Before you can understand why businesses are allowed to claim their VAT back, it must first be understood which businesses can reclaim VAT and also how the VAT system works.
VAT stands for Value Added Tax and is charged on a large number of goods that are sold in the UK. The current rate of VAT is 20% and this percentage is added on to the price of goods sold by retailers and service-providers.
Which Businesses Does VAT Apply To?
Only businesses that are VAT-Registered are able to charge and reclaim VAT; VAT registration becomes mandatory after a business reaches turnover of £85,000 as of April 2020 and more guidance on registration can be found on the government website: Here
A business can register at any point and does not have to meet a turnover threshold before doing so; there are multiple reasons why a business may consider doing this which are not relevant to this article.
Charging/Reclaiming VAT
After a business becomes registered for VAT, it MUST immediately add the charge of 20% to all of the goods/services it sells, unless they are exempt items. In doing this, they are effectively charging their customers a tax charge on behalf of the government. It is absolutely crucial to understand that a business does not keep one single penny of the VAT it charges to it’s customers. This charge is known as output VAT – the VAT that has been charged on the business’ outputs (sales). Records of this are kept and declared to HMRC at the end of a VAT period by the way of submitting a VAT return and the VAT that the business has collected on behalf of HMRC will be paid over.
When the business buys goods for resale/manufacturing, they will likely also be paying VAT on the goods that they have purchased. This is known as Input VAT – the VAT that has been charged on the business’ inputs (purchases). As with Sales tax, records of the purchase VAT paid will be kept and declared on the VAT return and are deducted from the end balance that is due to be paid over to the HMRC.
So why can Input VAT be reclaimed?
Essentially the intention of VAT is for it to be paid by the end consumer. The product in question may pass through many hands before it reaches the shop and is bought by the consumer. Therefore, the Input VAT can be reclaimed by all of the producers/retailers of the end product as the end customer will likely be unable to reclaim the VAT as they will be an individual member of the public.
Example
If we take a simple example of a shirt:
- The shirt manufacturer purchases all the necessary materials for producing the shirt: the buttons, fabric etc. On each of these items, the manufacturer paid VAT to the seller and then reclaimed the VAT back from HMRC.
- Once the shirt was made, it was sold to a wholesaler. Again VAT was charged on this sale and the wholesaler later reclaimed the VAT back from HMRC.
- The shirt was bought from the wholesaler by a department store. VAT was charged on the sale to the department store who later reclaimed the VAT back.
- Finally, a customer comes into the department store and purchases the shirt. The price the customer has paid for the shirt is inclusive of VAT and the department store is responsible for charging this VAT to their customers and then paying it over to HMRC.
Clearly, the customer the bought the shirt will not be able to reclaim the VAT and thus the final VAT due on the shirt has been reclaimed by HMRC without having an effect on the producers.
This also ties in to the view that since business are effectively carrying out the tax-collection work themselves and having to carry the burden of doing so, they are entitled to reclaim the tax that they pay over to other companies. The VAT system is perpetual and will always result in some VAT being paid over to the government.
VAT is just one of the many taxes levied by the government; I have written a guide around income tax which can be found here.