What is the Difference Between Zero Rated and Exempt from VAT?

Many business owners will often assume that “zero rated” and “VAT exempt” are the same thing, and it’s easy to understand why. But just because no VAT is added to each invoice does not mean they are the same!

As a buyer, whether a product or service (often called a “supply” or “supplies”) is zero-rated or exempt does not matter - no VAT is payable either way.

However, as a seller, it makes a difference to whether VAT is incurred on the costs of providing the goods or services that can be reclaimed from HMRC. If most of a business’s costs have VAT on them, it can make a massive financial difference to the business if business is making zero rated supplies vs VAT exempt supplies.

What is Zero Rated VAT?

If goods and services are “zero rated” it means that they are classified as taxable but at a rate of 0%.

This means that the customer does not have to pay any VAT, but since the supply is taxable, the supplier can reclaim VAT paid on the costs of making that supply.

Items with Zero Rated VAT include, but are not limited to:

• Most food items - in retail supply (not catering, which has separate rules)
• Certain goods sold at charitable fundraising events
• Equipment for disabled people
• Children's clothes
• Maternity pads and sanitary protection products

In these instances, the VAT rate is simply 0%, rather than 20% or 5%.

What are VAT exempt supplies?

Being VAT exempt means certain goods or services, have been established to not be subject to VAT at all, meaning no VAT is added to the price, and also are not classified as taxable supplies.

However, specific conditions or restrictions may apply to certain exemptions, so it’s important to speak to your accountant/advisor for further guidance.

VAT-exempt goods and services include:

• Insurance, finance and credit services
• Education
• Some charitable fundraising events
• Certain property transactions
• Postal services
• Subscriptions to membership organisations
• Genuine healthcare services delivered by a registered heath care professional.

Zero Rated vs Exempt VAT: The Biggest Differences

Why does this matter? - Commercial and strategy

Zero rated businesses

Zero rated businesses can normally recover VAT on business purchases. For example, a children’s clothing retailer:

• Sells all products at 0%
• Still reclaims VAT on:
  
  • Rent
  • Software
  • Marketing
  • Equipment‍

‍Exempt businesses

Exempt businesses, however, cannot reclaim VAT relating to exempt supplies.

For example, a mortgage broker:

• Charges no VAT
• Usually cannot recover VAT on many business costs

Naturally, the distinction can therefore significantly impact pricing and strategy where ultimately the true cost of making supplies is likely to be significantly different, whereby a business generates zero rated supplies as opposed to VAT-exempt supplies.

VAT Registration Threshold: Example (compliance)

One of the main practical differences between zero rated and exempt income is how it affects your VAT registration threshold, currently £90,000.

It’s important to note that while zero rated income counts as taxable turnover, exempt income does not.

For example:

Business A: standard-rated + zero-rated income‍

• £50,000 of standard rated supplies (charged at 20%)
• £50,000 of zero-rated income
• Combined taxable turnover: £100,000

Because this exceeds the £90,000 threshold, Business A must register for VAT.

Business B: standard-rated + exempt income

• £50,000 of standard-rated supplies
• £50,000 of exempt income
• Taxable turnover (exempt income doesn't count): £50,000

Because this stays under the £90,000 threshold, Business B does not have to register for VAT mandatorily.

What happens if your business makes both taxable and VAT exempt supplies?

When it comes to mixed suppliers that do not comfortably distinguish between one or the other, this is when partial exemption comes in.

Some examples of mixed businesses include:

• Private healthcare clinic (often with a dispensary route)
• Property company - with a mix of opted to tax and not opted to tax properties
• Education provide

If your business makes both taxable supplies (including zero rated supplies) and exempt supplies, you may only be able to reclaim the proportion of the VAT you incur on your business costs that relates to your taxable supplies, otherwise known as partial exemption.

The amount you recover depends on the nature and mix of your business supplies and how your costs relate to your taxable and exempt activities. If this applies to your business, it’s worth seeking professional advice to ensure that you’re claiming the right amount of VAT, as partial exemption is complex and costly if you overclaim VAT.

Common Mistakes Businesses Make

Some common mistakes that businesses make include:

• Assuming zero-rated means VAT exempt
• Not reclaiming VAT when they could (reclaiming VAT on costs relating to zero rated income)
• Incorrectly treating retail foods as exempt
• Registering unnecessarily
• Missing partial exemption adjustments

If you’re still unsure how your transactions should be treated or concerned you could be missing out on claiming back VAT, get in touch.

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