How does VAT work?

VAT is a tax applied to most goods and services supplied in the UK. The standard rate is 20%, but depending on the circumstances, VAT may be charged at the zero rate or the reduced rate of 5%. Some supplies are exempt from VAT, and some transactions are outside the scope of the tax altogether. 

VAT-registered businesses charge output VAT on their sales, collect it from their customers, and pay it to HMRC. Where VAT is charged on a supply from one VAT-registered business to another, the purchaser may be able to recover from HMRC the VAT it incurred on the purchase as input tax. 

There are several special regimes to help businesses manage their VAT obligations, including the flat rate scheme. 

How important is VAT?

The government’s figures suggest that, for 2024/25, VAT was the third-biggest tax in terms of revenue raised, contributing £171bn. This was equivalent to 20% of the total tax raised. Only income tax and national insurance brought in more in tax.

Which businesses are VAT registered? 

A business must register for VAT if:

• its taxable supplies for the last twelve months are more than £90,000 (the turnover threshold); or
• it expects its taxable supplies to exceed £90,000 in the next 30 days. 

It is possible for a business to register for VAT voluntarily. 

Should the threshold be changed?

The turnover threshold was last changed in April 2024, when it was increased from £85,000. It had been frozen at that amount since April 2017. When the increase to £90,000 was announced in March 2024, the then government said this would give the UK the joint highest threshold in the OECD.

It is generally accepted that some businesses take action to prevent their turnover from exceeding the threshold to avoid having to register for VAT. This may include turning down work or delaying plans to expand by taking on more employees or buying equipment. This is a barrier to growth in the UK. 

However, opinions are divided on whether the threshold should be increased or lowered, or if a different approach would give better results. 

The case for reform

With its exemptions, multi-rate structure and special regimes, VAT can be complicated and costly for businesses to apply. The experiences of other countries, including New Zealand and Singapore, suggests that the UK could benefit from moving to a system where VAT is charged at a single rate on a broader range of supplies, with lower-income households compensated for any increase in VAT. 

That is why, in 2024, ICAEW launched its How to Fix VAT campaign, bringing together experts, businesses, and policymakers to generate debate about how to create a tax system fit for the 21st century. Visit the campaign page to learn more. 

Successful reform will depend in part on greater and improved use of technology. ICAEW welcomes the government’s commitment to encourage the adoption of e-invoicing.