A VAT registered business charges VAT on its taxable sales (output tax), reclaims the VAT it pays on business purchases (input tax), and pays HMRC the difference on each VAT return, or receives a repayment if input tax is higher. Each business in a supply chain pays VAT only on the value it adds, and the full tax ends up being borne by the final consumer who cannot reclaim it.

What is VAT charged on?

Section 4(1) of the Value Added Tax Act 1994 charges VAT on any supply of goods or services made in the United Kingdom where it is a taxable supply made by a taxable person in the course or furtherance of a business. Section 4(2) defines a taxable supply as any supply of goods or services made in the UK other than an exempt supply. HMRC’s VAT guide (VAT Notice 700, paragraph 3.2) describes VAT as a tax on consumer expenditure that is collected on business transactions, imports and acquisitions.

Each element of that test can take a transaction out of VAT. Paragraph 3.2 lists supplies that are outside the scope of UK VAT because they are made by someone who is not a taxable person, made outside the UK and the Isle of Man, or not made in the course or furtherance of business. A taxable person is anyone who is, or is required to be, registered for VAT.

Taxable supplies then fall into one of three rates: standard, reduced or zero. Exempt supplies carry no VAT at all and sit outside the taxable regime. The rates are explained in VAT rates: standard, reduced and zero.

What is output tax?

Output tax is the VAT due on the taxable supplies a business makes (section 24(2) VATA 1994 and Notice 700, paragraph 7.1). It is worked out on the tax value of the supply, which is the consideration the business receives. Paragraph 7.2 confirms that consideration includes any payment covering the costs of making the supply, unless the business incurs those costs as an agent.

Where a price already includes VAT, the tax is found with the VAT fraction rather than by applying the rate. Notice 700, paragraph 7.3.1, gives the formula as rate divided by 100 plus the rate. At 20% the fraction is 20/120, or one sixth, and at 5% it is 1/21. HMRC’s own example is a sale for £2.40 at 20%, on which the VAT is 40 pence, which is one sixth of the price and not 20% of it.

What is input tax, and what can be reclaimed?

Input tax is the VAT a business is charged on its purchases and expenses, including goods and services supplied in the UK, imported goods and services received from abroad (Notice 700, paragraph 10.1). Under section 26 of VATA 1994 a business can recover input tax only so far as it is attributable to its taxable supplies, or to supplies outside the UK that would be taxable if made here.

Paragraph 10.3 lists VAT that cannot normally be reclaimed, including VAT on:

  • goods and services not used for the business
  • a car, including fitted accessories and delivery charges (see VAT on cars, vans and fuel)
  • business entertainment
  • costs relating to exempt supplies
  • any amount charged incorrectly

The business must also hold valid evidence, normally a VAT invoice, that it received a taxable supply (paragraph 10.6). Input tax should be claimed on the return for the period in which the supplier’s tax point occurred. Paragraph 10.5 sets a time limit of four years from the due date of the return on which the business was first entitled to claim it. If a business has not paid its supplier within six months of the date of supply, or the due date for payment if later, it must repay the input tax it claimed (paragraph 10.6.1).

How does the VAT return bring the two together?

Section 25 of VATA 1994 requires a taxable person to account for and pay VAT by reference to prescribed accounting periods. At the end of each period the business is entitled to credit for its allowable input tax and deducts it from its output tax. If there is no output tax, or the credit is larger, HMRC pays the excess as a “VAT credit” (section 25(3)).

The standard tax period is three months, and businesses are placed in one of three groups of quarter ends (Notice 700, paragraph 20.3). A business that normally receives repayments can ask for monthly periods. The return and any payment are usually due one calendar month and seven days after the end of the period, and the payment must reach HMRC’s account by then. In practice, output tax and input tax are tracked through a VAT control account that reconciles to Box 5 of the return.

When does VAT become due on a sale?

VAT is accounted for in the period in which the tax point falls, at the rate in force at that time (Notice 700, paragraph 14.1). The basic tax point for goods is usually when they are sent to the customer or collected, and for services it is when the work is performed, normally when everything except invoicing is complete (paragraph 14.2.1). This basic tax point is overridden by an actual tax point:

  • if a VAT invoice is issued or payment received before the basic tax point, the earlier of the two becomes the tax point for that amount
  • if a VAT invoice is issued within 14 days after the basic tax point, the invoice date becomes the tax point

Paragraph 14.2.2 stresses that once an invoice creates a tax point, VAT must be accounted for in that period even if the customer has not paid. Businesses that want to pay VAT only when they are paid need the cash accounting scheme.

How does VAT work through a supply chain?

Illustration only. A table passes from a timber merchant to a furniture maker, then to a shop, then to a consumer. All three businesses are VAT registered, all supplies are standard rated at 20%, and the merchant’s own purchases are ignored for simplicity.

Stage Net price Output tax charged Input tax reclaimed Paid to HMRC
Merchant sells timber to maker £1,000 £200 £0 £200
Maker sells table to shop £2,500 £500 £200 £300
Shop sells table to consumer £4,000 £800 £500 £300
Total £800

HMRC collects £800 in total, which is 20% of the £4,000 final selling price. Each business pays 20% of the value it added: the maker added £1,500 and the shop £1,500, so each paid £300. None of the businesses bears the tax as a cost. The consumer pays £4,800 and, not being able to reclaim input tax, carries the whole £800.

The chain breaks down where a business cannot recover input tax. If the shop’s sales were exempt, it could not reclaim the £500 charged by the maker, and that VAT would become part of its costs. That difference is explained in zero rated vs exempt supplies.

Who has to register?

A business must register if its taxable turnover for the last 12 months goes over £90,000, or if it expects taxable turnover to go over £90,000 in the next 30 days. It can register voluntarily below that level, for example to recover input tax. Taxable turnover includes zero rated and reduced rated sales but not exempt or outside the scope sales. The timing rules and effective dates are covered in our guide to the VAT registration threshold.

What mistakes come up most often?

  • Applying 20% to a VAT inclusive price instead of using the one sixth fraction, which overstates output tax.
  • Claiming input tax without a valid VAT invoice, or on blocked items such as cars and business entertainment.
  • Claiming input tax in the wrong period. Notice 700 treats a missed claim as an error that must be corrected under the error correction rules rather than simply added to a later return; see correcting VAT errors.
  • Waiting for payment before accounting for output tax on an invoice already issued, when the business is not on cash accounting.
  • Forgetting to repay input tax on supplier invoices still unpaid after six months.

If HMRC opens a check into your return, tax investigation insurance pays your accountant’s fees. Solar Protect cover pays up to £100,000 with no excess; it never pays tax, interest or penalties. Read how our cover works or get a quote.

Sources

Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.