Everyone has probably heard about VAT but it is perhaps not something that everyone will understand how it functions. In the first of this three-part series on VAT, I talk about the basics of what it is and who pays it.
What is it?
First of all, VAT stands for Value Added Tax. It is applied to sales of all goods and services within the UK. The idea is that whenever value is added to something, the government will take a cut of this value as a tax.
Who pays it?
The end consumer will usually bear the full burden of the tax and this is because companies – as long as they are VAT registered – can reclaim any VAT that they pay on their purchases.
An example of the VAT chain
An example might help to make this clearer. Let’s say that JK Rowling buys a TV. She’s been doing ok for herself, so let’s say she buys herself one of those Samsung 85 inch Smart TVs that have been advertised which retails for just £15,000*. She may have decided that she wants to watch all the Harry Potter films on a large screen.
She buys this from a retailer called TV Shop. The current VAT rate is 20% which is added on top of the actual sales price set by the store.
The retailer is therefore actually selling the TV for £12,500 and then adding 20% of the value on top of this, which works out to be £2,500, to make the sales price of £15,000. The £12,500 will go to TVs R Us and the £2,500 will go to HMRC.
If you want to calculate this, the formula is £15,000 / 120 x 100. This is because the total sales value is 120% of what the company have set.
Let us assume that TV Shop bought the television from Samsung directly for £7,200 including VAT. So the amount that Samsung get to keep is £6,000 (£7,200 / 120 x 100) with the other £1,200 – 20% of the price that Samsung charge – going to the tax man.
TV Shop will be able to reclaim the £1,200 that they paid in VAT from HMRC. This is known as Input Tax and it will offset against output tax, which is the £2,500 which they claimed in VAT from JK Rowling.
For the sake of simplicity, we will assume that Samsung made all of the parts themselves. The VAT situation of each of the parties is therefore as follows:
- JK Rowling paid £2,500 in VAT and was not able to reclaim any.
- TV Shop received £2,500 in VAT from JK Rowling, but paid £1,200 in VAT to Samsung. They will make a net payment of £1,300 to HMRC.
- Samsung received £1,200 in VAT which they will pay to HMRC.
- In total, HMRC received £2,500 from TV Shop and £1,200 from Samsung although they refunded all of this £1,200 to TV Shop.
VAT is always added onto the price that a seller wants to receive for their goods or services.
The diagram below should hopefully help to demonstrate this process. Hopefully that has been useful to you in understanding the mechanisms behind VAT. In the next article, I will discuss different VAT rates, when you are legally required to register for VAT and when you might decide to do so voluntarily.
* Please note other ridiculously expensive television sets are available.