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Confusing VAT

If I had a pound for every time somebody told me they weren't sure how VAT works... I would have to apply for VAT registration!

There are plenty of web sites that try to explain VAT but most of them simply repeat phrases like "input tax", "output tax" and "registration threshold". And that's before starting on the maths.

Instead, this page gives you an absolutely simple overview of VAT in the UK followed by an example showing the maths.

What Is VAT?

VAT stands for Value Added Tax. It's a tax on the value you add to a product or service that you sell. For example if you buy widgets for £10 each and sell them for £12 each, tax is due on the £2 profit (the added value).

To make life difficult for businesses, the government actually makes you collect tax on the selling price but "generously" allows you to reclaim the tax you paid on the purchase amount. Using the current UK standard VAT rate of 20%, in the example above you owe the government £2.40 (20% of £12) but can reclaim £2 (20% of £10). The end result is that the government gets 40p in tax (20% of the £2 added value).

The tax is not your money, you simply collect it on behalf of the government so you have to record it separately in your accounts then avoid spending it.

To make the system even more fun, you or your company must be registered for VAT before you can add it to your sale prices or reclaim what you have paid on your purchases. If you are not registered you end up always paying the total and the VAT amount.

The Maths

There is sometimes confusion over what the VAT amount is especially when trying to work it out from the total amount paid.

Where no VAT system operates the total to pay would be the same as the real price.

Compare real price with total to pay

In a system using VAT, when you sell an item, the total to pay (technically known as the gross amount) is the real price (technically known as the net amount) plus a percentage for the tax (the VAT amount).

Compare real price with total to pay

An Example

At the time of writing the UK standard rate of VAT is 20%. Suppose you sell a small blue widget, the real price is £10 and the VAT is £2 (20% of £10). This makes the total to pay £12 (£10 plus £2 VAT).

Working Backwards

You sell a large green widget for £21 including VAT. If a customer wants to know how much VAT they have paid it's not just 20% of the total (which would be £4.20). When working backwards from the total paid to find out how much of it is VAT, the percentage is smaller than 20%. In this example it's 16.666% (or one sixth) amounting to £3.50 (16.666% of £21).

Compare real price with total to pay

We can easily prove this by double checking what the VAT should be from the real price. The real price is £17.50 (£21 total - £3.50 VAT). The VAT due on this real price would be £3.50 (20% of £17.50). So all the figures add up whichever way you look at it.

An Even Simpler Explanation

If you think the example above still involves a lot of numbers, let's try to simplify it further.

You grow watermelons, I grow apples. It's a hot day and I fancy a slice of watermelon.

You charge 5 apples for a watermelon and the tribal chief adds tax of 20% (one fifth) of what you charge. That's one extra apple I have to give you.

Compare real price with total to pay

I now have my juicy watermelon. You have 6 apples.

The tribal chief calls round to collect his tax of one apple (one sixth or 16.666% of what you received) and you are left with the 5 apples you need to bake a tasty apple pie.

Further Information

You can find full information about UK VAT at the government's web site.

If you need the correct mathematical formulas for other tax rates you can speak to your accountant or the VAT office at HMRC.

Updated 09/09/2016 DB

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