One of the most frustrating things about VAT is that it’s not neutral. So what does that mean and why is VAT never neutral?
Compared with company tax or income tax, or the “direct” taxes; VAT operates in a different way. For example, if you own a company then you’ll know that the company pays corporation tax on its profits at the end of the year. It’s a single calculation done each year. You add up all of the income and take off the purchases and expenses and any other deductions and you pay CT on the amount remaining.
VAT: the transaction tax
Most of you will know that VAT isn’t like that. It’s true to say that a VAT registered business’s quarterly VAT return is calculated in much the same way, but the difference is that every single sale or purchase or expense has it’s own VAT liability. In other words, the quarterly return isn’t just the output tax on sales less the input tax on purchases and expenses; in fact when it comes to VAT, every single sale and every single cost is liable to VAT in its own right, whether it’s at 20%, 5%, the zero-rate or even VAT exempt. So when you do the VAT return, you’re working out the liability based on the sum of the VAT on every single transaction in that period.
What does this mean? Well suppose you sell clothes, both adults and children’s clothing. All of your sales are “taxable”, the adults at 20% and most of the children’s at the zero-rate. Your output tax for the period is calculated by adding together the VAT charged on each individual sale that is liable to VAT. But even though your sales are all “taxable”, that doesn’t mean you can claim VAT on all your costs.
Isn’t it VAT neutral if the final use is “taxable”?
Clients often ask if it all really matters if, ultimately, one business (A Ltd) charges VAT and another business (B Ltd) claims the VAT. In this case, B Ltd only makes taxable supplies so it can claim all of the VAT on its costs. Unfortunately, that’s not correct. In fact, it’s a basic principle of VAT that YOU CAN ONLY CLAIM VAT THAT HAS BEEN CORRECTLY CHARGED.
Let’s consider a couple of practical examples.
- Charges between associated companies
Suppose A pays the annual premium for B’s insurance policy. It recharges the exact amount to B, adding VAT. Unfortunately B can’t claim the VAT charged by A, even though B’s only makes taxable sales for VAT purposes. As I’ve said many times in the past, charges between associated businesses are one of the messiest subjects when it comes to VAT. You have to consider each type of recharge to determine the correct treatment because each recharge is a transaction and you have to establish the correct VAT liability every time you issue an invoice or receive a payment. Check out my ebook: VAT on intercompany services, management charges etc for more about this subject.
- Property stuff
Suppose you have a group of companies, the main business activity being the provision of serviced accommodation. Co A is a development company, buying and refurbishing or converting properties that are sold on completion to Co B, the leasing company. Co B leases the properties to Co C, which operates the serviced accommodation business. In this case, even though the end use of the properties is liable to VAT at 20%, Co A can’t claim the VAT on the conversion costs. In this case, Co A may be able to claim VAT if the sale of certain converted properties qualifies for the zero-rate, but otherwise its sales are VAT exempt and it can’t claim any VAT.
So why is VAT never neutral?
That’s why VAT is never neutral. You have to consider each and every transaction individually. You can’t “look through” to the end use – you have to consider every single transaction in the chain of purchases and sales to determine if you can claim VAT on costs.