How the VAT system works

VAT is a transaction based tax, bourne by the final consumer.

Click on link for illustration of how the VAT system works.

The example starts with a producer (P) and a manufacturer (M) who are prepared to enter into a business transaction. The producer wants to sell his goods for £50.00 and the manufacturer is prepared to purchase at this price. HMRC, however, require that the transaction is taxed, and therefore P charges M £50.00 + £10.00 VAT = £60.00. P will be required to complete a VAT return which summarises this transaction and pay £10.00 (called output tax) to HMRC at the time that the return is submitted. 

A second transation now occurs, between M and the retailer (R). Again, HMRC wish to collect tax on the transaction value and M charges R £100.00 + £20.00 VAT = £120.00. M has collected output tax of £20.00, which it will pay to HMRC, however in this case M has also suffered £10.00 VAT on goods it previously purchased from P (called input). Assuming that M is registered for VAT, and as long as it charges VAT on the sale to R, it is entitled to recover from HMRC the VAT suffered. M will complete a VAT return summarising its output tax collected on the sale, and the input tax suffered on the purchase, which leaves M with a net amount payable to HMRC of £10.00.

Finally R sells the goods to the final consumer. R will complete a VAT return as M has done above, and pay net VAT of £20.00 to HMRC.

It should be noted that because of the mechanism of paying VAT collected and reclaiming (or offsetting) VAT suffered, that VAT has had no financial effect on P, M, or R. After making their payments to HMRC each is left with £50 (P), £100 (M), and £200 (R), which is the value that each demanded for their goods. Effectively P, M and R have acted as unpaid tax collectors on behalf of HMRC. 

The consumer has paid £200.00 for goods and £40.00 VAT = £240.00. This can be viewed as if he has paid the retailer £200.00 and handed £40.00 to HMRC, however it is seen that the £40.00 VAT that the consumer suffers has actually been collected and paid to HMRC by P (£10.00), M(£10.00) and R(£20.00) on his behalf.

The example therefore demonstrates (i) Transaction based nature of the VAT system, (ii) VAT cost is suffered by the final consumer, and (iii) The necessity to keep track of VAT aspect of transactions.

The University will generally sit in the middle of a chain of transactions, that is it will suffer VAT on most of its purchases, and in some cases charge VAT on supplies which it makes.