The importance of applying VAT correctly

Writing a Business Plan

If your company is involved in both VAT’able’ and exempt sales, it is important that you work out which purchases you can and cannot recover VAT on in order to maximise the VAT you can reclaim.

To begin
Firstly you must identify whether your purchases are used to make VAT’able’ or exempt sales as this will determine your next course of action:

  • VAT’able’ sales – all of the input tax can be reclaimed
  • Exempt sales – none of the input tax can be reclaimed

These two categories are simple to create and process; however there is a third category where the procedure becomes more complicated and that is where you have a mixture of VAT’able’ and exempt sales together.

VAT’able’ and exempt sales
These purchases are usually comprised of overhead costs, such as accountancy fees, office costs etc… and this is where a price to earnings ratio formula must be applied in order to work out how much VAT you can reclaim. It is important you spend time categorising your purchases as if you assign the wrong ones you will either miss out on some of the VAT you can reclaim, or worse, you may reclaim more than you should, which HMRC can penalise you for. In order to assign these categories correctly it is essential your bookkeeping is reliable and efficient. Your bookkeeper also needs to be informed of what purchases will be used to make VAT’able’ or exempt sales, if these are not obvious. Problems arise, however, where an invoice covers items you need for both VAT’able’ and exempt supplies. HMRC declares that a price to earnings ratio formula must be applied in these instances in order to work out the VAT you can reclaim, even if 90% of the invoices was used for taxable supplies. When applying the formula if you receive a lower rate of recovery you will be unable to reclaim VAT. However, if your earnings are greater you are safe to reclaim the VAT. It is always advisable to get your suppliers to split invoices in order the ensure situations like the above do not arise too often.