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Your employment status will determine the charge to tax on income from your employment or self-employment. It will also determine the class of NICs, which are to be paid.

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VAT The real cost of VAT an introduction and guide to VAT

VAT - Value Added Tax

Introduction to VAT

VAT is a tax applied at the Point of Sale (POS) or Point of Transfer (POT) between EU countries or when imported into the UK from outside the EU. VAT is applied to most goods and services that VAT registered businesses provide. Not all businesses are registered for VAT. A business must register for VAT if its annual sales exceed £79,000.00 in a 12 month cycle. Businesses can choose to register for VAT when sales are below £79,000.00 though HMRC may refuse application if they feel the business doesn’t meet specific criteria. If HMRC refuse a VAT application you can reapply at a later date or appeal the decision.

How much money is generated by VAT?

Forecast is circa £90 billion for the 2013/14 tax year.

How is VAT calculated?

VAT is calculated by applying a direct percentage of the sell rate of good/service and applied at the point of transaction.

2013/14 tax year VAT percentage rates are currently:

  • 20% - standard VAT rate
  • 5% - reduced VAT rate
  • 0% - VAT not applied or exempt

How does VAT work?

VAT, in theory, is charged once per product or service.

VAT Process Example 1 - General

VAT transation process

In the diagram above, the Manufacturer will pay HMRC the VAT or the product or service. The Manufacturer then sells their goods to the Importer and applies the VAT. The Importer does the same to the Wholesaler and so on up to the Customer/Consumer. This simple overview shows that VAT is only charged once as the monies paid for VAT simply transition through those involved in the movement of goods/service.

VAT Process Example 2 – Limited Company

Limited Company VAT Process

As a contractor running your own limited company (or small business etc) you will be liable for paying VAT to HMRC and then charging your client(s) VAT in return. If you are a new contractor setting up your own limited company you should register for VAT straight away (or this may be provided as part of a limited company setup package offered by your accountant). Most clients will expect to be charged VAT, it makes no odds to them as they will be claiming the VAT back from HMRC (see below – claiming back VAT). As a contractor, being VAT registered will enable you to claim back VAT or a lot of your expenditures, thereby reducing your operational overhead and increasing margin. In this model it is the contractor (who is the director of the company) who is directly accountable to HMRC for VAT payment.

VAT Process Example 3 – Umbrella Company

Umbrella Company VAT

If you are a contractor using an umbrella company, it is the umbrella company that must pay VAT to HMRC. They in turn apply VAT back through the service supply chain to the client (who in this instance is the consumer of your service. In this model, the contractor has no VAT responsibilities; it is the umbrella company who takes this responsibility as part of their service.

Reclaiming VAT

In the examples above, we have looked at VAT payment transition on one service/product. This simplified version of VAT transition (accounting) becomes a little more complex in reality. When thinking of VAT transition, it is easier to visualise in terms of HMRC expectation. Lets go back to example one. The manufacturer will most likely be selling to several importers, who in turn sell to several wholesalers and so on until we end up with 60 million consumers... wow. You are now probably thinking, how does that all work? Millions of transitions just on one product... It is difficult to be exact as there are no clear statistics published but VAT transactions per day number in their billions. What is clear is that VAT is worth almost 90 Billion (forecast 2013/14 Tax year) per year for the UK Government, approximately 13% of total Government income. That’s a huge amount of transitions to account for, how do HMRC manage it? They keep it simple, they make businesses do the work and ensure that the responsibility for the accounting lies with the directors.

HMRC manage their VAT expectation my monitoring the VAT point of creation, which is the first point at which VAT is applied. Let’s apply some figures to our original example to illustrate, we will keep the numbers small and simple as the key is your understanding of the process. Once you understand the process of VAT it becomes much simpler to think your way through your accounts.

Example of VAT calculation through supply chain

In the example above, the manufacturer sells the goods to 10 importers. Each Importers sells to 10 Wholesalers (giving a total of 100 Wholesalers). Each Wholesalers sells to 10 Retailers (giving a total of 1000 Retailers). Each Retailer sells to 10 Consumers (giving a total of 10000 Consumers). Simple enough? Let’s assume no one makes a profit. This would mean that at each Point of Sale (POS), an equal split of the sale price and VAT occurs. If you follow the VAT example in the image above you will see that basically, each consumer pays £1.00 of vat which equates to the £10,000.00 actually payable to HMRC. So, HMRC expect £10,000.00 and the businesses facilitate that through the service/goods supply chain. Got it? Excellent, now let’s look at an example where each link in the supply chain adds a 40% margin (not unrealistic) for operational costs and profit margin.

Detailed VAT example illustration

In our new VAT example we have added new columns. The Sale rate is now adjusted by 40% at each point of the supply chain. The buy rate for each point has also risen due to the increase in cost at each stage. As you can see, the VAT paid through the supply chain does not change. The same £10,000.00 is still expected by HMRC however, each individual part of the supply chain is now increasing their cost (for service or product). This ‘Added Value’ becomes liable for Value Added Tax – VAT. So, in addition to the original £10,000.00 VAT payment expected from the manufacturer, HMRC now expects an additional:

  • £400.00 from Each Imports (total £4,000.00 VAT)
  • £96.00 from each Wholesaler (total £9,600.00 VAT)
  • £17.44 from each Retailer (total £17,440.00 VAT)

Giving a grand total of £41040.00 payable in VAT. Wow you scream! This is only an example, the reality is far worse! Or better, depending on your perspective. The figures in the illustration are purely example, the key point is that VAT has a logarithmic effect on price structure.

The logarithmic impact of VAT should also help you to understand why it is such a crucial fund generator for HMRC. How does this help with claiming back your VAT?

Imagine you slot in as the Wholesaler in our example, you have £100.00 of VAT commitment through the supply chain and £96.00 commitment to VAT. When it comes to calculating your VAT return for HMRC, your total VAT commitment to HMRC is £196.00 minus the £100.00. You have to claim back the £100.00 which you do so in your VAT return. In order to do this you will need a VAT receipt which specifies the £100.00 applied at point of sale. Lost your receipt? Fool! Receipts are accounting gold. You can complete an affidavit for lost VAT receipts but be warned, they will be audited and if you do lie, you face a free trip to HMP courtesy of HMRC.

So far, we have learned that:

  • VAT is only paid once per value added activity
  • You must be registered for VAT to claim it back
  • You need receipts to claim VAT back
  • VAT has a logarithmic impact of the cost of goods with cost increased at each point of value added activity

The impact of VAT on the consumer

In our example the consumer pays nearly 4 times the original manufacturer retail rate. Lets look at this again with some actual VAT figures.

 

Consumer VAT - Understanding the impact of VAT increases on the consumer and wider UK economy

This VAT example shows 4 points of the supply chain before Point of Sale to the Consumer and generates an end Consumer Cost. For the point of this exercise, 40% combined operational cost and profit has been applied at each point of the supply chain. A further 20% VAT is then applied. The end result for the consumer in this instance is £0.95 of VAT. Now let’s look at this same, four stage supply chain with different levels of VAT applied.

Graphical and data view of impact of VAT on the consumer - the true measure of VAT

The table above shows that if there were no VAT being charged, the consumer would save £2.00 per unit compared to that of 20% vat in our 4 tier supply chain. The staggering increase is due to the margin uplift being applied on the gross cost of the goods at each point. Operational margins clearly fluctuate and businesses drive to keep their margins down but this shows why businesses and consumers don’t like VAT. There is good argument to suggest that increased VAT reduces business flexibility and reduces consumer spending, which in turn means less cash flow, less jobs and economic shrink. Incredible then that the Government increased VAT as part of their austerity measures. A better approach may have been realised with a reduction in VAT to increase consumption/demand and cash flow. Earlier we said that VAT is expected to generate circa 90 Billion in the 2013/14 Tax year (circa 13% of total Government income). Compare this to 73.4 Billion in 2010/11 tax year when VAT rates were at 17.5 % (VAT increased from 17.5% to 20% on 4 January 2011). Earlier reductions to VAT to 15% witnessed the same levels of return with the increase to 17.5% seeing a £15 million reduction in VAT return in 2009/10 tax year. Clearly the global economic pressures didn’t help this figure.

VAT like all taxes, can be debated at length. There is argument for the support of debt repayment, social security, national health etc. Aside all this, what we need to remember is that the rate of VAT has a logarithmic impact on the consumer and businesses. High VAT rates make our cost of living higher, spending power weaker and reduce the flow of cash in the country. Clearly we need VAT but with revenues approaching £90 billion it is clearly time to reduce VAT. A year of 10% would be an interesting boost to the economy. Look at the table above to see how the unit cost on our 4 tier supply chain would change with a VAT rate of 10%. In the real world, any forthcoming VAT change is likely to see a return to 17.5%. Remember that you heard it at Umbrella Compare first. Election looming, economic growth evident, VAT returns high... a reduction in VAT is a good political carrot.

How did VAT change the high street?

Our 4 tier supply chain illustrated how VAT has a compound impact on cost with each additional link of the supply chain adding cost. This is a simple example, some supply chains are incredibly complex with hundreds of separate handing points and cost added value, just think of goods which start from materials mined or foraged. The widespread use of the internet has empowered the consumer and altered the supply chain system. A long story short, numerous manufacturers to deal direct with their end consumer meaning less supply chain cost and increased revenue for the manufacturer (who typically applies an uplift as they know what the consumer I used to paying). VAT is not the only but is a contributing factor to this change in the consumer transaction. We know operate in a demand and supply rather than supply and demand economic model.

VAT Summary

A long VAT article but we hope this provided you a thorough insight into VAT and you now understand what VAT is, why we have VAT and the impact of VAT on the economy and your business.

What does VAT mean to me as a contractor?

If you run your own limited company, you need to understand VAT because you are accountable to HMRC for working out how much VAT you owe, how much VAT you can claim back and for paying your VAT on time.

If you use an umbrella company, VAT is their problem.

Please ask any questions you have or leave comments on this VAT guide below.

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