How your SaaS business can stay VAT-Compliant in the UK

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In the United Kingdom, more than half of residents' household expenses are subject to value-added tax (VAT).

If you have customers in the UK, your first thought might be: “Does my company have to pay VAT on sales?”

This becomes even more complicated if you run a software-as-a-service (SaaS) company, as the tax laws for these businesses are notoriously complex.

In short, the answer is: yes. 

If you have customers in the UK, you are required to pay VAT. In this article, we'll detail how this process works. 

By the end, you’ll know when VAT applies to your SaaS company, when to register with the UK tax authority, and how to calculate your VAT. 

How Value-Added Tax Works in the UK

Value-added tax is a consumption tax levied on goods and services that enables governments to collect taxes indirectly. In contrast, a direct tax would be something like income tax. 

Unlike sales tax in the U.S., VAT is charged at every stage of production to account for real-world economic activity. 

For example, if you’re baker, your chocolate-covered shortbread would be subject to the following VAT rates: 

• Buying ingredients: In the UK, the standard VAT rate is 20%. If the ingredients cost £100, the 20% VAT rate adds £20, making the total cost £120.
• Selling to a shop: If you sell your treats for £150, you need to include a 20% VAT rate, which adds £30. So, the shop pays you £180 in total (£150 + £30).
• Customers buying from the shop: If a customer gets your shortbread for £2, they need to pay £0.40 in VAT. This makes the total price they pay £2.40 (£2 + £0.40).

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In 1973, when the United Kingdom joined the European Economic Community—now the European Union (EU)— they started charging VAT. This was a requirement for their admission to the group. 

By 2022/23, VAT had become the UK Government’s third largest source of tax revenue, totaling £160 billion. 

In the UK, VAT falls into one of the following three categories: 

• Zero-rated VAT (0%): This is when no VAT is applied to a sale. This includes items like women's sanitary products, children's clothing, and postage stamps. 
• Reduced VAT rates (5%): This is a quarter of the standard VAT rate. It includes items, such as children's car seats, domestic fuel, and heating oil. 
• Standard VAT rate (20%): This is the general VAT rate that’s applied to most items, such as soft drinks, alcoholic drinks, and most food items. 

Is It Cake or a Biscuit? 

In 1991, the owner of Jaffa Cakes went to court about the VAT rate on their products. He insisted that his product was classed incorrectly as a biscuit, while it was really a cake. 

At the time, if it was classified as a cake, it would be exempt from VAT (0%), but if considered a biscuit, it would be subject to the standard tax rate (20%).

After a long legal battle, they were deemed cakes due to their soft texture, and they received a VAT-free status. 

How Is SaaS Defined in the United Kingdom? 

Just like Jaffa Cakes, SaaS businesses are incredibly tricky to categorize for VAT. In many countries, there’s debate over whether it falls under goods or services. 

To settle any uncertainty, the UK decided to classify SaaS products as a “digital service”, along with other online products, such as web hosting and e-learning services. 

Here are some examples of SaaS businesses that supply digital services: 

• Cloud-based office suites: Subscription-based access to cloud-based software such as Microsoft 365 or Google Workspace.
• Project management software: Platforms like Asana or Trello that provide online project management and collaboration tools.
• Accounting software: Online accounting platforms, such as QuickBooks Online or Xero, that offer cloud-based financial management.
• Collaboration tools: Video conferencing and collaboration software, like Zoom or Slack, that enable remote teamwork.

When to Register for Value Added Tax in the UK

If your SaaS company serves customers in the UK, it must register to pay VAT upon reaching the country’s VAT threshold. 

The government won’t send you a notice. It’s your responsibility to register with tax authorities. The threshold for this depends on your location: 

1. UK-based businesses

The UK VAT threshold for registration—which also applies to SaaS businesses—has stood at £85,000 since 2017 (this is subject to change in March 2024). 

If your business operates in the UK, VAT registration is mandatory when your taxable turnover passes this amount during the tax year (or it will do so within the next 30 days).

Let’s say you run a UK-based business that offers cloud storage software in the UK. If you expect your taxable turnover to reach or exceed £85,000 in the next 12 months, you need to register for VAT. 

2. Non-UK businesses 

If your business is based outside the UK, VAT registration is required if you meet the following criteria:

• You or your business is based outside the UK
• You supply any goods or services, including digital services, to the UK (or expect to do so in 30 days) 

Let’s assume your cloud storage business is based in the U.S. Even if you only have a handful of clients in the UK, you must be a VAT-registered business. 

Regardless of whether your business is located in the UK, once registered for VAT, you are required to charge VAT on your sales, keep an accurate record of your sales and purchases, and submit regular VAT returns.

VAT Rules for Selling to UK Customers 

When discussing VAT in the UK, you need to consider the impact of the EU. 

In 2015, while the UK government was still a member state, the EU government introduced changes to its VAT rules for digital services—many of which are retained by the UK today. 

Here are the key modifications:

1. Place of supply of services for UK VAT rules

Traditionally, VAT was based on the supplier's location. However, post-2015, they started applying it to the consumer's location.

For example, if a UK SaaS company sells to a French customer, VAT is determined by the French customer's location. 

Today, the United Kingdom government refers to this as the customer location principle.

Let's explore another example: 

• An American company providing global email marketing services recently gained subscriptions from UK customers. 
• Following the customer location principle, the company must apply the UK's VAT rate to these subscriptions. 
• This ensures fair taxation based on where the service is consumed, rather than where it produced. 

Note that if the same SaaS company was based in the UK, it would be subject to the same VAT rate as the American company. 

This is because they would also be selling to UK clients. 

2. Reverse charge mechanism for UK VAT

To facilitate cross-border trade and reduce bureaucracy, EU countries (including the UK) adopted the reverse charge mechanism. 

In essence, it shifts the VAT responsibility from the seller to the buyer in B2B transactions. In other words, the business that uses the SaaS product pays the taxes. 

Let’s say an American SaaS company provides cloud-based tools to a UK consulting firm. 

With the reverse charge mechanism, the SaaS company invoices the UK consulting firm for its cloud-based tools. However, the invoice is issued net of VAT, indicating that it does not contain a separate itemized VAT amount. 

What Is “Net of VAT”? 

In a transaction, when an amount is referred to as "net of VAT," it means that the VAT has not been included in the given price. 

Once the UK company receives the invoice, it accounts for the VAT on both sides of the transaction, including:

• Input tax: The UK firm debits its VAT account for the tax it would have paid if it were the seller. This is the VAT on the product purchased from the American company.
• Output tax: The UK firm also credits its VAT account for the tax it would have hypothetically collected if it were the seller of the services. 

The input and output taxes then offset one another, balancing their VAT account. 

The reverse charge doesn't apply to B2C transactions. Here, the SaaS company remains responsible for VAT collection and remittance. 

For example, the U.S. SaaS company would charge and collect VAT on their sales to UK consumers and personally remit it to the UK tax authorities. 

How to Calculate VAT for Your UK Customers 

Calculating VAT for your UK customers can be complex, particularly given the evolving tax regulations pre- and post-Brexit.

To help you make sense of this, let’s use an example to demonstrate how VAT can be calculated if you have UK customers. 

Suppose you operate an American-based SaaS company named SafeHaven, specializing in cybersecurity. It provides SaaS solutions to safeguard customers from digital threats. 

Today, you notice that UK customers have subscribed to your cybersecurity services. As a result, you need to ensure that you’re VAT-compliant in the UK. 

Here are five steps to guide you through the process: 

Step 1: Establish the place of supply

First, check if you need to pay UK VAT. 

The customer location principle says that UK businesses are liable for VAT if they exceed £85,000, and non-UK businesses need to be VAT-registered as soon as they have UK customers. 

SafeHaven is based in the U.S., but because you now have UK customers, you need to start paying VAT. 

Registering for UK VAT allows you to fulfill your responsibilities for collecting, recording, and remitting VAT on your transactions with UK customers. 

The tax authority in the UK is called Her Majesty's Revenue and Customs, or HM Revenue and Customs. Follow this link to become a VAT registered business. 

Step 2: Determine the correct VAT rate 

Now that you've determined your liability, you need to identify whether your SaaS product is subject to the standard rate (20%), reduced rate (5%), or zero-rate (0%) VAT. 

SaaS businesses that offer certain taxable supplies might qualify for reduced or zero VAT rates. 

For example: 

• Healthcare management software: Tools to record patient records may qualify for reduced rates if they’re regarded as an essential healthcare service.
• Charitable organization software: Exemption may apply if your software facilitates donor management, fundraising, and program tracking for UK-based nonprofits.
• Eco-friendly initiatives software: Solutions that measure and reduce the environmental impact of businesses might receive a reduced rate. 

After consulting HM Revenue & Customs (HMRC) guidelines, you determine that your cybersecurity services don’t qualify for reduced or zero-rate VAT. 

Therefore, your services supplied are subject to the standard VAT rate of 20%. 

Step 3: Determine the reverse charge mechanism 

Once you’re set up for VAT and you’ve determined how much you’re liable for, the next step is to figure out who your customers are. 

If you learn that SafeHaven's UK clientele consists solely of businesses (B2B) and not direct consumers (B2C), you would need to implement the reverse charge mechanism. 

In this scenario, the responsibility for VAT payment shifts from the seller to the buyer. 

Once you know that a client qualifies for this, you need to verify that they’re registered for VAT in the UK. 

If they’re not, the tax burden will bounce back to the seller, leading to disputes between businesses, which can be time-consuming and may harm business relationships.

Step 4: Incorporate VAT details in invoices 

Now that you've found out who’s using your cybersecurity services in the UK, you need to include the appropriate details in your invoices.

Since SafeHaven is responsible for B2B transactions, you should keep the following in mind when managing your invoices: 

• Mention the reverse charge: Indicate on your invoices that the reverse charge mechanism applies. This communicates the shift of responsibility for VAT payment from your SaaS company to the UK business client.
• Include VAT identification numbers: If possible, include the UK VAT numbers of your SaaS company and the UK business client on documents to help the tax authority confirm your VAT-related business connection.
• Record transaction details: Maintain comprehensive records of B2B transactions, including the VAT details, even though the VAT paid isn't collected by your SaaS company. This documentation is essential for VAT compliance. 

Step 5: Collect and remit taxes 

Now that you've established your VAT obligations, the final step is to collect and remit the taxes.

In our example, SafeHaven doesn’t remit taxes to the United Kingdom because their UK client will do this on their behalf. SafeHaven’s VAT liability ends after submitting correct invoices. 

The UK business client is responsible for remitting taxes to the UK authorities on behalf of SafeHaven through the reverse charge mechanism.

If SafeHaven had B2C customers, they would be responsible for directly collecting VAT from the end consumers and subsequently remitting it to the United Kingdom tax authorities.

They need to clearly indicate the correct tax amount on customer invoices and ensure its collection. 

This amount is then paid as VAT to HM Revenue & Customs.

Do You Need a Merchant of Record (MoR)? 

Managing your VAT liability in the UK can be complicated. 

To be tax-compliant in the UK, you must understand the intricacies of VAT, including its application to digital services, place of supply rules, and recent regulatory changes. 

And if your SaaS business serves customers in multiple countries, things can get even more complex. 

For instance, selling to customers in the United States can require compliance with over 13,000 tax jurisdictions.

At Lemon Squeezy, we serve as a merchant of record for businesses with clients in multiple tax jurisdictions, making it easy to remain compliant across the world. 

We calculate, collect, and remit all your taxes globally, meaning you can focus on growing your business without worrying about the tax implications.  

If you'd prefer to entrust your taxes to us, we'd love to assist you. 

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