Many business owners think VAT is simple: if you are registered, you add 20%. In practice, the rate depends on what you are selling, who you are selling to, where the supply takes place and whether certain conditions are met. A supply might be standard-rated, reduced-rated, zero-rated, exempt or outside the scope of VAT altogether.
Get it wrong and you could undercharge your customers and have to pay the difference yourself, or overcharge them and lose sales. You could also face interest and penalties.
Want your VAT returns done right?
We prepare and file VAT returns using Making Tax Digital software. Get a fee estimate in minutes.
Get a Fee EstimateThe five VAT treatments at a glance
| Treatment | Rate | Common examples | Can you reclaim VAT on related costs? |
|---|---|---|---|
| Standard-rated | 20% | Most goods and services, confectionery, adult clothing | Yes |
| Reduced-rated | 5% | Domestic fuel and power, children’s car seats, renovating homes empty for at least 2 years | Yes |
| Zero-rated | 0% | Most food, children’s clothes and footwear, books and newspapers, new homes | Yes |
| Exempt | None | Insurance, most financial services | Generally no |
| Outside the scope | None | Freely given tips, many statutory fees | Depends on the business’s other activities |
Standard rate: the default, but do not assume
The standard rate is 20% and applies unless the law says otherwise. Do not assume a product is standard-rated just because a similar one is. Small differences in ingredients, presentation or use can change the answer.
The best-known example is the Jaffa Cakes case (United Biscuits, 1991). Cakes are zero-rated, but biscuits wholly or partly covered in chocolate are standard-rated. The tribunal looked at the ingredients, the sponge texture and the fact that Jaffa Cakes go hard when stale, like a cake, and decided they were cakes. HMRC’s own VAT Food manual still uses this case to explain the borderline.
Reduced rate: 5%
The 5% rate applies only to specific items listed in VATA 1994, Schedule 7A. Examples include domestic gas and electricity, and certain building work such as some residential conversions and renovating homes that have been empty for at least two years. By contrast, building a qualifying new home can usually be zero-rated if the conditions are met.
Zero-rated: taxable at 0%
Zero-rated supplies (VATA 1994, Schedule 8) are still taxable supplies, just at 0%. That has two big advantages. First, they count towards your taxable turnover. Second, you can usually reclaim VAT on the costs of making them. A business selling only zero-rated goods can register, charge no VAT and still get VAT back on its purchases, often receiving repayments from HMRC.
Not sure which rate applies?
Borderline products and mixed supplies are where mistakes happen. Book a free call to talk it through.
Book a Free CallExempt: no VAT, but no reclaim either
Exempt supplies (VATA 1994, Schedule 9) also carry no VAT, but they are not taxable. That means you generally cannot reclaim VAT on the costs of making them, and they do not count towards the £90,000 registration threshold. A business making only exempt supplies does not need to register, however large its turnover.
If you make both taxable and exempt supplies, you may be partially exempt. You then need to work out how much of your input VAT relates to taxable supplies, which can be complex.
Worked example: zero-rated versus exempt
Two businesses each have sales of £200,000 and pay £60,000 plus £12,000 VAT on their costs.
Business A sells children’s clothing (zero-rated). It charges no VAT to customers but reclaims the full £12,000 from HMRC. Its costs are £60,000.
Business B provides insurance services (exempt). It also charges no VAT, but cannot reclaim the £12,000. Its real costs are £72,000.
Same sales, same purchases, but Business B is £12,000 worse off purely because of how its supplies are treated.
Outside the scope
Some receipts are not part of the VAT system at all. A tip a customer chooses to leave in a restaurant is outside the scope, because it is not payment for the meal. A compulsory service charge is different: HMRC treats it as part of the price of the meal, so VAT is due on it, even if it is passed on to staff.
What happens if you get it wrong
Using the wrong rate affects what you charge, what you can reclaim, whether you need to register and how your VAT return is filled in. A mistake made despite taking reasonable care should not lead to a penalty. Otherwise, under FA 2007, Schedule 24, the maximum penalties are:
| Type of error | Maximum penalty (% of VAT lost) |
|---|---|
| Reasonable care taken | No penalty |
| Careless | 30% |
| Deliberate | 70% |
| Deliberate and concealed | 100% |
Penalties can be reduced, sometimes to nil for a careless error, if you tell HMRC before it finds out and help it put things right. Interest is charged on late-paid VAT as well.
Practical tips
- Check the VAT treatment of every product or service line, not just the main ones.
- Remember the key difference: zero-rated and exempt both mean no VAT for the customer, but only zero-rated supplies are taxable.
- Review your treatment whenever you add new products or change suppliers.
- If in doubt, check HMRC’s VAT notices or take advice before you invoice.
Hand your VAT to the experts
From bookkeeping to quarterly VAT returns, we keep your rates right. Request a fee estimate today.
Get a Fee EstimateDisclaimer: This article is for general information only and does not constitute legal, tax or financial advice. Your specific position depends on your individual circumstances. Always speak to a qualified tax adviser before making any decisions.
