VAT and the tax authorities / HMRC

We’ve already seen that, when VAT is charged on sales, the business is merely acting as an agent and collecting VAT on behalf of the tax authorities. This sales tax is called ‘output tax’ and is paid over to HMRC.

But we have also seen that businesses pay VAT on purchases they make and on services they receive. If they are VAT registered, then this VAT is not an expense / cost to them – it is called ‘input tax’ and the business can reclaim this from the tax authorities.

Let’s have a closer look at output tax and input tax and how they link with each other.

A business will:

• owe output tax to HMRC
• wish to reclaim input tax from HMRC.

Instead of this being done as two separate transactions, the two taxes are netted off and settled on a net basis – after all, both relate to HMRC.

So periodically, the business will net off output tax and input tax to see which is greater. There are guidelines on how frequently they need to do this, but that’s more of a tax issue than a bookkeeping one and we don’t need to cover it here.

• If the output tax is greater than the input tax, then the net amount is paid by the company to HMRC. This is shown as a payable / liability in the statement of financial position.
• If the input tax is greater than the output tax, then the net amount is reclaimed from HMRC. This is shown as a receivable / asset in the statement of financial position.

As we’ve already seen, both input and output taxes are entered on the relevant side in the same VAT ledger account. The ledger account will therefore look like the image above.