What is VAT and How VAT Works in the UK

Value Added Tax (VAT) is a mandatory consumption tax levied on most goods and services sold in the United Kingdom, administered by HM Revenue & Customs (HMRC).

For the 2025 tax year, businesses with a taxable turnover above £90,000 must register for VAT and submit digital returns through HMRC’s Making Tax Digital (MTD) platform using compatible accounting software such as Xero, QuickBooks, or Sage.

VAT applies differently to imports, exports, and cross-border digital services under post-Brexit trade rules. Accurate calculation of input and output tax, timely submission of VAT returns (Form VAT100), and proper record-keeping are essential for compliance and to maintain effective cash flow management.

This 2025 VAT guide outlines the registration criteria, reporting obligations, and practical steps to ensure full adherence to UK VAT legislation.

Understanding the Core: What is VAT?

Value Added Tax, or VAT, is a consumption tax levied on most goods and services sold in the UK. Unlike income tax or Corporation Tax, VAT is a tax on the transaction itself, collected by businesses on behalf of HM Revenue & Customs (HMRC). It’s essentially a tax on the “value added” at each stage of a product’s supply chain, from raw material to final consumer.

The key to understanding how VAT works is recognising that the ultimate burden of the tax falls on the final consumer, who cannot reclaim it. Businesses, however, act as HMRC’s tax collectors: they charge Output VAT on their sales and pay Input VAT on their purchases. The net difference is what is paid to or reclaimed from HMRC.

The Mechanism: How VAT Works at Every Stage

How VAT works is a cyclical process involving two main components:

1. Output VAT: The VAT that a registered business charges to its customers on the goods or services it sells.
2. Input VAT: The VAT that a registered business pays to its suppliers on business-related purchases.

When a business files its VAT Return (usually quarterly), the calculation is straightforward:

VAT Payment/Refund = Output VAT Collected − Input VAT Paid

• If the Output VAT is higher, the business pays the difference to HMRC.
• If the Input VAT is higher (often the case for businesses with large investments or those selling zero-rated goods), the business reclaims the difference from HMRC.

This structure ensures that tax is paid on the value added at each step, preventing ‘tax on tax’ and maintaining neutrality for VAT-registered businesses in the chain.

UK VAT Rates for 2025: Know Your Percentages

The UK operates a multi-rate VAT system. Knowing the correct rate to charge is a crucial part of understanding how VAT works for your specific products and services.

VAT Rate	Percentage	Applicability	Key Examples (2025)
Standard Rate	20%	Applies to most goods and services.	Electronics, professional services (accountancy, legal), adult clothing, alcohol.
Reduced Rate	5%	Applies to certain essential or beneficial supplies.	Domestic fuel and power (gas and electricity), children’s car seats, energy-saving materials installed in residential accommodation.
Zero Rate	0%	Taxable supplies where the rate is 0%. Businesses charge no VAT but can still reclaim Input VAT.	Most food (excluding restaurant meals, takeaways, confectionery), children’s clothing, books, newspapers, most medicines dispensed on prescription.
Exempt Supplies	N/A	Outside the scope of VAT. Businesses cannot charge VAT nor reclaim Input VAT on related costs.	Insurance, certain financial services, education and training by eligible bodies, certain land/property transactions.

The distinction between a Zero Rate and an Exempt Supply is vital to grasp how VAT works and impacts a business’s finances. A business with high sales of Zero-Rated goods benefits greatly as it can reclaim Input VAT, whereas a business with high sales of Exempt goods is unable to reclaim any associated Input VAT, leading to an irrecoverable cost.

Mandatory Registration: The £90,000 Threshold (2025)

One of the first questions any entrepreneur asks is, “Do I need to worry about what is VAT yet?” The answer hinges on your taxable turnover.

For the 2025 financial year, the mandatory VAT registration threshold for UK businesses is £90,000.

Key Rules for Registration in 2025:

• Historic Test: You must register if your total VAT taxable turnover (including zero-rated sales, but excluding exempt sales) has exceeded £90,000 in the previous rolling 12-month period. You must notify HMRC within 30 days of the end of the month in which you breached this limit.
• Forward-Look Test: You must register if, at any point, you expect your taxable turnover to exceed £90,000 in the next 30 days alone. You must register by the end of those 30 days.

Failure to register on time can result in significant penalties and backdated VAT liabilities. Understanding these thresholds is essential to properly calculate what VAT is owed.

Voluntary Registration

Even if your turnover is below £90,000, you can choose to register voluntarily. This is often a strategic business decision:

• Benefit: Allows you to reclaim Input VAT on significant business purchases (e.g., equipment, stock). If your business is buying more than it’s selling (or selling zero-rated goods), voluntary registration can lead to valuable VAT refunds, improving cash flow.
• Drawback: It requires administrative work (quarterly returns) and may make your goods or services more expensive for non-VAT registered customers.

The Compliance Landscape: Making Tax Digital (MTD)

A critical component of how VAT works in the UK for 2025 is the full adoption of Making Tax Digital (MTD) for VAT. This digital compliance initiative means that VAT-registered businesses must:

1. Keep digital records of their transactions using MTD-compliant software.
2. Submit their VAT Returns directly from that software using a digital link to HMRC.

This move by HMRC is designed to reduce errors and improve the efficiency of the UK’s tax system. For any business asking what is VAT compliance, MTD is the definitive answer for record-keeping and submission.

Sample VAT Calculation for a Small Business

For a small business registered for the UK Standard VAT Scheme (not a Flat Rate Scheme user), the VAT payable or reclaimable is calculated based on the difference between the Output VAT (VAT charged on sales) and Input VAT (VAT paid on purchases). The standard UK VAT rate is 20%.

Month/Quarter	Sales (Net of VAT)	Purchases (Net of VAT)
Quarter 1	£25,000	£10,000

Step 1: Calculate Output VAT (VAT on Sales)

Output VAT = Net Sales ×20% Output VAT = £25,000×0.20 Output VAT = £5,000

Step 2: Calculate Input VAT (VAT on Purchases)

Input VAT = Net Purchases ×20% Input VAT = £10,000×0.20 Input VAT = £2,000

Step 3: Calculate VAT Payable to HMRC

VAT Payable = Output VAT − Input VAT VAT Payable = £5,000−£2,000 VAT Payable = £3,000

Note: If the Input VAT were greater than the Output VAT, the result would be a negative number, meaning the business could reclaim VAT from HMRC (a VAT repayment).

Forward-Looking HMRC Policy Analysis (Beyond 2025)

The trajectory of HMRC policy is defined by a commitment to full digital transformation, primarily through the Making Tax Digital (MTD) initiative and a likely move toward e-invoicing/real-time reporting.

1. Making Tax Digital (MTD) Expansion

The MTD program is proceeding with its rollout for Income Tax Self Assessment (ITSA):

• Sole Traders and Landlords: The mandatory start dates for MTD for ITSA are being phased in based on gross income (combined from self-employment and property):
  • April 2026: Mandatory for those with annual gross income over £50,000.
  • April 2027: Mandatory for those with annual gross income over £30,000.
• Beyond 2027: The government has signaled an intention to lower the threshold further, likely to £20,000, to bring more taxpayers into MTD. This is expected to be legislated and implemented in the years following 2027.
• MTD for Corporation Tax (CT): Although delayed, a mandatory MTD regime for Corporation Tax is widely expected to be the final major phase of the MTD rollout. While no official dates are set, planning for digital record-keeping and potentially quarterly reporting for Limited Companies is advisable for the post-2027 period.

2. E-Invoicing and Digital Reporting

The UK government, following a global trend, has consulted on the potential introduction of e-invoicing (electronic invoicing) and associated digital reporting requirements.

• Potential Mandate: The consultation explored moving from a voluntary approach to a mandatory e-invoicing system, which would require businesses to issue and receive invoices in a structured electronic format directly linked to HMRC systems.
• Impact: If mandated, this would be a significant overhaul of VAT compliance. It would likely lead to:
  • Near Real-Time VAT Reporting: Moving beyond quarterly MTD submissions to a system where transaction data is automatically reported to HMRC as it occurs.
  • Reduced Compliance Costs (Long Term): While requiring initial investment in compliant software, the goal is to reduce manual administrative burdens and combat tax fraud more effectively.
• Timeline: While a UK-wide system is unlikely to be fully mandated before 2028-2030, the legislative framework and system development will be a key focus in the immediate years beyond 2025.

3. VAT Rate and Threshold

• Standard Rate: Historically, the 20% standard rate of VAT is a significant revenue generator, and major changes are politically sensitive and unlikely to be announced far in advance.
• VAT Registration Threshold: The VAT registration threshold was recently increased from £85,000 to £90,000. While thresholds were previously frozen for many years, the current pressure on public finances and the ongoing MTD simplification may lead to further, gradual, inflation-linked increases, though this remains politically uncertain. A significant drop in the threshold is unlikely given the administrative burden it would place on small businesses not yet prepared for MTD.

Simplified Schemes: Making How VAT Works Easier

For smaller businesses, HMRC offers several simplified accounting schemes that impact how VAT works in practice, significantly reducing administrative complexity.

1. VAT Flat Rate Scheme (FRS)

• Eligibility: Turnover is expected to be no more than £150,000 in the next year.
• How it Works: You pay HMRC a fixed percentage of your total VAT-inclusive turnover, which is determined by your business sector. You do not reclaim Input VAT on purchases (except for certain capital assets over £2,000). This scheme simplifies record-keeping dramatically and can be advantageous if your Input VAT costs are low.

2. VAT Cash Accounting Scheme

• Eligibility: Annual turnover does not exceed £1.35 million.
• How it Works: You account for VAT based on when cash is actually received or paid, not when invoices are issued or received. This is a massive cash flow benefit, as you only pay Output VAT to HMRC once your customer has paid you.

3. VAT Annual Accounting Scheme

• Eligibility: Annual turnover does not exceed £1.35 million.
• How it Works: You submit one VAT Return per year, instead of the standard four, making advance payments towards your annual VAT bill throughout the year. This reduces administrative workload significantly.

International VAT: Post-Brexit & Global Services in 2025

The question of what is VAT and how VAT works is particularly complex for businesses trading internationally in 2025.

Trade with the EU and Northern Ireland

• Goods: Complex rules govern the movement of goods between Great Britain (England, Scotland, Wales) and the EU, as well as the special arrangements under the Northern Ireland Protocol (Windsor Framework). Imports from the EU to GB are subject to Import VAT, but for low-value consignments, the rules shifted to a reverse charge or collection via online marketplaces.
• Services: The Place of Supply rules determine which country’s VAT is due. Generally, for business-to-business (B2B) services, the Reverse Charge Mechanism applies, where the customer accounts for the VAT, avoiding the need for the UK supplier to register for VAT in the EU country. The changes to digital and virtual event services implemented in 2025 mean that for business-to-consumer (B2C) digital sales, VAT is often due in the consumer’s country of residence.

The Bottom Line

To excel in the 2025 commercial environment, every business must not only understand what is VAT but also have robust systems in place to manage it efficiently.

1. Monitor Turnover: Use your MTD-compliant software to constantly track your rolling 12-month turnover against the £90,000 threshold.
2. Know Your Rates: Correctly apply the 20%, 5%, or 0% rate to every sale. Getting this wrong is a common cause of HMRC penalties.
3. Maximise Input Tax: Ensure you keep meticulous records to reclaim every penny of Input VAT you are legally entitled to. Understanding how VAT works is fundamentally about optimising this reclaim process.
4. Embrace Digital: Full MTD compliance is non-negotiable. It is the core mechanism for how VAT works in the modern UK tax environment.

For growing businesses, knowing what is VAT represents a compliance hurdle, but mastering how VAT works offers a genuine opportunity to improve cash flow and professional standing. If your business is nearing the £90,000 turnover mark, or is involved in international trade, seeking professional advice from a qualified UK accountant or tax advisor is a prudent investment.

Disclaimer: The content on AccoBee.co.uk is for informational purposes only and do not constitute tax or financial advice. 

We recommend consulting a certified tax professional or the HM Revenue and Customs Dept (HMRC) for accurate guidance. AccoBee.co.uk is not responsible for any decisions made based on the information provided.