While the rules regarding VAT compliance may appear straightforward at first glance, there are several common pitfalls that can lead to problems which, if not rectified, can lead to penalties. Some of the more frequent VAT traps that small businesses face are detailed below:
VAT traps and 5 common compliance mistakes
Late registration
One of the more common ‘VAT traps’ is failing to register for VAT on time. Registration is required once taxable turnover exceeds the VAT threshold (£90,000) within a rolling 12-month period, not just at the end of the financial year. Many small business owners misunderstand this rule and only review their turnover annually, which can result in late registration.
The consequences of late registration can be significant. To rectify the error, a business may be required to pay VAT on sales made after the date they should have registered, even if they did not charge customers VAT traps at the time. This effectively means absorbing the VAT cost themselves, which can severely impact profit margins and cash flow.
Penalties (which automatically expire after two years, provided the filer has not yet reached their threshold), will be calculated as a percentage of VAT that should have been paid (with the percentage depending on whether the failure was prompted or unprompted, and whether behaviour was non-deliberate, deliberate or deliberate and concealed). Interest charges will be levied on unpaid VAT from the date it should have been remitted, and there may be the potential loss of input tax recovery on purchases made before registration, all of which could add up to a considerable amount of money. Note that businesses can generally reclaim input tax on goods and services purchased before registration (subject to time limits: four years for goods still on hand; six months for services).
Exceeding the limit temporarily
In some cases, a business that temporarily exceeds the VAT registration threshold can apply for an exception from registration. To qualify, it must demonstrate that its taxable turnover will not exceed the £88,000 deregistration threshold within the following 12 months. However, HMRC is increasingly refusing exceptions, particularly where businesses have not adequately monitored turnover on an ongoing basis.
To avoid late registration, businesses should regularly monitor their turnover (ideally on a monthly basis) and keep accurate records.
Incorrect zero-rating or partial exemption claims
Another frequent ‘trap’ involves misunderstanding as to which goods or services qualify for zero-rating or fall under the partial exemption rules. Zero-rated supplies are taxable at 0%, but they still count as taxable turnover and must be reported correctly and included in the 12-month registration calculation.
Businesses making both taxable and exempt supplies (partial exemption) must be careful in calculating how much input VAT they can reclaim. Undercharging VAT by applying reduced or zero rates to supplies that should be standard rated creates liability for the underpaid VAT plus potential penalties if HMRC determines the error resulted from carelessness or deliberate attempt to underpay. To manage this risk, business owners should ensure they fully understand the VAT treatment of their products and services and consider seeking professional advice when dealing with mixed supplies.
Reverse charge obligations
The reverse charge mechanism is another area where small businesses often make mistakes. This rule shifts the responsibility for accounting for VAT from the supplier to the customer in certain transactions, particularly in sectors such as construction or when dealing with overseas suppliers.
Under the domestic reverse charge, suppliers do not charge VAT; rather, the customer accounts for the VAT on their own return. Similarly, when purchasing services from overseas, businesses may need to account for VAT, even if no VAT is charged on the invoice. Failing to apply the reverse charge correctly can lead to incorrect invoicing and reporting errors.
Late submissions
Submitting VAT returns late or with inaccuracies is another common compliance problem. VAT returns are typically filed quarterly (although annual submissions are possible), and deadlines are strictly adhered to. Late submission penalties work on a points-based system where a penalty point is applied for each return submitted late. The penalty point threshold differs by filing frequency: annual filers reach the threshold at two points, quarterly filers at four points and monthly filers at five points. Once the applicable penalty point has been reached, a penalty of £200 is levied. A further £200 penalty is levied for each subsequent late submission.
Practical point
By being aware of these common VAT traps, businesses can take proactive steps to stay compliant. These include keeping accurate and up-to-date records, reconciling accounts regularly and reviewing VAT returns carefully before submission. Bank streaming used in conjunction with accounting software can be useful, and seeking professional support can also help ensure compliance.
Partner note:
VAT Regulations 1995 (SI 1995/2518), Regulations 99–107
HMRC guidance:
VAT Notice 700/1: Who should register for VAT
Factsheet CC/FS11: Compliance checks – penalties for failure to notify
