What is VAT exemption (and who does it apply to?)
A value-added tax (VAT) is a type of tax that is applied to taxable goods and services at every stage in the supply chain. There are some goods and services that the government deems as not taxable or VAT exempt. There are also some items that are entirely out of scope of VAT.
Exempt and out of scope items are not the same as reduced or zero-rated items. Even though less or no VAT is charged on reduced rate items, these rates are still officially considered VAT taxable (VATable) and thus differ from exemption.
If you sell only VAT exempt items, you cannot become VAT registered and therefore are a VAT exempt business. If you sell some exempt items but also some taxable items then you are a partially exempt business.
VAT exemption means that you cannot register for any VAT scheme because you do not sell any taxable items to your customers. That said, you may still need to buy some taxable items to conduct your business, in which case you must still pay VAT on those items and cannot reclaim VAT credit for those purchases.
On the other hand, partially exempt businesses can become VAT registered and thus can reclaim VAT on certain taxable purchases that they make.
In this article, we’ll unpack the spider web of what qualifies as taxable or not taxable goods and services, explore the difference between VAT exempt, out of scope, reduced and zero rates, examine the benefits and drawbacks of being VAT exempt and outline how partially exempt businesses can register for VAT.
Table of contents
- How does VAT work?
- What is VAT exemption and who does it apply to?
- The benefits and drawbacks of VAT exemption
- Wrapping up
How does VAT work?
Before we dive into the specifics of VAT exemption, it’s important to fully grasp the basics of VAT. VAT represents the ‘value-added’ to goods or services as they move through the supply chain (e.g. from the manufacturer or supplier to the business (you) and ultimately the customer).
VAT is a consumption tax that applies to many types of goods or services, both physical and digital. Essentially, VAT registered businesses collect VAT on behalf of the government and pay it back to them throughout the year. The exact payment schedule and amount depends on your chosen VAT scheme and/or your specific industry rate.
VAT registered businesses are responsible for charging an output tax to customers (similar to sending an invoice) and also paying an input tax to suppliers (similar to paying an invoice).
In the case that your business has paid more VAT to suppliers than what you charged to customers, you must reclaim the difference from HM Revenue and Customs (HMRC). If the opposite is true and you’ve earned more VAT from customers than you’ve paid to businesses, you must pay the difference to HMRC.
As you are simply acting as a tax collector for HMRC, the idea is that you pay as much as you collect, or reclaim the difference, and ultimately break even.
As we will explore in detail in the next section, if your business only sells VAT exempt goods or services then you cannot register your business for VAT because you are a VAT exempt business. However, if you are partially exempt because you sell some goods or services that are exempt and others that are not, you must still register for VAT if you meet the threshold requirements.
At time of writing, the VAT registration limit or threshold is £85,000, which means that if you make annual sales in excess of the limit you must register your company for VAT, regardless of your business type.
Alternatively, you can voluntarily register for VAT even if you know that you won’t meet the threshold so that you can reclaim the VAT that you pay to other businesses by passing the charge onto your customers.
Top Tip: There are many benefits and drawbacks to voluntarily registering for VAT. Learn more about what those are, the alternative VAT schemes you can choose from to save money as a small business, how to charge VAT, how to create a VAT invoice and much more in our guide to everything you need to know about VAT.
What is VAT exemption and who does it apply to?
VAT works like a well-oiled machine when VAT registered businesses that buy and sell taxable items do business with each other. It gets more complicated when exempt, out of scope, reduced rate and zero-rated items come into the picture.
While complicated, these exceptions are a wonderful thing. They exist to make certain goods or services more accessible to the general public, especially those experiencing financial difficulties.
Often, the nature of those goods or services is considered necessary for the public to easily access. Examples include healthcare and medical services, charitable organisations, grants or loans, energy, maternity products and so on (we’ll get more specific in the subsequent sections).
Therefore, the government does not want those businesses to have to increase their prices by charging VAT to their customers. Fully exempt businesses do not have to worry about VAT at all, whereas partially exempt businesses have to navigate some complicated rules, regulations and paperwork (more on that below).
Note: At time of writing, the standard VAT rate under the standard VAT scheme is 20%. The reduced rate is 5% and the zero rate is 0%.
Exempt goods or services
Some items are entirely exempt or out of the scope of VAT. If you only sell exempt or out of scope goods or services then you cannot register for VAT and you will be a VAT exempt business.
As an exempt business, you cannot reclaim VAT credit for items that you purchase for your business operation.
For example, all health services provided by registered doctors, dentists, opticians, pharmacists and other health professionals are VAT exempt. That said, they still may require taxable services to conduct their business, such as paying an accountant or bookkeeper for financial assistance. In that case, the health service business cannot reclaim the VAT they pay to their accountancy firm.
The following items are exempt or ‘out of scope’ and therefore not subject to VAT:
- Postage stamps or services
- Health services provided by doctors
- Sales made as part of a hobby, like coin collection and sales
- Donations made to a charity if nothing is received in return
- Statutory fee, like the London congestion charge
- Grants or licences used to occupy property, land or buildings
- Granting credit loans
Reduced rate items
Some items are set at a reduced rate of 5%. If you sell reduced rate and exempt items you must still register for VAT if you meet the threshold and you will be a partially exempt business.
If you do not sell any exempt items but sell many reduced rate items, you are not a partially exempt business. You simply are a regular business that sells many reduced rated goods or services.
The following items often have a reduced rate:
- Children’s car seats
- Mobility aids
- Maternity products
- Protective products and services
- Power (electricity, gas and fuel) for domestic and residential use or for non-business use by a charity
In light of COVID-19, the UK government is issuing a temporary reduced rate of VAT for hospitality, holiday accommodation and attractions. The temporary dispensation is an effort to support businesses that have been severely affected by the coronavirus pandemic and need some financial relief. This reduced rate is in effect from 15 July 2020 to 12 January 2021.
According to GOV.UK, this special reduced rate applies to “organisations that make supplies of hospitality, hotel and holiday accommodation and admission to certain attractions, and their advisers.”
To learn more and see if you qualify, visit GOV.UK’s reduced rate for hospitality, holiday accommodation and attractions page.
Zero-rated items have a 0% rate applied to them. Items given a zero-rate are considered highly necessary or critical components in a supply chain and therefore the 0% rate makes them more affordable for buyers.
If you do not sell any exempt items but sell many reduced rate or zero-rated items, you are not a partially exempt business and you will be able to recover all of your input tax, or the tax you paid to suppliers, for goods or services.
The following goods or services are often zero-rated:
- Children’s clothes
- Publications such as books, brochures, leaflets, pamphlets and more
- Prescription medicines
- Food and drink, with some exceptions such as alcoholic drinks and ice cream, for example
- Certain animals, animal feeding products, plants and seeds
- Donated goods sold by charity shops
Some businesses will buy 0% items and then use those materials to produce standard rate items that they must charge a higher percentage of VAT on. This is often the case when it comes to restaurants, as raw food and drink materials are often zero-rated but standard VAT must be charged on the final product.
It’s important to note that zero-rate is not the same as exempt. Even though zero-rated goods are VAT free, it’s still a rate of tax and thus must be recorded in VAT accounts and reported in VAT returns.
For example, if you sell a mixture of zero-rate or reduced rate items, you must still tally the net value of the sale as part of your VAT taxable revenue.
GOV.UK has issued a how to fill in and submit your VAT Return (VAT Notice 700/12) notice, which goes into detail on how to fill out your VAT return. Section “3.7. Filling in box 6” explains exactly how you can show the total value of your sales while excluding reduced rate items.
What about discounts and free gifts?
The VAT rate for discounts and free gifts varies depending on the discount or gift type.
For example, if you are giving away an item for free alongside a purchase, no VAT is due on the free item. If you are discounting an item, standard VAT is due on the discounted price. Further, you do not have to pay VAT on free samples as long as they follow certain conditions.
For the full details on the rules that apply to discounts and gifts, visit GOV.UK’s discounts and free gifts page.
Top Tip: For a full and up to date list of exempt, out of scope, reduced rate and zero-rated items, visit GOV.UK’s VAT rates on different goods and services directory.
The benefits and drawbacks of VAT exemption
Most businesses don’t have a choice in whether or not the items they buy or sell are VAT exempt. The decision is often determined by the pure nature of your business.
VAT exempt businesses
If you do fall into the VAT exempt category and thus cannot become VAT registered, you will experience several benefits:
- Save money on the items that you purchase for your business, assuming that your supplier is also a VAT exempt business
- Do not need to charge your customers VAT, thus can offer lower prices
- Do not need to keep VAT records
- Do not need to submit VAT returns
- No impact on cash flow
However, VAT exempt businesses also experience some drawbacks:
- Cannot reclaim any VAT that you paid to a VAT registered business for goods or services unless the VAT is below certain limits (see section 11 of Partial exemption (VAT Notice 706) for more details).
- Having a VAT registration number can add credibility to your business, but once you make it clear that you are VAT exempt this should be a moot point
Partially exempt businesses
If you are partially exempt because you sell both taxable and nontaxable goods or services, things get a bit more complicated. The only items that do not count as taxable are exempt or out of scope, so you still need to account for your zero-rated, reduced rate and standard rate items in your VAT records.
Here are some benefits that partially exempt businesses enjoy:
- Can reclaim the VAT you pay to VAT registered businesses for goods or services
- VAT can make your business appear more credible and established, thus expanding your options when considering what businesses to buy from and sell to
- Displaying a VAT number on your website can make your business more appealing, especially to larger businesses
Here are some of the drawbacks that partially exempt businesses face:
- Must keep VAT records, and more specifically keep separate records for your VAT-exempt vs. non-exempt sales and purchases
- Must file VAT returns, which may affect your cash flow
- Adding VAT to your sales will increase your prices and potentially deter your customers
- If you end up charging more VAT to customers than you pay to businesses, you will need to pay HMRC the difference, which could negatively impact your finances if it is a large lump sum
Top Tip: Calculating VAT is no easy task for partially exempt businesses. Accounting for both taxable and exempt items calls for far more complicated accounting than standard VAT calculations. To learn more about partially exempt businesses and specifically how to calculate VAT as one, read our detailed guide to what VAT partial exemption is and who it applies to.
Businesses that mainly sell zero-rated items
If you primarily sell zero-rated items and are over the threshold, you can apply for a VAT exemption to avoid VAT paperwork. You can also apply for a VAT exemption if you think you will temporarily exceed the threshold but at the end of the year will still be underneath the limit.
You have to weigh up whether or not the time spent on VAT paperwork is better or worse than the ability to reclaim VAT spent on taxable supplies or services.
For more details on how to apply for a VAT exemption, read paragraph 3.11 “When you might be exempt from registration” of VAT Notice 700/1.
VAT for charities
If you are a VAT registered business, you can sell goods or services to charities at a zero or reduced rate.
If you are a charity, you must register for VAT once your taxable sales exceed the £85,000 threshold—making you a partially exempt business. There are detailed guidelines for charities on GOV.UK’s website that outline what items and activities are considered VAT exempt, out of scope, zero-rated or reduced rate. For example, admission charges for events that you may hold are exempt from VAT, but advertising services are 0%.
If you are not a charity, you alone are responsible for double-checking that the charity is eligible for reduced rates, as some may not be. For example, community amateur sports clubs (CASCs) don’t qualify for VAT reliefs.
In order to do everything by the book and guarantee eligibility, the charity must give you their Charity Commission registration number and a letter of recognition from HMRC if they are not registered with the Charity Commission for England and Wales.
You alone also must figure out what the VAT rates are when working with charities so that you apply the correct rate when sending your VAT invoice. The charity is also legally required to give you an eligibility certificate if you are charging a 0% VAT rate.
To learn more, visit GOV.UK’s charging VAT to charities page.
VAT exemption is straightforward if you are a business that does not sell any taxable goods or services, thus are VAT exempt.
If you are a partially exempt business, VAT exemption is more complicated and requires strict record-keeping and more complicated methods when it comes to filing your VAT return.
If you are a business that is VAT registered but sells mostly reduced rate or zero-rated items, you can apply for VAT exemption and may be granted an exemption if your circumstances are deemed justified.
VAT exemption has many benefits and drawbacks and the right choice for your business depends entirely on your unique circumstances. After reviewing all of the rules and regulations yourself, consider hiring an accountant to help ensure you are following the correct procedures and avoid any penalties.
Photo by Anastasia Shuraeva, published on Pexels