VAT, or Value Added Tax, can be a complex area of finance to navigate, particularly when it comes to understanding the different classifications of costs. In this guide, we’ll explain the distinctions between zero-rated, exempt, and out-of-scope costs for VAT.
Zero-rated Costs
When a cost is categorised as zero-rated, it means that VAT is applied at a rate of 0%. Examples of zero-rated costs include books, newspapers, and most forms of travel, such as train or air fares.
Despite VAT being applied at 0%, these costs will still appear on your VAT return.
However, since there’s no actual VAT to reclaim, it won’t affect the amount you can reclaim in box 4 of your VAT return.
Exempt Costs
Exempt costs are those that do not carry any VAT. Examples of exempt costs are services provided by a post office (like postage and stamps), insurance and other financial services, bank charges, and certain medical services. Similar to zero-rated costs, exempt costs have no effect on your VAT reclaim and will also appear in box 7 on your VAT return.
Interestingly, the law makes a distinction between zero-rated and exempt costs. When calculating your sales for VAT registration purposes, zero-rated sales should be included, but exempt sales should be excluded. Likewise, when determining which costs you can reclaim VAT on, costs related to making zero-rated sales are eligible, but those related to making exempt sales are not.
If you’re using the VAT Flat Rate Scheme, both zero-rated and exempt sales should be included in your flat rate turnover.
Out-of-scope Costs
Out-of-scope costs are those that are not covered by the UK VAT system, meaning VAT doesn’t apply to them. Examples include government-imposed tolls (like MOT certificates, council tax, and business rates), staff wages and pensions, and taxes. As such, out-of-scope costs don’t appear on your VAT return and don’t affect the figure in box 4 or the total cost in box 7.
However, an exception exists for costs related to services purchased overseas but used in the UK. If you buy a service overseas and use it there, it would be considered out of scope for UK VAT and not included on your UK VAT return.
For businesses using the VAT Flat Rate Scheme, sales that are out of the scope of VAT are not included in your flat rate turnover.