VAT – What is it and who pays it?

VAT – What is it and who pays it?

VAT – value added tax – is currently 20% in the UK and is paid when most goods and services are purchased, whether by individuals or companies. It is one of the big three tax raisers, along with income tax and national insurance, and contributes about 17% of tax revenues.

It is different from a sales tax, which is paid by the final purchaser, in that it is payable at each stage value is added to a product or service.

Unlike other taxes, it is collected by businesses as well as HMRC and is paid by companies with annual taxable turnover of above £90,000. This means most UK companies do not pay VAT. However, they may find themselves being liable for VAT if they have a jump in revenues so it is important to be aware of it and how it works.

How does VAT work?

Let’s have a look at how it operates in practice.

The MyFashion company makes womenswear. The raw materials for a dress cost £25. MyFashion pays the government £5 in VAT for these materials. A retailer buys the dress for £70 plus 20% VAT (£14).

MyFashion hands over £9 to the government (as it has already paid £5).

The retailer sells the dress for £120, handing over £6 in VAT (as it has already paid £14).

It is worth noting that if all the businesses in the supply chain are VAT-registered none of them pay VAT on purchases.

How VAT is paid

The amount of VAT owing is based on the past 12 months and is usually paid quarterly although businesses can elect to pay it monthly or annually. Once you are registered you have to submit a VAT return even if there is no VAT to pay.

Input and output VAT

A business pays VAT on purchases (input VAT) and receives VAT on sales (output VAT). Input VAT can be reclaimed for up to four years from the time of purchase.

Benefits of being VAT registered

A company that registers for VAT will immediately enjoy a reduction in running costs as it is able to recoup input VAT. In addition, its products may become more attractive to other companies because they will be able to reclaim the input VAT from things they buy from the company.

Furthermore, a business may seem more reputable and established if it pays VAT.

Disadvantages of being VAT registered

The price of the company’s goods will go up by 20% if they are standard rated items. Also there is more administration to do because of the quarterly reporting.

Some companies may end up with a large tax bill if their input VAT bill is greater than their output VAT bill.

Reduced rates and exemptions

Many goods and services where there is an obvious public interest in not pricing people out of access to them are zero-rated or exempt for VAT. These are some of the most important examples.

• Cultural and sporting activities
• Healthcare products and services
• Educational goods and services
• Most food and drink bought in shops, excluding alcohol
• Children’s clothes
• Publications
• Financial products such as insurance and credit
• Sales and leasing of property

If a company sells zero-rated goods it can reclaim its input VAT on raw materials used to make those goods.

Energy for domestic use is on a special 5% VAT rate. This includes work on central heating systems and heating hardware such as radiators and renewable energy systems.

VAT and private schools

VAT was added to private school fees in January. Treasury figures estimated this would raise £460 million in the current tax year and just over £1.5 billion in subsequent years.

These figures have been disputed. Many parents paid school fees early to avoid the tax and the Times reported in July that at least 54 private schools had shut or announced plans to shut since the imposition of VAT.

In addition, the extra cost to the state education sector of educating former private school pupils is not yet known nor has the impact of the new ability of private schools to reclaim input VAT or move some activities into zero-rated or exempt categories been quantified.

The policy is too recent for it to be possible to assess its fiscal impact but it may be the case that the government’s revenue figures are overestimates and even that the measure may shrink the tax take when the extra cost of educating an influx of pupils at taxpayers’ expense is taken into account.

VAT and charities

Charities do not have to pay VAT on some goods and services, and like individuals pay the 5% rate on energy. Gov.uk has a list of the zero-rated goods and services for charitable purposes.

VAT and Europe

The rate of VAT in Europe varies by country but must be at least 15%. Many countries have set the rate at or around 20%, the lowest is in Luxembourg at 17% and the highest in Hungary at 27%. British businesses importing goods and services from the EU and elsewhere normally pay the same rate of input VAT that they would pay for things bought in the UK.

Companies that buy from overseas suppliers have to account for the VAT themselves. This is known as the reverse charge. The company charges itself VAT and then claims it back as input VAT, in effect acting as the supplier and the customer.

VAT and fairness

VAT is a regressive tax in that the lower a person’s income is the greater a share of that person’s expenditure goes in tax. It is the opposite of income tax, which takes up a larger share of a higher or additional rate taxpayer’s income than of someone on low earnings.

However, some argue that VAT is in fact a progressive tax because people with large incomes pay more because they spend more.

History of VAT

VAT was first levied in the UK in 1973, replacing purchase tax at different rates, and had one rate of 10%. The new tax was consequent on the country having joined the European Economic Community that same year.

The rate has bounced up and down since 1973 until it settled at 20% in 2011 under the coalition government. The biggest rise was in 1979 under the new Thatcher administration when it went up from 8% to 15%, although higher rate VAT was abolished.

This hefty increase was done to fund cuts to punitive income tax rates and in response to the Conservatives’ preference for taxing consumption rather than income. They favoured consumption taxes rather than taxes on income because they believed lower taxes on income and profit would encourage entrepreneurship.

The 20% rate looks set to stay for the foreseeable future as Labour promised in its election manifesto that VAT was one of the three taxes that it would not increase in this parliament. So although businesses do not need to worry about an imminent hike to it some may find calculating it and dealing with HMRC to be challenging. If this sounds like you – or if your business’s turnover is approaching the VAT threshold or has exceeded it – and you would like advice about VAT or any other tax or business matter, please contact Finsbury Robinson.

We are a full-service tax, accountancy and business advisory firm, and our friendly and highly experienced team is available on 020 8858 4303 or via email at info@finsburyrobinson.co.uk

Angus Walker 10/11/2025

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