The basic rule for VAT is that everything is subject to VAT at the standard rate unless the legislation makes an exception for it. The list of zero-rated supplies is contained in Schedule 8 of the VAT Act 1994.
Zero-rating applies to most basic food stuffs, water and sewage services, books and newspapers, some building works, exports, transport services such as buses, trains and aircraft, new residential accommodation, some supplies to charities and children’s clothing. Even though there is no VAT on zero-rated supplies, the zero-rate is a rate of tax, and businesses that make only zero-rated supplies can register for VAT and recover the VAT on their costs and overheads.
What is Exempt?
Exempt supplies are outside the VAT regime and are not a rate of tax, as such if you only make exempt supplies you cannot register for VAT and you cannot recover any VAT on costs attributable to making the exempt supplies. If you make both taxable and exempt supplies you can register for VAT but you will not be able to recover all of the VAT on your costs.
What are Exempt Supplies?
Exempt supplies are listed in Schedule 9 of the VAT Act 1994 and include: most supplies of land and ‘second hand’ residential properties and residential property rental, insurance, education, health, betting, finance, postal services, professional subscriptions, sports competitions and some charity fund raising events and cultural activities.
A common trap that businesses fall into is where they normally make zero-rated taxable supplies, but change their mind, often due to economic circumstances, and end up making exempt supplies and do not consider the implication on VAT recovery.
For example, a building company that normally builds and sells residential property buys an old office block and converts it into flats. The intention is to sell them (zero-rated taxable supply) so he recovers all of the VAT.
Because of the slump in the housing market he decides to rent them out (exempt supply) so potentially he now has to pay back all the VAT he has claimed on the conversion costs.
Another example would be an accountant who decides to expand his business into providing financial advice and starts receiving sales commission from the financial products he recommends. This income is exempt from VAT and he suddenly finds that a percentage of his VAT on overheads is irrecoverable.
Make sure you are aware of the difference between zero-rated and exempt supplies and the effects that it can have on your ability to recover the VAT on your costs. If you are going to make exempt supplies, you will need to factor in the extra costs of the irrecoverable VAT before you start, or else you could be in for a nasty and costly surprise.
If you make both exempt and taxable supplies you are what is called partly exempt, and every quarter you will need to do a calculation to see how much VAT you can recover.
By Andrew Needham
This article was first printed in Tax Insider in November 2010.