In the UK we use VAT (value added tax). This is a form of sales tax, which means charging an extra percentage on goods and services that are sold, and passing this on the government.
So what exactly is VAT, when it it used, and how do we calculate it?
What is VAT?
Unlike the sales tax used in countries like the United States, VAT is imposed each time value is added during the production process, not just on the sales price at the end.
For example, when a TV is sold, VAT will have been charged on each component bought by the manufacturer, and on the finished product bought by the seller from the manufacturer, not just on the price paid by the customer.
VAT registered sellers can normally reclaim the VAT they have paid at each stage of production. The logic is that sellers are encouraged to register for VAT and charge it to their customers, as this is the only way they can reclaim the VAT charges faced throughout the production process.
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What is the VAT rate?
Almost everything that is bought and sold in the UK has VAT added to it, and the standard rate of VAT currently is 20%. There are other rates of VAT, including the reduced rate of 5%, and zero rated VAT, which is (as you might guess) 0%.
One type of product for which 5% VAT is applied is heating costs for domestic fuel. Goods that are zero rated tend to be essential, including some food and children’s clothes.
Who must charge VAT?
If a company’s turnover from selling goods and services that are not VAT exempt is more than £82,000, they will have to register for VAT. Companies that are VAT registered must charge VAT to customers on applicable items. Read our blog post on when to register for VAT.
How to calculate VAT
Calculating VAT from the net figure
In most cases, VAT means charging 20% on top of the sales price. Say you have goods with a sales price of £100; you will need to multiply this by 0.2 to give 20%, giving you a VAT figure of £20. The £20 is added to the net figure of £100 to give a new total sales price of £120.00.
Calculating VAT from the gross figure
If you have been given the gross figure rather than the net figure, this means that VAT is already included. To find out what VAT has been added, you will need to look at the gross figure as 120%.
Let’s say the gross figure is £120. As this represents 120%, divide £120 by 120, giving you £1. This can then be multiplied by 20 to give the VAT figure of £20.
Find out more about calculating percentages within accounting in this blog post.
How to include sales tax in prices
Whether sellers display the net or gross figure normally depends on whether customers are able to reclaim the VAT.
Shops that sell directly to consumers will not need to display the VAT figure, as consumers cannot become VAT registered and reclaim the VAT. Therefore, they will usually only display the gross figure.
Businesses that are registered for VAT will need to charge VAT on their sales invoices, but they will also be entitled to reclaim the VAT on any purchase invoices they receive. Therefore, retailers whose customers are VAT registered businesses will normally display net figures and VAT charges separately.
A thorough understanding of how sales tax, and particularly VAT, works is essential for anyone looking to go into accounting.