Zero-Rated vs Exempt Supply

Four kinds of zero on a sale

A sale with no VAT on it can mean at least four different things, and only one of them is a zero rate.

Zero-rated: the sale is taxable, at 0 percent. GOV.UK’s VAT rates guide lists books, newspapers and magazines at 0%, and says food and drink for human consumption “is usually zero-rated” and goods exported outside the UK are zero-rated, subject to conditions. Notice 700 points to the specialist notices for each category in its section 29.

Exempt: the sale is not taxable. Notice 700’s list of exempt categories includes insurance, finance and securities, betting and gaming, many supplies of land and buildings, medical and dental care by health professionals, and education and vocational training, where the VAT rates guide gives the exemption for education provided by an eligible body other than a private school.

Outside the scope: the sale is not within VAT at all. Notice 700 says a supply is outside the scope of UK VAT if it is made by someone who is not a taxable person, made outside the UK and the Isle of Man, or not made in the course or furtherance of business.

The fourth group is about the customer, not the product: a reverse-charge sale to a business that accounts for the VAT itself, or a customer you have marked exempt. Stripe has a separate taxability reason for each case, covered in the entry on the Stripe taxability reason. This entry is about the first two, because they are the pair that looks the same to the customer and costs the seller differently.

Partial exemption: when you make both

VAT Notice 706 says a business that makes, or intends to make, both taxable and exempt supplies, and incurs input tax relating to both, is “partly exempt” and must work out how much input tax it can recover. HMRC sets out three steps.

First, direct attribution. Input tax on purchases used only to make taxable supplies, including zero-rated ones, is recoverable in full. Input tax on purchases used only to make exempt supplies is not, unless the de minimis rules below apply.

Second, apportionment of residual input tax, which Notice 706 defines as input tax on purchases used for both, “because it’s used directly to make both taxable and exempt supplies or because it’s an overhead of the business.” Under the standard method, the recoverable share is the value of taxable supplies divided by the value of all supplies, both excluding VAT. The percentage is rounded up to the next whole number, unless residual input tax averages more than £400,000 a month, in which case it is rounded to 2 decimal places. Sales of capital assets used in the business, and incidental financial or real estate transactions such as bank interest, are left out of both values. The standard method applies unless HMRC has approved a special method.

Third, an annual adjustment at the end of the longer period, usually the partial exemption year, which corrects the recovery percentages used on the individual returns.

The EU Directive works the same way. Article 173(1) says that for goods and services used for both kinds of transaction, “only such proportion of the VAT as is attributable to the former transactions shall be deductible,” and Article 174 builds the proportion from turnover with the right to deduct over total turnover, leaving out capital goods and incidental real estate and financial transactions. Member states have options to vary this, including treating non-deductible VAT as nil “where the VAT which is not deductible by the taxable person is insignificant.”

The de minimis limits

The UK version of that insignificance rule is the de minimis test. Notice 706 says you can be treated as fully taxable, and recover your exempt input tax, in a tax period or longer period if your exempt input tax is not more than £625 per month on average and not more than half of your total input tax. Exempt input tax here means the input tax directly attributed to exempt supplies plus the exempt share of residual input tax. Blocked input tax, such as VAT on business entertainment, is left out of the total.

Both conditions have to be met. HMRC’s own worked example in Notice 706 fails because exempt input tax averages more than £625 a month, even though it is under 50 percent of the total.

Two simplified tests can save the full calculation in a VAT period. Test One is passed if total input tax is no more than £625 a month on average and exempt supplies are no more than 50 percent of all supplies. Test Two uses total input tax minus the input tax directly attributable to taxable supplies, against the same two limits. A business that passed the test in its previous year can also choose to apply it once a year instead of every period, provided it has reasonable grounds for not expecting more than £1 million of input tax in the current year. If it then fails at year end, it repays the exempt input tax it recovered during the year.

Worked example: same sales, different recovery (illustrative)

The figures are round, illustrative numbers for one VAT quarter, not a template. A UK company sells £150,000 of goods and services excluding VAT through Stripe. Its costs carry £9,000 of input VAT: £3,000 on purchases used only for its taxable sales, £1,500 on purchases used only for its exempt sales, and £4,500 on shared overheads such as rent, software and accounting fees. None of it is blocked.

Case 1, mixed. £90,000 of the sales are standard rated at 20 percent and £60,000 are exempt. Output VAT is £18,000. The standard method recovery rate is £90,000 divided by £150,000, which is 60 percent, so £2,700 of the £4,500 residual is recoverable. Recoverable input VAT is £3,000 plus £2,700, or £5,700. Exempt input tax is £1,500 plus £1,800, or £3,300, an average of £1,100 a month. That is over £625, so the de minimis test fails and the £3,300 stays a cost. The return shows £18,000 in box 1, £5,700 in box 4, £12,300 to pay in box 5, and £150,000 in box 6.

Case 2, the exempt sales are zero rated instead. Same £60,000 of sales, same customer invoices showing no VAT. Now every sale is a taxable supply, there is nothing to apportion, and all £9,000 of input VAT is recoverable. The return shows £18,000 in box 1, £9,000 in box 4, £9,000 to pay, and still £150,000 in box 6.

The difference is £3,300 in the quarter, or £13,200 over a year at the same run rate, and nothing on the Stripe invoices or in box 6 shows it. It comes entirely from how the £60,000 is classified and how the costs behind it are tagged.

How Stripe shows the difference

Stripe Tax records the reason for every tax result in a taxability_reason field, on each tax_breakdown entry of a Tax Calculation and in the tax amounts of an invoice line item. Its guide to zero tax amounts lists zero_rated as “The transaction is subject to the zero rate” and product_exempt as “The product is exempt from tax.” The same guide separates both from not_subject_to_tax, used where the jurisdiction does not impose a tax, chooses not to tax the transaction, or the sale of the product is not a taxable transaction.

Stripe’s own summary of the consequence matches HMRC’s. Exempt products “aren’t subject to VAT, and sellers typically can’t reclaim input VAT on costs related to producing or supplying them,” while zero-rated products “are technically taxable, but a 0% VAT rate is applied.”

The classification comes from the product tax code. Stripe says it “automatically determines when a product is exempt or zero-rated,” unless you assign the Nontaxable code, txcd_00000000, to stop tax on a product. That code produces not_collecting, the same reason Stripe gives when you have no registration in the customer’s location. It is a fast way to stop tax and a poor way to record why. A product that is genuinely zero rated or exempt in the places you sell is better left on the tax code that describes it, so the taxability reason on each line tells your bookkeeper which kind of zero it is.

Zero-rated and exempt sales in your QuickBooks books

Notice 700 asks for the split in your records, not just on the return. A VAT invoice that includes zero-rated or exempt items must show clearly that no VAT is payable on them and give a separate total for their values. Your sales records must let you produce, for each tax period, the VAT-exclusive value of your standard-rated, reduced-rated and zero-rated supplies and, separately, the value of any exempt supplies.

In QuickBooks Online, that would typically mean separate tax codes for zero-rated and exempt sales rather than one shared no-VAT code, with each Stripe line recorded under the code that matches its taxability reason. The return does not need the split, because box 6 takes both, but the partial exemption calculation does: the standard method needs the value of exempt supplies for each period and for the year.

Purchases need the same care. Direct attribution depends on knowing which costs were used only for taxable sales, only for exempt sales, or for both, so a partly exempt business would typically tag its purchases by use, for example with separate expense accounts. The input VAT that cannot be recovered becomes part of the cost, and the annual adjustment usually produces one more entry at year end. If your sales are entirely zero rated and you have no exempt income, none of this applies, and every pound of input VAT on business costs goes against your output VAT as normal.