Value Added Tax

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What is Value Added Tax?

Value Added Tax (VAT) is tax on business transactions, charged by companies at the point of sale in respect of goods and services sold in the UK and the Isle of Man. VAT is a tax on the value added at each stage of the production process: it is not simply a tax on expenditure. As such, it is the most financially significant indirect tax in the UK today.

VAT is collected on behalf of HM Customs and Excise by companies. In determining their VAT bills, however, companies are permitted to deduct any VAT they have paid on inputs into their products.

All goods and services are either VAT-rated or VAT-exempt. Products that are VAT-exempt include rent, private education, health services, postal services, finance and insurance, and gambling.

Most goods and services are VAT-rated, however. Any company with an annual turnover in VAT-rated products ("taxable turnover") in excess of £61,000 is required to register with HM Customs as a "taxable person".

VAT is charged on VAT-rated goods at three different levels. The Basic Rate of 17.5 per cent applies to most goods and services. A Reduced Rate of 5 per cent applies to domestic fuel and power, women's sanitary products, children's car seats and certain residential conversions. Finally, there is a Zero Rate on food, construction of new dwellings, domestic and international passenger transport, books, newspapers and magazines, children's clothing, water services, prescription drugs, supplies to charities, certain ships and aircraft, and vehicles and some other supplies to disabled people. Although goods and services subject to the Zero Rate incur no VAT charges, they nonetheless count towards taxable turnover.

Background

Value Added Tax was introduced in 1973 as a replacement for Purchase Tax and Selective Employment Tax, as a condition of UK entry into the European Economic Community.

In 1967, the EEC Council of Ministers had decided to harmonise its member states' systems of indirect taxation, and legislated to require members to adopt a VAT system. Today, that requirement is embodied in a series of Directives, principally the Sixth VAT Directive (Directive 77/388/EC).

Purchase Tax was the main indirect tax of its day. It had been introduced in 1940 as a tax on the wholesale values of a wide range of goods, but excluding services, food and goods subject to other excise duties. During Purchase Tax's 33-year life, there were as many as seven different rates in operation at any one time, and the structure of the regime changed frequently.

Purchase Tax had been administered by HM Customs throughout its history, and on its replacement by VAT, Customs took over responsibility for the new system, on the basis of its experience in administering invoice-based business taxation.

The Sixth Directive permitted member states to have up to two reduced rates, which could be no lower than 5 per cent. The UK won the right to Zero Rate some goods through derogations from the Directive (Article 27.5), under which the Government was obliged to inform the European Commission of goods and services to be zero-rated for clearly defined social reasons or for the benefit of the final consumer by the beginning of 1978.

In 1979, the UK had a Zero Rate, a Basic Rate of 12.5 per cent charged on "luxury" items and a reduced rate of 8 per cent charged on most other goods and services. When the Conservatives came to power that year, Chancellor Geoffrey Howe increased both of these to a single rate of 15 per cent, to partially offset the impact of large cuts to the Basic and Higher Rates of Income Tax. This was portrayed as a deliberate move aimed at shifting the burden of taxation from earnings to consumption.

VAT remained at 15 per cent until 1991, when Norman Lamont increased it to 17.5 per cent. This step was intended to provide revenue for the "Community Charge Reduction Scheme", aimed at assisting local authorities suffering from the fall-out of massive levels of defaulting on the "poll tax".

The March Budget of 1993 saw Mr Lamont propose the phased introduction of VAT on domestic heating and fuel (at 8 per cent for 1994, and 17.5 per cent for 1995). The move was widely unpopular, but was to be offset by increased benefits. Despite widespread opposition, the new Chancellor Kenneth Clarke restated the Government's commitment to the plans in the 1994 Budget. However, a number of Conservative MPs rebelled against the legislation needed to enact the measure in December that year. In an extraordinary financial statement that month, Mr Clarke responded to the funding shortfall by cancelling some of the benefit reforms and raising tobacco duty by 6p per 20 cigarettes.

A major event in the history of VAT was Gordon Brown's 2001 Budget, in which it was announced that the Reduced Rate would be cut to 5 per cent.

In his 2008 Budget statement, Chancellor Alistair Darling announced that following a review of VAT rules and administration, and as part of its rolling programme of tax simplification, the Government would consult on simplifying the operation of the partial exemption regime and capital goods scheme, and explore the need for business to seek permission from HMRC before taxing otherwise VAT-exempt supplies of land and property.

He also announced that claims for repayment of VAT for tax periods before 4 December 1996 (tax previously overdeclared) and tax periods before 1 May 1997 (tax previously underclaimed) would become subject to a three-year time limit on 1 April 2009.


Controversies

VAT is a tax with a very diffuse impact on consumers, as it applies to so many goods and services. As the rate of Income Tax has declined, VAT has risen to compensate, marking a shift in taxation strategy away from transparent direct taxes towards more opaque indirect taxes, whose cost to the individual is harder to calculate. Between 1973 and 2003, VAT raised £828 billion for the Treasury.

While the headline rate has stayed relatively stable, the range of items subject to VAT have risen year on year. Rarely do these individual inclusions generate public attention, although domestic heating and fuel was a notable exception. As such, it is sometimes criticised as a "stealth tax".

Nonetheless, UK VAT remains low compared to the rest of the EU. Based on a series of Directives, VAT requirements are subject to national interpretation, but the basic rate in all member states must not be below 15 per cent. Moreover, few other countries have a Zero Rate. As pressures for the further harmonisation of indirect taxation increase, many analysts expect that UK VAT will have to rise.

The complexity of the VAT system has also generated comment. A whole industry dedicated to reducing companies' liabilities has sprung up in recent years, and a number of high-profile incidents have probed the limits of the rules. In 1994, for example, the owners of Blackpool Pleasure Beach sought to class its "The Big One" rollercoaster as a form of public transport in order to exempt it from VAT. The VAT Tribunal agreed, but this decision was overturned on appeal. In 1991, the courts had to decide whether the Jaffa Cake was a biscuit (VAT-rated) or a cake (VAT-exempt), eventually ruling that it is a cake.

Nonetheless, businesses have long expressed concerns about the complexity of the VAT system, with many small firms struggling to assess their liabilities suffering penalties at the hands of Customs. The 2002 Budget saw the Government introduce a flat-rate VAT scheme for some small businesses in order to address this problem.

Finally, the range of inclusions in the VAT regime is widely debated, although the Government's room for manoeuvre is limited by EU law. Particularly controversial in recent years has been the liability of repair work carried out on church buildings, which many have claimed has allowed historic churches to fall into disrepair by inflating the costs.

Statistics

VAT receipts are projected to raise £81 billion for 2007/8.

Source: HM Treasury

Standard VAT rate applied in EU member states as at 1st July, 2008:
Austria 20, Belgium 21, Bulgaria 20, Cyprus 15, Czech Republic 19, Denmark 25, Estonia 18, Finland 22, France 19.6, Germany 19, Greece 19, Hungary 20, Ireland 21, Italy 20, Latvia 18, Lithuania 18, Luxembourg 15, Malta 18, Netherlands 19, Poland 22, Portugal 20, Romania 19, Slovakia 19, Slovenia 20, Spain 16, Sweden 25, UK 17.5

Source: European Commission


Quotes

"The UK and France have proposed the introduction of a new category of reduced VAT rate, for environmentally-friendly goods.

"Many Member States have experience of the effectiveness of well-targeted reduced VAT rates as a policy tool to shape values and change citizens’ behaviour; the current principal VAT Directive should be updated to allow Member States to use a reduced VAT rate to meet their climate change objectives."

Extract from a joint letter from Prime Minister Gordon Brown and French President Nicolas Sarkozy to EU President, Jose Manuel Barroso, on using VAT to combat climate change – March 2008

"Major changes are needed to the EU VAT rules on financial services to reflect the modern business environment and restore the competitiveness of EU businesses."

CBI – September 2008