Everyone has probably heard about VAT but it is perhaps not something that everyone will have an understanding of 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?

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. However, the burden will effectively be borne by the first purchaser in the chain that isn’t VAT registered.

An example of the VAT chain

An example might help to make this clearer. If I want to buy myself a new TV, I might go to the shop and spend £500 to purchase a SmartTV it from TVShop Ltd, a VAT registered company. The shop is charging me their set sales price of £416.67 and then adding 20% VAT on top. The total VAT I would pay is £83.33.

If I bought this for a VAT registered business, I would then be able to reclaim the VAT element of this. As I am just buying it for my own personal use, I am not able to do so.

Of the £500 I spent, £416.67 goes to TVShop Ltd, with the £83.33 going to HMRC.

If you want to calculate the selling price yourself, the formula is Total / 120 x 100. This is because the total sales value is 120% of what the company have set.

Let us assume that TVShop Ltd bought the television from SmartTV directly for £300 including VAT. The amount that SmartTV get to keep is £250 (£300 / 120 x 100) with the other £50 – 20% of the price that SmartTV charge – going to HMRC.

TVShop Ltd will also be able to reclaim the £50 that they paid in VAT to SmartTV from HMRC. This is known as Input Tax and it will offset against output tax, which is the £83.33 which they claimed in VAT from me.

Summary

For the sake of simplicity, we will assume that SmartTV made all of the parts of the TV themselves. The VAT situation of each of the parties is therefore as follows:

• I paid £83.33 in VAT and was not able to reclaim any.
• TV Shop received £83.33 in VAT from me but paid £50 in VAT to SmartTV. They will make a net payment of £33.33 (£83.33 – £50) to HMRC.
• SmartTV received £50 in VAT which they will pay to HMRC.
• In total, HMRC received £83.33 from TVShop Ltd and £50 from SmartTV although they refunded £50 to TVShop Ltd. HMRC have therefore received a total of £83.33 which effectively came straight from me.

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.