How does VAT work?

VAT is charged on the supply of all goods and services made in the course of a business by a taxable person, unless they are specifically exempt. All businesses must register for VAT if their annual turnover of taxable goods and/or services is above a given threshold, currently £85,000.

VAT is charged on the additional value of each transaction. It is collected at each stage of production and distribution. A business pays VAT on its purchases (known as input tax), and charges VAT on its sales (known as output tax). It will settle up with HM Revenue & Customs (HMRC) for the difference between the two. In the end the cost of the tax is borne by the final consumer. 

VAT is charged either at the basic rate – currently 20% – or the zero rate, though there is limited use of a reduced rate of 5%.

The exemption of goods and services from VAT should be distinguished from their being charged a zero rate.

Although a business will not charge a customer VAT on their supply of zero-rated goods or services, the supply will still count as part of a business’ taxable turnover. VAT charged on inputs relating to zero-rated activities can be reclaimed, unlike the VAT incurred by a business in the course of an exempt activity. In the latter case, a business making exempt supplies has to absorb the VAT charged to it by its suppliers. This is often called ‘irrecoverable’ VAT.

From the perspective of the final consumer, both zero-rated supplies and exempt supplies will be VAT-free.

Some activities lie outside the scope of VAT because they are classified as ‘non-business’. These activities will include purely private or personal transactions, but also activities that are carried out for no charge and no other form of consideration, or activities carried out for a charge but with no degree of frequency or scale and without continuing over any period of time. As an example, an activity that is carried out mainly as a hobby, such as stamp collecting, would not be a business. However, if someone started to sell items they collected on a regular and continuing basis, then their hobby could become a business for VAT purposes (HMRC, VAT Guide: VAT Notice 700, March 2023 para 4.6.4).

VAT law is consolidated in the VAT Act (VATA) 1994, as amended.

Schedule 9 to the Act sets out those goods and services which are exempt from VAT. Categories of exempt supplies include land, insurance, finance, education, health and welfare.

Schedule 8 to the Act sets out those goods and services which are charged a zero rate. Categories of zero-rated supplies include food, construction of new dwellings, domestic and international passenger transport, drugs and medicines on prescription, and certain supplies to charities.

Schedule 7A of the Act sets out those goods and services which are charged a reduced (5%) rate. Categories of reduced-rated supplies include domestic supplies of fuel and power, residential conversions, and children’s car seats.

HMRC publishes detailed guidance on the rate of VAT that is charged on different goods and services (VAT rates on different goods and services, updated July 2022).

How much money does VAT raise?

VAT is forecast to raise £162.2 billion in 2023/24. Only income tax and National Insurance contributions (NICs) raise equivalent sums; these taxes are forecast to raise £268.0 billion and £172.3 billion respectively in the same year (Office for Budget Responsibility, Economic and Fiscal Outlook, CP 804, March 2023 – Table A5). Taken together these three taxes account for around 2/3rds of total tax receipts

The Office for Budget Responsibility (OBR) note that around half of household expenditure is subject to VAT at the 20% standard rate. Around 3 percent of expenditure is subject to the 5% reduced rate (OBR, Tax by tax, spend by spend: VAT, April 2023).

HMRC publish further statistics on VAT, and estimates of the costs of the principal tax reliefs that are given, including the various zero and reduced VAT rates.

Public bodies and VAT

Although public bodies may account for VAT on supplies of goods and services they make in the same way as any other business, they will often be in a position where they are undertaking ‘non-business’ activities. These activities are outside the scope of VAT.

As HMRC’s guidance for local authorities and other public bodies explains “the general rule is that where a public body is funded by way of public expenditure (such as grant-in-aid) to do something for the public good, it’s unlikely to be engaging in business activities for VAT purposes.” (VAT Notice 749, January 2023 para 2.2). In this context public bodies include government departments, non-departmental public bodies, NHS bodies, local government bodies, the police and the fire and rescue services. Section 41A of VAT 1994 sets out the conditions under which supplies of good and services made by government and public bodies would be treated as non-business activities (VAT Notice 749, January 2023 para 2.3).

VAT incurred in the course of non-business activities is not generally recoverable. Special provision is made for local authorities and certain other specified bodies to recover the VAT (input tax) they have incurred on goods and services purchased related to non-business activities. These refund arrangements also allow these bodies to recover VAT incurred on exempt supplies, in limited circumstances.

The relevant legislation is set out in section 33 of VATA 1994. A list of these ‘section 33’ bodies is given in HMRC’s  VAT Government and Public Bodies Manual (see paras 4120 and 4300). HM Treasury has powers to add to this list by means of secondary legislation. As HMRC’s guidance notes “Treasury will consider applications from bodies that meet both the following criteria: the body must undertake a function ordinarily carried on by local government and have the power to draw its funding directly from local taxation” (VAT Notice 749, January 2023 para 4.3). HMRC estimate that the annual cost of these refunds is around £11 billion (Structural tax relief statistics, January 2023 – Table 1).

Separate provision is made for Government Departments and health authorities to recover VAT incurred on certain of their non-business activities (under section 41(3) of VATA 1994).

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