What is VAT exemption?

Jump to a section

VAT exemption applies to specific goods and services that sit entirely outside the VAT system. Unlike zero-rated items, businesses that only sell exempt goods cannot register for VAT or reclaim VAT paid on business expenses. Knowing the difference is vital for your pricing, expense management, and HMRC compliance.

As a small business owner, navigating tax categories can feel like a hurdle. While most goods attract the standard 20% rate, others are exempt or zero-rated. Grasping these definitions early empowers you to make well-informed decisions about your pricing strategy and helps you understand the true operational costs of running your company.

What is VAT?

Value Added Tax (VAT) is a type of indirect tax which businesses must pay to the government on goods and services supplied. It applies to every stage of the supply chain from manufacture all the way to the consumer. If a product or service is subject to VAT, it means that the standard VAT rate applies unless an exemption or zero-rating applies.

How does VAT work?

VAT works by adding a percentage of the item's price onto the cost for each stage in the process, giving rise to its name. By collecting taxes at many stages along the production chain, it reduces evasion due to under-the-table dealings and is relatively difficult to skirt around or avoid. The funds collected as VAT goes on to be used by governments for various public expenses like infrastructure improvements, healthcare, and education.

VAT exemption is an important, though complicated and often misunderstood, concept. In essence, it allows certain items or services to be exempt from VAT, meaning businesses do not have to charge VAT on these sales. This benefits both consumers and businesses by reducing costs and making certain essential goods and services more affordable.

VAT exempt vs zero-rated: Key differences

While both "exempt" and "zero-rated" mean you do not charge VAT to your customers, they have very different impacts on your ability to reclaim tax.

VAT exempt items: These are completely outside the VAT system. You do not charge VAT, but you also cannot reclaim any VAT you pay on business purchases (input tax) related to those sales.
Zero-rated items: These are taxable at 0%. Because they are technically "taxable supplies," you can still register for VAT and reclaim the VAT you pay on your business expenses.

Understanding this distinction is crucial because it directly affects your cash flow. If you sell zero-rated goods, you can get money back from HMRC; if you sell exempt goods, the VAT you pay to your suppliers simply becomes an added cost to your business.

Comparison of UK VAT rates

To help you identify which category your products or services fall into, refer to the table below:

VAT Category	Rate	Reclaim Input VAT?	Examples
Standard Rate	20%	Yes	Most electronics, professional services, and taxi fares.
Reduced Rate	5%	Yes	Domestic fuel, children's car seats, and some energy-saving materials.
Zero-Rated	0%	Yes	Most basic food, children’s clothes, books, and newspapers.
VAT Exempt	N/A	No	Insurance, financial services, education, and health services.

List of VAT-exempt goods and services in the UK

There is a specific range of activities and items that HMRC deems entirely exempt from the VAT system. These include:

Financial and insurance services: Most banking fees, loans, and insurance premiums.
Education and training: Tuition provided by eligible schools, colleges, or universities.
Health and welfare: Services provided by registered doctors, dentists, and opticians.
Postal services: Specifically those provided by the Royal Mail.
Betting and gaming: Lottery tickets and most forms of gambling.
Land and buildings: Selling or leasing residential property (though commercial property rules can vary).

List of VAT-rated goods and services in the UK

The rate of VAT you charge depends on the nature of the product or service. HMRC categorises these into zero-rated and reduced-rate items to ensure essentials remain affordable for consumers.

Zero-rated items

Zero-rated items are taxable at 0%, meaning you do not charge customers VAT but you can still reclaim VAT on your related business expenses. These include:

Most food: Basic groceries like bread, vegetables, fruit, meat, and dairy products.
Children’s clothing and footwear: Items designed for young children (usually under age 14).
Books and publications: Physical and digital books, newspapers, magazines, and maps.
Health and medical: Prescriptions dispensed by a pharmacist and equipment for disabled people.
Public transport: Fares for bus, train, and domestic air travel.
Sanitary products: Since 2021, women's sanitary protection products are zero-rated.
Household water: Water and sewerage services provided to domestic residences.

Reduced rate VAT items

Certain goods and services qualify for a reduced VAT rate of 5%. This lower rate is typically applied to energy-related services and specific health-related products:

Domestic fuel and power: Electricity and gas used in homes or by charities for non-business use.
Energy-saving materials: While many installations (like solar panels) were moved to 0% in 2022, certain residential energy materials still fall under the 5% rate.
Mobility aids: Items like grab rails or ramps installed for people over age 60.
Children's car seats: Including safety seats, booster seats, and carrycots with restraint straps.
Smoking cessation: Nicotine patches and gum.
Residential conversions: Certain building works that change the number of dwellings in a property.

What businesses are VAT exempt?

Some businesses qualify for VAT exemption, meaning they do not need to register for VAT or charge it on sales. Below are some key categories:

VAT exempt businesses

Businesses that only sell VAT-exempt goods or services do not need to register for VAT. Examples include:

Healthcare providers.
Educational institutions.
Financial service providers.
Insurance companies.

Partially exempt businesses

Some businesses sell a mix of taxable and exempt goods or services. These are known as partially exempt businesses. If your taxable turnover is below £85,000, you do not need to register for VAT, but you can only reclaim VAT on certain business expenses.

Business selling zero-rated VAT items

Businesses in this category must still register with HM Revenue & Customs (HMRC), but they don't have to charge customers any taxes while selling zero-rated items like food, books or pharmaceuticals. However, these businesses will still have to account for all sales using invoices or other forms of documentation so that HMRC is aware of revenue generated through such activities.

Can an exempt business reclaim input tax?

Generally, a business that only makes exempt supplies cannot reclaim any input tax. However, if your business sells both taxable and exempt items, you are considered "partially exempt."

Identify direct costs: Separate the VAT you pay on purchases used purely for taxable sales (reclaimable) from those used for exempt sales (not reclaimable).
Apportion residual VAT: For overheads like rent or utilities that support both, you must calculate a fair percentage to reclaim.
Check de minimis limits: You may still be able to reclaim VAT on exempt supplies if the total amount is less than £625 per month on average and stays below 50% of your total input tax for the year.
Keep separate records: Ensure your accounting software distinguishes between these two streams to make your VAT Return easier to manage.
Perform an annual adjustment: Review your quarterly claims at the end of the year to ensure the total amount reclaimed was accurate.

Managing VAT for charities and promotions

Charity organisations are often exempt from VAT on their core activities, such as non-business fundraising and healthcare services. However, if a charity sells new goods, they may need to register if they cross the £90,000 threshold. You can find more information on VAT for charities on the GOV.UK website.

When offering discounts or gifts, the VAT rules change. If you give a "free gift" that is actually a separate item, you may still owe VAT on its cost. For full information on the rules, GOV.UK has all the information and know-how needed to make sure your business stays compliant.

Bottom line

Understanding VAT exemption, zero-rated VAT, and reduced VAT rates is crucial for businesses to remain compliant and manage their tax obligations effectively. Whether your business sells VAT-exempt services, zero-rated products, or a combination of both, knowing your VAT status can help you optimise cash flow and avoid potential tax issues. If you’re unsure about your VAT responsibilities, it’s always best to consult with a tax advisor or refer to the official guidance on VAT exemption and partial exemption on the GOV.UK website.

Frequently asked questions

Is insurance VAT exempt or zero-rated?

In most cases, yes. Insurance is VAT exempt, meaning VAT is not charged on premiums or fees. However, some fees related to insurance services may still be subject to VAT, so it's best to check with HMRC or your provider.

Can I register for VAT if my business is exempt?

No. You cannot register for VAT if your business only sells exempt goods and services. However, if you sell a mix of exempt and taxable items, you must register if your taxable turnover (standard, reduced, or zero-rated) exceeds £90,000.

How do I report exempt sales on a VAT return?

You only need to report the total value of your exempt sales in the "total sales" section of your return (known as Box 6). Since you don’t charge VAT on these items, you leave the "VAT charged" section (Box 1) empty for these specific sales. Most modern accounting software will handle this for you automatically when you categorise the sale as exempt.

Are charitable donations VAT exempt or zero-rated?

Charitable donations are usually VAT exempt. However, if a charity provides goods or services in return for a donation, different VAT rules may apply. Always check with HMRC for specific cases.

Do you pay VAT on business rates?

Generally, no. Business rates are outside the scope of VAT, meaning VAT is not applicable. However, if a property is rented out commercially, the landlord may be required to account for applicable taxes.

Is postage VAT exempt?

Royal Mail postal services are VAT exempt, but some courier services charge VAT. Always check your provider’s VAT policy.

What is the difference between zero-rated and exempt?

Zero-rated items have a VAT rate of 0%, allowing businesses to reclaim VAT on expenses.
Exempt items are outside VAT regulations, and businesses cannot reclaim VAT on related costs.

Do you pay VAT on congestion charges?

No, London’s Congestion Charge is outside the scope of VAT. However, future changes to VAT rules may affect this.

Can I apply for VAT Exemption?

Yes, you can apply for VAT exemption if your business meets the eligibility criteria. Check with HMRC or a tax advisor to understand the process and ensure compliance.

This does not constitute advice if you want to understand your business tax liability in detail you should speak to your accountant.

Arianna Colomb Marketing & Communications Associate