Sep 062013
 

Let us say you go into your local shop to buy a CD or a packet of cigarettes. You see that the item is labelled £10 plus VAT (yes, I know, it’s more likely to be something like £9.99, but I’m making the price £10 so that the sums are easier). What does this actually mean in tax terms, and why is it so important?

Well, it’s obviously important to the customer who has to part with £12 – from his point of view he’s paying more than the marked price. If the VAT rate increases from the current 20%, he’ll be paying even more.

As far as the shopkeeper is concerned however, although he receives £12 from the customer, he has to pay £2 to HMRC, meaning that he keeps £10 – so from his point of view, the marked price is the “correct” price.

But although this sounds simple, there are a few subtleties, as we shall see in this article.

What is VAT?

VAT is a tax on consumption, which has its legal basis in European law, rather than UK domestic legislation. The concept of how it operates can best be explained by the following diagram.

VAT Supply Chain 2

If we think about how a CD or packet of cigarettes started life and eventually ended up in a shop, we come to realise that a lot of work went into this process. Raw materials are taken, transported, manufactured, packaged and distributed until eventually the customer buys and consumes the end product.

The concept behind VAT is that each person in the supply chain will charge an amount of VAT, which is then passed on to the next person1. The intention is that the ultimate customer at the very end of the chain, will foot the entire bill. For as we can see from the diagram, there is no one left that he can pass the cost on to.

So going back to our example of items marked £10 plus VAT, it is clear that the customer pays the required £2 in addition to the purchase price, and this £2 is passed on to HMRC. However, while the customer has indeed “paid the VAT”, in legal terms – in the UK at least – he isn’t actually liable for it.

How can this be the case? And does it really matter?

What does the legislation say about VAT?

As always, the answer is in the legislation. The starting point is that2:

“VAT shall be charged on any supply of goods or services made in the United Kingdom, where it is a taxable supply made by a taxable person in the course or furtherance of any business carried on by him.”

Breaking this down, there are four main conditions:

  • We need a supply of goods or services – this is clearly the case in our example. A supply is anything done for a consideration3, so includes a straightforward sale;
  • The supply takes place in the UK – yes, we are assuming that you haven’t crossed the channel for your CDs or cigarettes;
  • The supply is made by a taxable person – this will be the shopkeeper, and he is taxable because he has registered for VAT;
  • The supply is made in the course or furtherance of any business carried on or to be carried on by that person – clearly yes, the sale takes place in the shop.

Note that at this stage, we haven’t been told who is liable for the tax. This comes later on, when we find that4:

“A taxable person shall – (a) in respect of supplies made by him, and (b) in respect of the acquisition by him from other member States of any goods, account for and pay VAT by reference to such periods…at such time and in such manner as may be determined by or under regulations and regulations may make different provision for different circumstances.”

So it is the taxable person – the shopkeeper – who has the liability to pay the tax. This cost is passed on to the customer by marking the price with the words “plus VAT”. Although the customer does foot the bill, the nature of the payment to the shopkeeper is a contractual payment, not a payment to discharge a tax liability.

This is illustrated in the following diagram. Note that there is no link between HMRC and the Buyer.

VAT - who pays the tax

So if the shopkeeper forgets to add the magical words to the price, it won’t be the customer who gets into trouble:

  • First of all, the VAT man can’t come knocking at his door asking where that £2 has disappeared to. As we have seen, the customer isn’t liable for the tax – it’s the shopkeeper’s headache;
  • The shopkeeper can’t come back to the customer and say “Oh, I forgot to charge VAT for the items, so can you please pay up?” The customer’s only liability is a contractual liability to pay the price. If the price is marked £10 and he’s paid £10, that’s it – there is no question of an additional amount being charged.

So the shopkeeper is in a pickle. He has received £10 from the customer, but has to pay the VAT amount – which leaves him out of pocket. But it isn’t £2 that he has to hand over – even though this is clearly 20% of £10. The sum is actually slightly lower at £1.67 – why is this? The answer lies in the way that VAT is calculated.

So how is VAT calculated?

The legislation clearly states that5:

“VAT shall be charged at the rate of 20% and shall be charged – (a) on the supply of goods or services, by reference to the value of the supply as determined under this Act…”

So if the value of the supply is £10, then the amount of VAT payable should be £2. But the value of the supply isn’t £10 at all! This is because the legislation states that6:

“If the supply is for a consideration in money its value shall be taken to be such amount as, with the addition of the VAT chargeable, is equal to the consideration.”

Whatever this means, it certainly doesn’t mean that you apply 20% to £10. There are two items to consider:

  • The consideration for the supply – which is simply the purchase price payable under the contract with the customer;
  • This is different from the value of the supply. The value is actually smaller than the consideration – because you have to add on the VAT to the value to arrive at the consideration.

In short:

 Value of Supply plus VAT equals Consideration 

The legislation tells us how to calculate the value.

  • If V is the value then;
  • The amount of VAT is 20% or 0.2 x V; and
  • V, together with the VAT amount – 1.2 x V – must be the consideration – which is £10 when the shopkeeper forgets to add the magic words.

This gives us £8.33 for the value V and therefore £1.67 for the VAT. This is the amount that the VAT man will be asking for.

But why was VAT £2 in the first case and not in the second?

To answer this question, let us focus on the poor old shopkeeper. He has to make a profit and he has calculated that he will achieve this if, at the end of the day he is left with £10 in his pocket. Anything less and he’s in the red.

But as we have seen, if he just charges £10, he’ll have to fork out £1.67 to the VAT man, leaving him with just £8.33. So he has to charge more than £10 to make up for it – how much more should he charge? If he charges £12 to the customer, then applying the statute:

  • The consideration is now £12 not £10;
  • So the value V must now be such that 1.2 x V is £12;

And this gives the result that V is £10 and the VAT amount is £2.

So the end result is that the shopkeeper charges £12 to the customer in order to retain £10 in his pocket. This is what £10 plus VAT means.

  • For the shopkeeper it means that he is secure in knowing that whatever the rate of VAT, he will always have £10 at the end of the day;
  • For the customer it means that he is ultimately footing the shopkeeper’s tax bill. But he is only doing this because the cost has been passed on to him via the contract of sale, and not because he is personally liable to the VAT man.

Let us just pause and rewind. Earlier on in this article, we noted the following:

“So going back to our example of items marked £10 plus VAT, it is clear that the customer pays the required £2 in addition to the purchase price, and this £2 is passed on to HMRC.”

This is actually an inaccurate statement. As we have seen from the legislation:

Value of Supply plus VAT equals Consideration

We have just noted that when the shopkeeper gets it right, the consideration – the purchase price – is £12, not £10. The bit that’s added on, is added on to the value of the supply, and it is the value, together with the VAT that equals the purchase price.

So when the customer pays £10 plus VAT, he isn’t  paying £2 in addition to the purchase price, he is paying £2 in addition to the value of the supply. £10 plus VAT comprises the entire purchase price.

How does it work in commercial contracts?

The principles that we have just stated apply equally to large scale commercial transactions. It is usual to insert a clause to the effect that all prices are exclusive of VAT. But what does this actually mean?

The term “VAT exclusive” and like terms are a shorthand for something more complicated. Contrary to what one might expect, it does NOT mean that VAT will be added to the price. There are two parts to this:

  • If this transaction is VATable (one which attracts VAT) then VAT will be charged; BUT
  • If this transaction isn’t VATable, then no VAT will be charged.

Why does this matter? Surely, the parties with their tax advisers ought to know whether the transaction is VATable? And what purpose does this statement serve? Surely it’s a mere truism.

Consider the case of the sale of a business. This is a transaction that shouldn’t normally attract VAT under the transfer of a going concern (“TOGC”) rules7. In theory, if the business sale agreement is silent on VAT, there shouldn’t be a problem if all goes well. But what happens if it transpires that this isn’t a TOGC after all? For example:

  • What happens if, after having acquired the business, the Buyer indulges in a spot of asset stripping?
  • Alternatively, what if HMRC were to challenge the transaction on the ground that the assets transferred don’t actually constitute a business?

In these circumstances the TOGC conditions break down and VAT becomes an issue. If nothing is said about VAT in the sale agreement, then, as with the shopkeeper, the Seller will have to fork out the amount from the sale proceeds.

It is no good going back to the Buyer and saying: “The transaction is VATable after all – can we have the money please?” The Buyer’s only obligation is the contractual obligation to the Seller to pay the purchase price, which it has paid. The Buyer has no tax liability – the liability is that of the Seller.

However, if there is a VAT clause, the Seller is entitled to go back to the Buyer and ask for the money. But it is important to note that although the Buyer is, in economic terms paying the tax, the legal position is that it is simply paying a further installment of the purchase price as agreed under the original contract. It is the Seller that has the tax liability – but because of the VAT clause, this cost is passed on to the Buyer.

In a nutshell, by including this term the parties are ensuring that whatever happens, the net price that goes into the Seller’s pocket is precisely the price that the Seller expected.

Conclusion – the bit that’s added on is important

Especially when you forget to add it on!

Although the intention behind the VAT regime is that the customer ultimately bears the tax, the legal position in the UK is that it is the supplier that is actually liable for it. The supplier ensures that he isn’t out of pocket by passing the cost to his customer, by means of the sale contract.

Forgetting to add that VAT is chargeable can have serious consequences – the supplier can’t go back to the customer, as the latter only has a contractual liability to pay the purchase price.

So don’t forget to add the VAT on!


 

  1. For the sake of making the illustration clearer, we shall assume that everyone is in the UK, and all transactions are subject to VAT.
  2. VATA 1994 s 4(1).
  3.  VATA 1994 s 5(2).
  4.  VATA 1994 s 25(1).
  5. VATA 1994 s 2(1).
  6.  VATA 1994 s 19(2).
  7.  VAT (Special Provisions) Order 1995 SI 1995/1268 Art 5.
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Satwaki Chanda

Satwaki Chanda

Satwaki Chanda is a tax lawyer with a First Class degree in Mathematics. Called to the Bar in 1992, he is the Editor of Tax Notes.
Satwaki Chanda

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