Learning Outcomes
This article explains the core principles of Value Added Tax (VAT) relevant to the SQE1 assessments, including:
- when VAT is charged under VATA 1994, focusing on scope, the taxable person requirement, the business test, and the place of supply;
- classification of supplies as standard-rated, reduced-rated, zero-rated, exempt, or outside the scope, and the exam-significant distinctions between zero-rated and exempt supplies;
- the mechanics of output tax on supplies made and input tax on business purchases, and how these interact to determine net VAT payable or recoverable;
- how to determine the value of a supply for VAT purposes, handle VAT-exclusive and VAT-inclusive prices, and apply the VAT fraction at the standard rate;
- basic VAT registration rules, including compulsory and voluntary registration, the registration threshold, and the main consequences of becoming a taxable person;
- the practical effects of making exempt supplies, including restrictions on input tax recovery and the need for partial exemption calculations;
- typical VAT issues arising in commercial problem questions, such as mixed supplies and common borderline items likely to feature in SQE1;
- core VAT compliance obligations, including VAT invoices, record-keeping standards, payment dates, and VAT return filing cycles;
- analytical steps for approaching SQE1-style VAT multiple-choice questions, ensuring systematic identification of scope, rate, and input tax recoverability issues.
SQE1 Syllabus
For SQE1, you are required to understand the practical application of VAT principles, including determining VAT liability in various business scenarios and applying the essential calculations, with a focus on the following syllabus points:
- The conditions under which VAT is charged (scope).
- The concept of a taxable supply and the different VAT rates.
- The key differences between taxable supplies (including zero-rated) and exempt supplies.
- The mechanics of input tax and output tax and how they determine VAT liability.
- Basic VAT registration requirements.
- VAT pricing basics (VAT-exclusive vs VAT-inclusive amounts and use of the VAT fraction).
- VAT invoice requirements and core record-keeping duties.
- The effect of partial exemption when both taxable and exempt supplies are made.
Test Your Knowledge
Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.
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Under VATA 1994, which of the following elements must be present for VAT to be charged?
- A supply of goods or services
- Made in the UK
- By a taxable person
- In the course or furtherance of business
- All of the above
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A VAT-registered business sells consulting services for £1,000 (exclusive of VAT). Assuming the standard rate applies, what is the output tax?
- £50
- £100
- £200
- £0
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True or False? A business making only exempt supplies can register for VAT voluntarily to reclaim input tax.
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Which VAT rate applies to children's clothing?
- Standard rate
- Reduced rate
- Zero rate
- Exempt
Introduction
Value Added Tax (VAT) is a tax levied on the consumption of most goods and services supplied within the United Kingdom. It forms a significant part of the UK tax system and understanding its fundamental principles is important for business law practitioners. This article covers the scope of VAT, the concept of supply, and the essential mechanics of input and output tax, as required for the SQE1 assessment. The primary legislation governing VAT is the Value Added Tax Act 1994 (VATA 1994).
VAT is collected in stages as goods and services move through the supply chain. Each VAT-registered supplier charges VAT on the value they add (output tax) and may deduct VAT they have incurred on their inputs (input tax). In this way, the overall VAT burden falls on the final consumer, while businesses act as collectors and remitters of the tax. Understanding how VAT attaches to transactions and how it is accounted for is essential to analysing commercial scenarios in the SQE1.
Key Term: Value Added Tax (VAT)
A consumption tax charged at each stage of the supply chain on the 'value added' to goods and services. Registered businesses charge VAT (output tax) on their sales and can reclaim VAT (input tax) on their purchases.
Scope of VAT
VAT is chargeable under s 4 VATA 1994 if all the following conditions are met:
- There is a supply of goods or services.
- The supply is made in the UK.
- It is made by a taxable person.
- It is made in the course or furtherance of any business carried on by that person.
These elements operate together. If one element is missing (for example, the supply is not in the UK or not made by a taxable person), UK VAT is not due.
Taxable Person
A business (whether a sole trader, partnership, LLP, or company) becomes a 'taxable person' when it is registered, or required to be registered, for VAT.
Key Term: Taxable Person
A person (individual, firm, company, etc.) who is registered for VAT or is required to be registered because their taxable turnover exceeds the current VAT registration threshold.
Compulsory registration is required if a business's turnover from taxable supplies exceeds the statutory threshold (currently £85,000) in any rolling 12-month period. This applies to the value of taxable supplies (standard-rated, reduced-rated, and zero-rated) made in the UK. Businesses below this threshold can register voluntarily, which may be advantageous if they primarily make zero-rated supplies or wish to reclaim significant input tax. Non-UK businesses supplying goods or services in the UK may also need to register, often with no threshold.
Registration changes the VAT position: once registered, a taxable person must charge VAT on taxable supplies it makes, can reclaim VAT on qualifying business inputs, and must comply with invoicing, record-keeping, and return obligations.
Supply
'Supply' encompasses nearly all transactions involving goods or services provided for consideration. Goods typically involve the transfer of ownership, while services cover everything else done for consideration. A supply of goods can include tangible property (e.g., machinery, stock) and certain intangible property (e.g., interests in land or intellectual property). Most transactions in the course of business that involve payment are supplies; gifts and supplies without consideration are generally outside the VAT charge unless a specific deeming rule applies.
The VAT charge is based on the value of the supply, which is the price net of VAT. Where a price is stated exclusive of VAT, VAT is added at the appropriate rate. Where a price is stated inclusive of VAT, VAT is extracted using the VAT fraction appropriate to the rate (for standard rate 20%, the fraction is 1/6).
In the UK
VAT is a territorial tax. The supply must generally take place within the UK to be subject to UK VAT. Detailed rules determine the 'place of supply', which can be complex for cross-border transactions, but the basic principle for SQE1 is that the supply occurs within the UK. Exported goods are often zero-rated, but careful consideration of place of supply rules is required before treating cross-border supplies differently. For domestic transactions, assume UK VAT applies where the other scope conditions are met.
Business
The supply must be made in the course or furtherance of 'business'. This term is widely interpreted and includes any trade, profession, or vocation. Regular commercial activity usually qualifies. Occasional private sales (e.g., selling a personal car outside any business) are not made in the course of business and fall outside VAT.
Key Term: in the course or furtherance of business
Activity with a commercial character carried on with continuity for the purpose of a trade, profession, or vocation; transactions incidental to and supporting the business also qualify.
Indicators of business include profit motive, holding out to the public, and repetition or continuity. Charities and not-for-profits can be in business for VAT purposes when making supplies for consideration.
Taxable Supplies
For VAT to be charged, the supply must be a 'taxable supply'. A supply is taxable unless it is specifically 'exempt' or 'outside the scope' of VAT. Taxable supplies are charged at one of three rates.
Key Term: Taxable Supply
A supply of goods or services made in the UK which is liable to VAT at the standard rate (20%), reduced rate (5%), or zero rate (0%).
VAT Rates
- Standard Rate (20%): The default rate applied to most goods and services, such as adult clothing, electronics, consulting, and most restaurant meals and confectionery.
- Reduced Rate (5%): Applied to specific supplies like domestic fuel and power and children's car seats.
- Zero Rate (0%): Applied to certain goods and services deemed essentials or socially important. Examples include most food items (excluding restaurant meals and confectionery), books, newspapers, public transport, prescription medicines, and children's clothing.
Importantly, zero-rated supplies are taxable supplies. This distinction is essential because businesses making zero-rated supplies can reclaim the input tax they incur on related purchases.
Key Term: Zero-rated Supply
A taxable supply where the rate of VAT charged is 0%. Businesses making zero-rated supplies do not charge VAT to customers but can reclaim input tax incurred on related costs.
Zero-rating often applies by category of item (e.g., printed books, basic foodstuffs), but boundaries matter (e.g., printed newspapers zero-rated, electronically supplied news content is generally standard-rated). In practice, always confirm a product’s VAT treatment by reference to HMRC guidance for the category in question.
Worked Example 1.1
A VAT-registered bakery sells a loaf of bread for £1.50. Bread is a zero-rated item. How much VAT does the bakery charge?
Answer:
The bakery charges £0 VAT. The supply is zero-rated. However, because it is still a taxable supply, the bakery can reclaim input VAT paid on its business expenses (e.g., VAT on flour, electricity, rent for the shop premises – assuming these are standard-rated supplies to the bakery).
Exempt Supplies
Certain supplies are specifically designated as exempt from VAT under Schedule 9, VATA 1994. No VAT is charged on exempt supplies.
Key Term: Exempt Supply
A supply listed in VATA 1994, Sch 9 that is not subject to VAT. Businesses making only exempt supplies cannot register for VAT and importantly, cannot recover any input tax related to making those exempt supplies.
Common examples of exempt supplies include:
- Insurance services
- Most financial services (e.g., provision of credit, bank charges)
- Postal services by Royal Mail
- Education by eligible bodies
- Health services by registered professionals (doctors, dentists, opticians)
- Betting and gaming
- Residential land and buildings (e.g., rent of dwellings and most residential sales), subject to specific exceptions and options in advanced scenarios
Exemption removes the supply from the VAT system entirely: no output tax is charged, and input tax that relates to those exempt supplies is generally irrecoverable. Where a business makes both taxable and exempt supplies (partial exemption), apportionment rules restrict input tax recovery to the taxable part.
Exam Warning
Do not confuse zero-rated supplies with exempt supplies. Zero-rated supplies are taxable (at 0%) and allow input tax recovery. Exempt supplies are outside the VAT charging system, meaning no output tax is charged, but no input tax can be reclaimed on costs associated with making those exempt supplies. This difference significantly impacts a business's VAT recovery position.
Input and Output Tax
The mechanism of VAT relies on the concepts of output tax and input tax.
Output Tax
This is the VAT that a VAT-registered business charges on the taxable supplies (sales) it makes to its customers.
Key Term: Output Tax
The VAT charged by a VAT-registered business on the value of the taxable goods and services it supplies.
The output tax due in a period is calculated on the VAT-exclusive value of all taxable supplies made in that period, multiplied by the applicable rates. Where prices are VAT-inclusive, output tax is extracted using the VAT fraction (for 20%, multiply the VAT-inclusive price by 1/6).
Input Tax
This is the VAT that a VAT-registered business pays when it buys goods or services for its business purposes.
Key Term: Input Tax
The VAT incurred by a VAT-registered business on goods and services received (purchases) for the purpose of its business, primarily for making its taxable supplies.
Not all VAT suffered is recoverable. Input tax is only recoverable to the extent that the purchases are used to make taxable supplies (including zero-rated supplies). Input tax clearly linked to exempt supplies is generally blocked. Where inputs support both taxable and exempt activities, an apportionment (partial exemption) is required to determine the recoverable portion.
VAT Accounting
VAT-registered businesses must account to HM Revenue & Customs (HMRC) for the VAT they collect and pay. This is done through periodic VAT returns (usually quarterly).
The basic calculation is:
Total Output Tax (on sales) − Total Recoverable Input Tax (on purchases) = Net VAT Payable to HMRC (or Reclaimable from HMRC)
- If output tax collected exceeds recoverable input tax paid, the business pays the difference to HMRC.
- If recoverable input tax paid exceeds output tax collected, the business can reclaim the difference from HMRC.
Importantly, input tax is only recoverable to the extent that the purchases relate to the making of taxable supplies (including zero-rated supplies). Input tax related to making exempt supplies cannot generally be recovered. Businesses making both taxable and exempt supplies ('partially exempt' businesses) must usually apportion their input tax and can only recover the portion related to their taxable activities.
Where supplies are priced VAT-inclusive, calculating output tax requires extraction using the VAT fraction. At 20% standard rate, the VAT fraction is 1/6 (because 20% of net is equal to 1/6 of gross). For example, a VAT-inclusive price of £120 includes £20 VAT (120 × 1/6), with net £100.
Worked Example 1.2
A VAT-registered graphic design company invoices a client £2,000 plus VAT for design services (standard-rated). In the same period, the company buys new design software for £500 plus VAT (standard-rated) and pays £100 plus VAT for printing business cards (standard-rated). Calculate the net VAT payable.
Answer:
- Output Tax (charged to client): £2,000 × 20% = £400
- Input Tax (on software and printing): (£500 × 20%) + (£100 × 20%) = £100 + £20 = £120
- Net VAT Payable to HMRC = Output Tax − Input Tax = £400 − £120 = £280
Worked Example 1.3
A VAT-registered retailer sells a standard-rated item to a consumer for £120 VAT-inclusive. How much output tax is due, and what net amount is recognised as sales income (exclusive of VAT)?
Answer:
Use the VAT fraction for 20%: VAT = £120 × 1/6 = £20; net sales income (exclusive of VAT) = £120 − £20 = £100. Output tax due is £20.
Worked Example 1.4
A firm makes both taxable and exempt supplies in a quarter. Taxable (including zero-rated) sales total £40,000, exempt sales total £10,000. The firm incurs £6,000 plus VAT of overheads, all of which support the whole business. VAT on the overheads is £1,200. Using a simple income-based apportionment, what proportion of input tax is recoverable?
Answer:
Total supplies = £40,000 (taxable) + £10,000 (exempt) = £50,000.
Recoverable proportion = taxable supplies ÷ total supplies = £40,000 ÷ £50,000 = 80%.
Recoverable input tax = £1,200 × 80% = £960; irrecoverable input tax (relating to exempt activity) = £240.
Revision Tip
Remember the fundamental VAT equation: Output Tax − Recoverable Input Tax. When analysing a scenario, identify the VAT charged by the business (output) and the VAT paid by the business on relevant purchases (input), then calculate the difference to find the net amount due to or from HMRC. Always consider if input tax relates to taxable or exempt supplies. Where both are present, an apportionment is needed.
Basic VAT Compliance
For SQE1, a basic awareness of registration and return requirements is needed.
VAT Registration
As noted, registration is compulsory if taxable turnover exceeds £85,000 in a rolling 12-month period. Turnover is measured by the value of taxable supplies made in the UK. A business below this threshold can register voluntarily; doing so enables input tax recovery but requires compliance with VAT obligations. Non-established or overseas businesses supplying goods or services in the UK often have to register with no threshold.
Once registered, businesses must:
- Charge VAT on taxable supplies at the correct rate.
- Issue VAT invoices where required (typically to other VAT-registered customers).
- Keep accurate VAT records and accounts.
- File VAT returns and pay any VAT due by the deadline.
If a business only makes exempt supplies, it cannot register and cannot recover input tax.
VAT Invoices and Records
VAT-registered businesses must issue valid VAT invoices for taxable supplies made to other VAT-registered businesses. These invoices must contain specific details (e.g., supplier’s name and address, customer’s details, VAT registration number, description of goods/services, VAT rate and amount, total VAT-inclusive amount, and the date of supply). Accurate records of sales, purchases, and VAT accounted for must be kept, typically for six years.
Maintaining clear records is essential for correctly completing VAT returns and evidencing input tax claims (e.g., having proper tax invoices from suppliers). Credit notes should be issued where consideration is reduced or a supply is cancelled; these adjust output tax accordingly.
VAT Returns
VAT returns, detailing output and input tax for a period (usually quarterly), must be submitted electronically to HMRC, typically via Making Tax Digital (MTD) compatible software. The net VAT payable is usually due at the same time the return is submitted. For most businesses, returns are due one month after the end of the quarter. HMRC may allow or require monthly returns in some circumstances. Where input tax exceeds output tax, the difference is reclaimed.
Timely filing and payment prevent interest and penalties. Accounting systems should be configured to capture VAT at the correct rates and track recoverable vs non-recoverable input tax (particularly important for partially exempt businesses).
Worked Example 1.5
A VAT-registered consultancy has the following in Quarter 1: VAT-exclusive fees of £60,000 (standard-rated), overhead costs £12,000 plus VAT (£2,400 VAT), and zero-rated book sales of £10,000. Calculate the net VAT due and confirm whether input tax on overheads is recoverable.
Answer:
Output tax: consultancy fees £60,000 × 20% = £12,000; book sales zero-rated = £0 output tax (but still taxable supplies).
Input tax: overhead VAT £2,400.
Because both consultancy fees and zero-rated book sales are taxable supplies, the overhead input tax is attributable to taxable activity and recoverable (subject to normal rules).
Net VAT due = £12,000 − £2,400 = £9,600.
Key Point Checklist
This article has covered the following key knowledge points:
- VAT is charged on taxable supplies of goods/services in the UK by a taxable person in the course of business.
- Taxable persons must register if taxable turnover exceeds £85,000 per annum in a rolling 12-month period; voluntary registration is possible below the threshold.
- Taxable supplies are standard-rated (20%), reduced-rated (5%), or zero-rated (0%).
- Zero-rated supplies are taxable; input tax attributable to them is recoverable. Exempt supplies (e.g., insurance, health, education, residential land) are not subject to VAT and do not allow input tax recovery.
- Output tax is VAT charged on sales; Input tax is VAT paid on purchases.
- Net VAT payable/reclaimable = Output Tax − Recoverable Input Tax; use the 1/6 VAT fraction to extract 20% VAT from VAT-inclusive prices.
- Input tax relating to exempt supplies is generally not recoverable. Businesses making both taxable and exempt supplies need to apportion input tax (partial exemption).
- VAT invoices must contain prescribed details; records should be kept for at least six years.
- VAT returns are usually filed quarterly via MTD-compatible software, with VAT due at the time of filing.
Key Terms and Concepts
- Value Added Tax (VAT)
- Taxable Person
- Taxable Supply
- Zero-rated Supply
- Exempt Supply
- Output Tax
- Input Tax
- in the course or furtherance of business