be it monthly or quarterly), the VAT return must be submitted, and the VAT paid by 7 October 2023. Late submission and late payments for VAT carry different penalties – full details of these can be found on HMRC online.

What can I reclaim & how can I reclaim it?

Paying output VAT on goods and services seems fairly straightforward as generally an individual will know what taxable supplies they are making – but about reclaiming VAT on expenses? This is entirely dependent on what the trade itself is. VAT on inputs can be reclaimed to the extent that they are used within the business. This means a self-employed gardener will therefore be reclaiming VAT on very different things to a barrister for example.

You can only reclaim VAT on expenses once you are VAT registered, however if you acquire capital items (which are big ticket items such a machinery, laptops, mobiles etc) in the 4 years prior to registration, you can reclaim the VAT on those on your first VAT return, providing you are using these in the business.

There may be a situation where a taxable expense has been purchased which has been used for both business and private purpose. For example, the cost of a monthly phone contract which is used half for business purposes and half for private. In this situation you can only reclaim half the VAT and most MTD software will have facilities that allow for private use adjustments.

In order to reclaim input VAT, receipts showing the VAT must be included. You can submit a VAT return without attaching receipts, however it is best practise to do so in case of HMRC inquiry.  VAT receipts and invoices must be kept in case of inquiry for a minimum of six years. There is MTD compliant software that is specifically designed to help with the assistance of attaching to receipts to VAT returns and where electronic receipts are kept there is no longer the need to keep the paper copies.

What is MTD for VAT?

It has been mentioned a few times and MTD stands for Making Tax Digital. It is a movement by HMRC to increase the digital nature of tax and record keeping. Prior to its inception on 1 April 2019, VAT returns could be filed on paper and/or through HMRC’s own personal software. Now they must be submitted through digital software that is compliant with MTD. It allows HMRC to keep a closer eye on VAT and reduces manual errors.

Software such as Xero, QuickBooks and Sage  meet these requirements  to prepare and file VAT returns direct to HMRC through the MTD Government Gateway.

In addition, software such as Dext can be downloaded onto your phone and receipts can be quickly scanned and uploaded whilst on the go. If you therefore stop for petrol whilst visiting a client or collecting some material, you can scan this and it will immediately be stored ready for the VAT return.

The software will then extract the VAT on the receipt and also categorise it into the correct category, for example fuel, cost of sales, accountancy fees etc. These can then be posted either automatically or manually to Xero where it is amalgamated on the VAT return.

There are various forms of MTD software and if submitting VAT returns yourself it is best to find the correct one for you and the best price for you. If you are ever unsure about VAT and MTD, please get in touch with your regular AAB contact or inquire on our general enquiry line.

One thing important thing to note is that the rules of income tax for the self-assessment tax return and the rules of VAT for the VAT return are not always aligned. This means something that is allowed for VAT, may not be allowable for income tax when you come to complete your self-assessment tax return and vice versa so it is important to get in touch if you are unsure.