What Is the Difference Between Zero Rated and Exempt VAT?

Zero rated and exempt VAT both mean no VAT is charged, but the tax treatment is different. Learn how each affects VAT registration and your ability to reclaim VAT.

Introduction

Understanding how VAT applies to different goods and services can be confusing, especially when terms like “zero rated” and “exempt” are used. Although both mean that no VAT is charged to the customer, they have very different implications for your business and your ability to reclaim VAT.

This article explains the difference between zero rated and exempt VAT, how each affects your business, and what to consider when deciding whether you should register for VAT.

What Is VAT?

Value Added Tax (VAT) is a tax charged on most goods and services in the UK. Businesses that are VAT registered must charge VAT on their taxable sales and can reclaim VAT on their business expenses.

There are several VAT rates in the UK:

  • Standard rate: 20% (applies to most goods and services).

  • Reduced rate: 5% (applies to certain items such as home energy or children’s car seats).

  • Zero rate: 0% (applies to specific goods and services such as food and books).

Some supplies are exempt from VAT entirely, meaning no VAT is charged, and they are treated differently for reporting and reclaim purposes.

What Are Zero Rated Supplies?

Zero rated supplies are goods or services that are still taxable for VAT purposes but are charged at a rate of 0%.

This means:

  • You must record them as taxable sales on your VAT return.

  • You can reclaim VAT on any business purchases or expenses related to these sales.

Examples of zero rated items include:

  • Most food and drink sold in supermarkets (not including catering or alcohol).

  • Books, newspapers, and magazines.

  • Children’s clothes and shoes.

  • Passenger transport services.

  • Exports of goods outside the UK.

Even though you do not charge VAT to the customer, these transactions count towards your VAT taxable turnover, which determines whether you need to register for VAT.

Example:
A bookshop sells £50,000 worth of books in a year. Although the books are zero rated, the shop’s sales count toward the £90,000 VAT registration threshold. If total taxable turnover exceeds that amount, the business must register for VAT.

What Are Exempt Supplies?

Exempt supplies are goods and services that are not taxable for VAT purposes. No VAT is charged to the customer, and you cannot reclaim VAT on any related purchases or expenses.

Examples of exempt supplies include:

  • Financial and insurance services.

  • Education and private tuition.

  • Health and medical care provided by registered professionals.

  • Certain property transactions, such as rent on residential properties.

  • Postal services provided by Royal Mail.

Because exempt supplies are outside the scope of VAT, they do not count towards the VAT registration threshold.

Example:
A private tutor earns £60,000 per year from teaching. Since tuition is VAT exempt, the income does not count towards the £90,000 registration limit, and the tutor cannot register for VAT voluntarily.

Key Differences Between Zero Rated and Exempt Supplies

Feature Zero Rated Exempt

VAT charged to customers 0% No VAT charged

Counts toward VAT registration threshold Yes No

Can reclaim VAT on related expenses Yes No

Shown on VAT return Yes (as taxable sales at 0%) No

Typical examples Food, books, children’s clothing Education, health care, rent

Partial Exemption

If your business sells both taxable (including zero rated) and exempt goods or services, you may be classed as partially exempt.

In this case, you can only reclaim a proportion of the VAT on expenses that relate to your taxable activities. HMRC requires you to use a specific calculation method, known as a partial exemption method, to work out how much input VAT you can reclaim.

Example:
A private school sells educational courses (exempt) and uniforms (zero rated). It can reclaim VAT on costs related to the uniform sales but not on costs related to teaching. Shared expenses, such as utilities, must be apportioned.

Why the Difference Matters

The distinction between zero rated and exempt supplies affects:

  • VAT registration: Zero rated sales count toward the £90,000 threshold; exempt sales do not.

  • VAT recovery: Businesses making zero rated supplies can reclaim VAT on expenses, while those making exempt supplies cannot.

  • Pricing: If you cannot reclaim VAT, it effectively increases your costs, which may impact your prices or profit margins.

Mistakes to Avoid

  • Assuming zero rated and exempt are the same. Zero rated items are still taxable, whereas exempt items are not.

  • Forgetting that zero rated sales count toward the VAT threshold.

  • Trying to reclaim VAT on costs linked to exempt income.

  • Failing to apply the correct VAT rate on mixed supplies.

Incorrect VAT treatment can lead to underpaid tax, loss of input VAT claims, or penalties from HMRC.

Example Scenarios

  1. Zero Rated Example:
    A bakery sells cakes and bread, both of which are zero rated. It buys flour, packaging, and equipment with VAT included. The bakery does not charge VAT to customers but can reclaim VAT on its purchases.

  2. Exempt Example:
    A landlord rents out residential properties. The rent is VAT exempt, so the landlord does not charge VAT to tenants and cannot reclaim VAT on related expenses, such as repairs or management fees.

  3. Mixed Business Example:
    A pharmacy sells prescription medicines (zero rated) and over-the-counter items (standard rated). It must charge VAT on standard-rated sales but can reclaim input VAT on costs related to both types of goods.

The Role of an Accountant

An accountant can help you:

  • Determine which VAT rate applies to your goods or services.

  • Calculate how much VAT you can reclaim if you sell both taxable and exempt items.

  • Complete accurate VAT returns.

  • Avoid misclassification errors that could lead to HMRC penalties.

Professional advice ensures your VAT accounting is correct and compliant, particularly if your business operates in a sector with mixed VAT treatment.

Conclusion

The main difference between zero rated and exempt VAT is that zero rated goods and services are taxable at 0%, allowing you to reclaim input VAT, while exempt goods and services are not taxable at all, meaning you cannot reclaim VAT on related expenses.

Understanding this distinction is crucial for accurate VAT reporting and financial planning. If your business sells both types of goods or services, maintaining clear records and seeking expert guidance will help you apply the correct VAT treatment and stay compliant with HMRC rules.