In a nutshell

• VAT is a type of government taxation which applies across the European Union. It applies to all sorts of financial exchanges, from business transactions to the sale of many services and goods.
• Do you pay VAT? Yes, if you buy practically any commodity in the UK. It's a charge to the consumer, rather than the provider. The more you buy, the more VAT you pay.
• Currently, the rate of VAT charged in the UK is 20% of the sale price or fee. Certain items, such as feminine hygiene products, nappies and domestic fuel and power are VAT rated at a lower level of 5%, while goods such as some foods, medicine and postal services are zero rated so you're not charged anything extra.
• If you're self-employed or run a business and your turnover reaches £68,000 or more in any 12-month period, you're legally required to charge VAT for your goods or services.
• Any individual or company that is VAT registered must pass on the VAT they charge to HM Revenue and Customs (HMRC) every three months. At the same time, they are entitled to claim VAT from certain goods and services and set that against what they owe. So the VAT man gets his money, while your business gets to keep a bit back for being the middleman.
• You can also choose to register even if your turnover doesn't exceed the £68,000 threshold. Some people find this makes financial sense if they run a business that involves purchasing a lot of materials. This means they can offset the VAT they've paid against the sum they've charged.

How does it work in practice?

Take this example: you've decided to buy a top hat costing £10. The retailer is VAT registered so must add 20% to the sum. In this case, the VAT works out at £1.75, so the price on display will be £11.75. The retailer is not obliged to break this down on the tag, but asking for a VAT receipt at the point of sale will provide you with the information if you need it.

When the retailer's financial quarter ends (every three months) he is sent a form by HMRC. This asks him to declare his income in that period as well as the VAT he has charged. At the same time, he's asked to add up the receipts for any VAT he has been charged in the course of running his business as he is entitled to reclaim it. In simple terms, he deducts the VAT he has paid out from the VAT he has charged others, then hands over the difference to HMRC.

Similarly, if you're VAT registered, and the top hat plays a vital role in your business (who knows, maybe you're a magician?) you can deduct the £1.75 VAT you were charged from the total VAT you have added to your fees.

Where's the catch?

Generally, unless you're an accountant, calculating VAT can be a bit of a minefield. If you're self employed or running a small business it's easy to think that becoming VAT registered is a licence to print money, but the reality is very different. Calculating what you charge people for your services is easy enough, but working out what goods and services are considered central to your work is often a grey area.

If you wash windows for a living, for example, can you really claim the VAT on your iPod because you listen to music when you're up your ladder? You might think it's fine, but the VAT man could take another view. Along with frequent tweaks to the rules and regulations, and extra guidelines if you import or export goods from the UK, it can make filling in your quarterly VAT return very difficult indeed.

HMRC can dispatch a VAT inspector to check your books and records at any time. If you're not on top of your finances it can be time consuming if they don't agree with your figures. Often, people require the services of an accountant to negotiate any disputes and this can be costly.

What else do I need to know?

• If you're not eligible to register for VAT then as a consumer it's a tax you'll have to pay. As it's almost always hidden in the price of day-to-day items.
• If you're thinking of becoming VAT registered, you need to be clear about your financial arrangements and keep up-to-date with your records. Legally, you're obliged to submit your VAT return and any payment due within a month of each financial quarter.
• If you're getting close to the threshold, consider registering early so you don't have to collect VAT for payments you've already received.
• While the threshold for registration is £68,000, you can't de-register until your turnover drops below £66,000.

If you're VAT registered, with a turnover of under £150,000 per year, it's possible to pay a flat rate percentage. Basically, you continue to add VAT to your goods and services, but rather than collecting VAT receipts for anything you're charged and totting it up at the end of each quarter, you pay a fixed percentage (agreed in advance with the VAT man).

Updated: 20/02/2013