How VAT works

VAT (Value Added Tax) is the tax added to most goods and services sold in the UK. If you run a business, understanding it matters even before you’re registered — because the threshold can creep up on a growing business. Here’s how it works.

What VAT actually is

VAT is charged at each stage of the supply chain, but ultimately it’s a tax on the final consumer. A VAT-registered business:

• Charges VAT on its sales (“output VAT”)
• Pays VAT on its purchases (“input VAT”)
• Pays the difference to HMRC on a VAT return, usually quarterly

Because businesses reclaim the VAT they pay on purchases, VAT doesn’t cost the business — it flows through to the end customer.

VAT through the supply chain

The “value added” part means each business pays over the VAT on the value it added, not on the whole sale price.

Worked example. A timber supplier sells wood to a furniture maker for £100 plus £20 VAT. The maker reclaims the £20, so the wood genuinely costs £100. The maker sells a table to a shop for £250 plus £50 VAT — paying HMRC the £30 difference (£50 output minus £20 already paid). The shop sells the table to a consumer for £400 plus £80 VAT, paying HMRC £30 (£80 minus £50). Total VAT collected: £20 + £30 + £30 = £80 — exactly 20% of the £400 final price.

The consumer can’t reclaim VAT, so they carry the whole cost. Every business in the chain simply handled their slice.

When you must register

For 2026/27 the registration threshold is £96,000. You must register if:

• Your taxable turnover exceeds £96,000 in any rolling 12-month period, or
• You expect it to exceed £96,000 in the next 30 days alone

You must register within 30 days of hitting the threshold. Once registered, you charge VAT on your sales (unless they’re zero-rated or exempt) and file VAT returns.

The threshold is based on your rolling 12-month turnover, not a calendar year — so a seasonal spike can trigger registration even if your annual average is lower. Keep a running total and check it monthly.

Voluntary registration

You can register before you reach the threshold. That’s often worth doing if:

• Your customers are businesses — they can reclaim the VAT you charge, so it doesn’t cost them, and registering makes your business look established.
• You buy a lot of VAT-inclusive goods — you reclaim the input VAT, which effectively cuts your costs by one-sixth of the VAT-inclusive price.

It’s less attractive if you sell mainly to the public: your prices will look about 20% higher to them. Weigh the admin and the price effect before volunteering.

The rates

• Standard — 20% — most goods and services
• Reduced — 5% — domestic fuel and power, some home energy-saving installations
• Zero — 0% — most food, books, newspapers, children’s clothing, public transport
• Exempt — e.g. financial services, insurance, education, health

Zero-rated sales still count toward the threshold and you can still reclaim input VAT. Exempt supplies don’t count toward the threshold and generally stop you reclaiming VAT on related costs.

Adding and removing VAT

Adding VAT is straightforward: multiply the net price by the rate.

Worked example. A service costs £100 net. At 20%, VAT is £20, so you invoice £120 gross. When you make purchases, VAT is already inside the price: a £120 bill is £100 net plus £20 VAT, which you can reclaim.

Removing VAT is the reverse — divide the gross price by 1.2 to find the net, and the difference is the VAT.

Gross price	Net (÷ 1.2)	VAT
£12.00	£10.00	£2.00
£60.00	£50.00	£10.00
£120.00	£100.00	£20.00
£240.00	£200.00	£40.00

How VAT affects your prices

Once registered, you must include VAT in the prices you quote to customers — unless you say it’s excluded. If you sell mainly to the public, registration makes your prices look 20% higher. If you sell to VAT-registered businesses, they simply reclaim the VAT, so it doesn’t cost them.

VAT returns and record keeping

Most VAT-registered businesses file quarterly VAT returns, and all new VAT-registered businesses must keep digital records and file using compatible software under Making Tax Digital (MTD). You’ll need:

• Your total sales and purchases (net and VAT)
• The VAT on any reduced or zero-rated items
• Correct VAT invoices for sales over £250

There are two common mistakes: forgetting the VAT on a mix of rate bands, and reclaiming VAT on purchases with no valid invoice. Both are easy to avoid with a decent bookkeeping habit — see our business bookkeeping basics guide.

Small business schemes

HMRC offers schemes that reduce admin: the Flat Rate Scheme (pay a fixed percentage of turnover instead of the detailed VAT calculation) and Annual Accounting (one return a year). They’re not always cheaper, so compare before joining. The flat rate scheme works especially well for low-cost, high-margin businesses, but usually means you give up reclaiming input VAT.

Work out the numbers

Use the VAT calculator to add or remove VAT at any rate, and see the net, VAT and gross amounts instantly.