Making Tax Digital for VAT phase 2: what your clients need to know

If you’re an accountant, you’re probably already familiar with the government’s Making Tax Digital (MTD) scheme. As part of an effort to make sure all tax records are kept and processed digitally, the government introduced new rules on what data businesses must keep and how and when they must send it to HMRC.

MTD started in 2019, but the shift is far from over. Phase two was rolled out on 1 April 2021, and it’s crucial your clients are compliant with it.

In this article, we’ll recap phase one, give you the basics on phase two and recommend our best accounting software for Making Tax Digital.

You might also find our article on the 2022 VAT portal closure helpful.

A recap of MTD for VAT phase 1

Many businesses will already be familiar with the basics of Making Tax Digital. Phase one was rolled out in April 2019, and that year saw many businesses and accountants working hard to get ready for the new programme. 

Under MTD phase one, eligible businesses had to:

• maintain digital records for certain items 

• keep those records in an HMRC-recognised format  VAT returns using HMRC recognised MTD compliant software

This only applied to VAT-registered businesses with a taxable turnover above £85,000. 

So what’s changing now?

What does Making Tax Digital phase 2 involve?

The government’s original plan was to give businesses a year to adjust to the new rules in what HMRC called a ‘soft landing’. Businesses had to keep digital records to support their VAT return, and also submit their VAT using HMRC-recognised “digital software”. The soft landing was designed to give businesses time to get 100% organised. 

Because of the COVID-19 pandemic, the deadline was extended, giving a little more leeway to deal with disruptions. 

Despite ongoing restrictions, phase two was rolled out on 1 April 2021, and is now live.

The core features of phase two include:

• penalties for non-compliance

• tighter rules on keeping and sending records

We’ll cover both of those, as well as the introduction of Making Tax Digital for Income Tax Self Assessment (MTD for ITSA), below. 

Digital links must be in place

The most important change for MTD phase two is the need for ‘digital links’. HMRC wants to see clear links between the data it receives and the records businesses keep, to provide a clear digital audit trail. What’s more, by April 2022 all these changes will apply to all VAT-registered businesses, whatever their turnover.  

What is a digital link?

A digital link is described as ‘a transfer or exchange of data’ that’s made ‘electronically between software programs, products or applications’.

In simple terms, it means that the journey data takes to get from one place to another occurs entirely digitally. 

It might help to distinguish a digital transfer from a manual one. Jotting down data from a spreadsheet by hand and then reentering it into a new program, for instance, would be a manual link, which isn’t permitted under MTD phase two. 

HMRC-approved forms of digital link include:

• automated data transfer

• emailing a spreadsheet and importing the information into another program

• transferring a set of records onto a portable drive and importing the data into a different program 

Crucially, HMRC doesn’t consider cut and paste or copy-paste to be digital links. 

What is a digital audit trail?

A digital audit trail means that the tax information held by HMRC can be traced all the way back to the original data recorded in the business’s accounting systems. 

HMRC hopes this will reduce the risk of human error and make it easier to review and correct discrepancies.

Making Tax Digital for Income Tax

On top of all this, the government is also ready to extend Making Tax Digital to the processing of Self Assessment Income Tax returns.

From April 2026, anyone who completes a Self Assessment Income Tax return will have to keep records and submit them to HMRC in the same way as MTD for VAT businesses do at present. 

This means they must: 

• keep digital records

• submit digital submissions to HMRC, which are usually quarterly

• keep, transfer and submit all data in HMRC-approved form 

They’ll also need to submit their full annual return. 

Who’ll be affected by Making Tax Digital for Income Tax?

These changes will only affect those who use Self Assessment for their Income Tax. Mostly, this means partners in business partnerships and self-employed sole traders who earn over £1,000 before claiming any tax relief. 

Others who may need to send a return include: 

• those who make money from renting out a property

• those who receive income from savings, investments and dividends

• those with foreign income

• those who take significant tips or commission 

While MTD for Income Tax is not due to be rolled out until April 2026, accountants can get ahead of the curve by getting them up to speed with digital record keeping. 

Making Tax Digital penalties

Phase one MTD rules only applied to companies with annual turnover of more than £85,000. Phase two extends to almost all VAT-registered businesses.

Phase two introduces penalties for non-compliance as follows:

• A default is recorded if you don’t comply with the rules or miss a filing.

• You then enter a 12-month surcharge period.

• Surcharges are penalties calculated as a percentage of the VAT due on your latest return.

• The surcharge period resets with each new default.

• Surcharges scale for each default, up to 15% of the VAT due.

On top of this, HMRC can charge interest fees for late payment or non-payment. 

And if a return contains ‘careless or deliberate’ inaccuracies, there can be fines of up to 100% of the VAT due or overclaimed. 

How to make sure your clients are compliant with MTD for VAT phase 2

With the introduction of penalties, it’s more important than ever that accountants keep their clients up to date with the rules. 

Accountants need to check that if they are using bridging software that it meets the MTD rules. HMRC states that there must be a clear digital audit trail. In addition the records - if not kept within accounting software - must be kept digitally. Otherwise they don’t meet HMRC’s standards for establishing a clear digital audit trail. 

It’s safest to use HMRC-approved software like QuickBooks Online, which offers an integrated solution, providing digital links at every step of the process. 

We hope this article has helped you get a handle on what MTD for VAT is, how it’s changed over the last couple of years and where it’s going in the future. 

As always, it’s crucial you keep up to date with the latest rules and regulations – and ensure you have the right accounting software in place to help your clients avoid penalties.