There is something to be said for a tax where important case law revolves around gingerbread men, Jaffa Cakes and cooling Cornish pasties.  Give your gingerbread characters fancy iced clothing and they instantly become Vatable.  No gingerbread supporters rose up en masse to fight that VAT imposition but remember the outrage, followed by a climb down, when the Chancellor tried to add VAT to our heated but cooling takeaway pasties! 

Despite having a fun factor VAT is a serious concern for businesses, not least because it has many quirks and eccentricities. To put that another way, it is easy to make mistakes which can lead to costly penalties and the pain of HMRC enquiries.

Let us look at some pitfalls that VAT creates.

1.     Forgetting VAT is not a simple tax

VAT was sold to us as a simple tax. You already know that isn't true. Just the basic facts show this. There are three rates: standard rate, reduced rate, zero rated. In addition, some items are exempt which is different to zero rated. 

Businesses calculate VAT using one of these methods:

1)    The Cash Accounting Scheme. You only pay and reclaim VAT based on what you've received and paid.

2)    The Standard or Normal accounting scheme. Here you pay VAT on your sales whether or not your customers have paid. You then reclaim VAT from your suppliers' invoices whether or not you have paid the bill.

3)    The Flat Rate Scheme which was introduced to help small businesses by simplifying VAT. You use the appropriate rate to charge your customers (e.g. 20%) but you pay over a lesser percentage to HMRC e.g. 14.5%. (the percentage depends on which trade  you carry out). You cannot reclaim VAT on your expenses except on some capital equipment.

Deciding which of the three schemes is best for your business is not as straight forward as you might think.

2.     Not evaluating the best VAT scheme for your business

The flat rate scheme can deliver cash flow savings to small businesses and it does simplify the accounting to a degree. However, you need to compare this scheme to, say, the cash accounting scheme to avoid a potentially costly mistake.

Where a business has chunky expenses to pay VAT on, it might not be tax efficient to join the flat rate scheme.

Where a business has some exempt income (rental income), review carefully before joining the scheme because you may find yourself paying VAT on income that is normally exempt from VAT.

3.     Not accounting for zero-rated items

As a business owner you will probably be delighted to have goods to sell that have 0% VAT which appears to make your life simpler and cheaper for your customers if you are selling B2C (Business2Customers).  What is important to remember is that this means that the VAT rate is currently 0% and you are charging your customers VAT at that 0%. Semantics?  No because you need to remember to include all those zero rated sales in your vat accounts and included them on your returns.

In addition, it's important to remember that if you have customers who are EU businesses registered for VAT you can apply the 0% rate if they are registered. Please check to make absolutely sure they are registered to avoid problems.

4.     Under-stating the flat rate turnover

When an income is exempt from VAT, it usually means just that. Exempt. You do not include it on your return. But here is a quirk of the flat rate scheme. The gross income you enter in box 6 of the VAT return should include the value of all exempt suppliers as well as the VAT-inclusive value of all standard-rated, reduced-rated and zero-rated supplies.

So, in some cases, you may end up paying more VAT under the flat rate scheme.

5.     Entering the wrong figures on the VAT return

There are eight boxes to complete. Box 6 can often cause problems depending on whether you're using the flat rate scheme or not. It's also the box where HMRC normally picks up mistakes.

If you're using the flat rate, double check that box 6 is the gross income you've applied the flat rate percentage to. If you're using the cash accounting scheme, then it's the net income (net of VAT) that goes in box 6.

Always check back to the box 1 figure. For example: you're on the flat rate scheme and your percentage is 14.5% and your VAT inclusive income for the quarter is £48,000. Your box 6 figure will be £48,000 and your box 1 figure will be £6,960 (14.5% x £48,000).

If you're using either the standard or cash scheme, then box 6 will be the net VAT of £40,000 and box 1 will show £8,000.

Of course, there may be other items and figures from box 8 feeding into box 6, so be very careful to make sure there are plausible reasons for any differences.

6.     Falling foul of new limited cost trader rules

Small businesses may be caught out by the new VAT status "limited cost trader". This rule comes into effect on 1 April 2017. Essentially it will increase the flat rate percentage for most service based businesses. A limited cost trader is one whose VAT inclusive spending on goods, is either less than 2% of the VAT inclusive turnover in a prescribed accounting period, or greater than 2% but less than £1,000 pa for a full prescribed accounting year.  The definition of "goods" means they must be used exclusively for the business but exclude capital expenditure; food or drink consumed by the business/employees; and vehicles, fuel and vehicle parts (unless your business is transport). The business will have to account for VAT rate at 16.5%  on gross turnover.

Official estimates suggest that of the 411,000 businesses using the FRS, 123,000 have limited costs and will be affected by these changes.  Is your business one of them?  As HMRC helpfully says "Businesses using the scheme, or thinking of joining the scheme, will need to decide whether they are a limited cost trader." You need to assess this very carefully - ensure your flat rate percentage is reviewed to avoid back-dated VAT.

7.     Lack of satisfactory evidence to support VAT reclaims

No VAT receipt, No claim. This is the accepted rule. Let's say you have a VAT receipt, double check that the item does carry VAT. While there are few exceptions to this rule, why take the risk?

To avoid losing money, why not try one of the apps that allow you to take snap copies of your receipts on the go. The receipts can be automatically stored in your book keeping system.

8.     Failing to appreciate VAT risk areas

Whenever you are dealing with transactions relating to any of the following risk areas, it is advisable to get professional help

  • Land and buildings
  • Property and construction
  • Travel and tour operators
  • Imports and exports
  • Exempt supplies
  • Partial exemption and various schemes
  • Zero rated supplies
  • Charity related transactions
  • Agency and principal transactions
  • Any other transaction where VAT might or might not be charged

Talk to your accountant and if necessary a VAT specialist.

9.     Items purchased before you registered for VAT

If your business has been growing there will come a time when you meet the threshold and you can no longer avoid registration for VAT.  It will come as no surprise to you that there are time limits.

So long as the purchases are relevant to the current purpose of your business you can include on your first VAT return:

Services purchased within the six months prior to registration

Goods you still have which were purchased over the past four years, or were used to make other goods you still have. Of course you will need the backup information including invoices and receipts and be able to provide detailed descriptions.

Remember if you register late you could receive a penalty.

10.  Not restricting VAT on non-business use expenses

Where you've incurred expenses which are partly business and partly personal (e.g.broadband at home), a mistake is to claim VAT on the full amount instead of applying a restriction on the personal or non-business element of the expense.

11.  Getting in a muddle over VAT on motor vehicle and fuel

A common error is to claim VAT on a motor vehicle which is available for private use. The VAT cannot be claimed except where the vehicle is to be used exclusively for business purposes i.e. not be available for anyone's private use.

Another error is claiming the full costs of fuel where the car is available for private use without restriction or without charging corresponding VAT in the form of a "fuel scale charge". 

12.  Getting confused by VAT and entertainment

Although in some business sectors, entertaining clients is justifiable in order to win contracts, VAT on these expenses is normally blocked and cannot be claimed back. During a VAT enquiry, this is one of the areas HMRC will have on their checklist.

As part of your review process, look at this when going through the VAT return and check your calculations just in case your computer software doesn't pick this up.

There is one exception to the block on claiming VAT for entertainment. When you entertain staff, including directors of the company, you can claim the VAT on the amount, assuming the type of entertainment or expense carries VAT. You are right - this is one of the quirks I mentioned.

13.  Over reliance on technology

Using technology to ease the administrative load and save time is something I recommend. However, having been involved in the development of tax apps, I must admit it's a myth that the computer will do it all for you. It's dangerous to rely heavily on software and fail to carry out basic checks on the VAT return. Errors such as the software claiming VAT on incorrect items, automatically coding expenses to wrong accounts, duplicated bank transactions are common. They raise red flags for HMRC.

14.  Book keeping errors

Common error which HMRC tends to look for come under the classification of transactions, for example:

  • Has input tax been claimed on costs incurred outside the UK (for example conference/business trip accommodation and meals)?
  • Has input tax been claimed on expenses which do not carry VAT (such as stamps, train/air/bus tickets, some tolls)?
  • Has self-billed sales invoices on which VAT is due been posted as purchase invoices?
  • Has business entertainment been classified as marketing and VAT claimed?

15.  Not accounting for VAT on services received from overseas suppliers

This involves the Reverse Charge and the complex Place of Supply Rules.

In its simplest form, it means that when a UK business buys services from an overseas supplier (EU), the UK business must account for VAT on those services in their VAT return, as if they were the supplier. Under the reverse charge output VAT (VAT on income) must be declared in box 1 of the VAT Return. This VAT, subject to the normal rules, is also recovered as input VAT (VAT on expenses) in box 4. So the effect is NIL. Now if you're scratching your head thinking...what's the point...? You're not alone.

16.  Not charging VAT on "non-standard business" transactions

HMRC knows that enquiries into the following areas are likely to generate additional VAT revenue because businesses usually fail to appreciate that VAT needs to be accounted for:

  • Management charges
  • Disposals of assets used in the business
  • Cash sales
  • Charges to sub-contractors for use of vans or tools
  • Sales of scrap
  • Supplies to staff - invoiced or by payroll deduction
  • Mandatory restaurant service charges
  • Recharges of costs to third parties
  • Receipt of reverse charge services
  • Incentive payments received from suppliers for meeting purchase or sales targets
  • Barter transactions

If you encounter any of the above, take a step back and seek advice.

17.  Putting your head in the sand and ignoring demands

Remember the VAT-man wants his money - and is legally entitled to it. It can be very costly to ignore demands and notices from HMRC. For example, when HMRC sends you an assessment (estimate) and you fail to send in the correct return in good time, if the assessments turn out to be higher than the actual return, HMRC is not obliged to change the figures.

And did you also know that VAT has more draconian penalties than income tax?

Don't lose money by burying your head in the sand or shutting your eyes. Running a business and staying on top of cash is hard enough without adding stress and self-inflicted costs.

18.  Forgetting about EC sales list or Accounting incorrectly for EC sales

There are two common mistakes here. If your business supplies goods or services to other EC VAT registered traders, then EC sales lists need to be submitted to HMRC. If you sell goods then the amount of sales to EC customers goes in boxes 6 and 8 of the VAT return, so chances are HMRC will pick up the box 8 figure send you a notice to complete an EC sales list.

If you sell services, then it becomes a bit tricky because whilst you include the amount in box 6, you don't include it in box 8 (the second common error), so you will need to remember to submit EC sales list. This will help avoid penalties and enquiries.

19.  Claiming VAT on import agent's invoice

If you import goods then you can only recover VAT on an official document issued by customs. This is called a 'C79' (Import VAT Certificate'). VAT cannot be claimed on the invoice issued by the import agent because it's not a VAT invoice.

20.  Failing to repay VAT on supplier invoices  

Where VAT has been recovered on purchases from a supplier, if you have not paid this supplier for over six months, you are required to repay any VAT recovered to HMRC. Similarly, where a customer has not paid you for over six months and you've already paid VAT on that invoice to HMRC, you can claim that VAT back. If you're using the standard VAT scheme, do watch out for this during your checks and reviews. 

In conclusion

VAT's eccentricities are such that my advice is to get an accountant or an experienced book keeper to help you manage it. For major, complex issues relating to land, property, imports and the other risk areas you may need specialist help. I am an accountant and by nature cautious.

However, if your business is very simple, and you have the time and determination to keep on top of any changes you can do it yourself. Just make sure you use a detailed checklist and don't leave VAT returns to the day they are due. 

Let me end where I began with our gingerbread man. He may be dressed beautifully in a sugary superhero cloak. He may even be called VAT Man but he cannot beat the super villain who has decided he is a VATable item. The quirks are not going away and we need to be aware of all the pitfalls they create.


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