I am a small business owner selling handmade products. I usually work on a 'sale or return' basis with local stockists but I have just received my first purchase order from a stockist who is buying my products wholesale. Within the purchase order sent to me, they have included VAT, which I have never mentioned before in our discussions of purchase. I am registered as a business but am not VAT registered. Do I include this VAT in my invoice to them? Or is it unnecessary?
If you are not registered for VAT, you must not charge it.
I take it from your post that your customer has mentioned VAT on a purchase order but has not yet paid you as you have not yet submitted an invoice. Your invoice will, in your normal manner, not include VAT. Your customer would be expected to pay the invoiced amount. Your invoices, of course, state you aren't VAT registered.
If your customer has paid you, including VAT, then they have overpaid. You should contact the customer regarding a refund.
They, as wholesalers, will probably have to charge VAT to their customer when they sell your product on. That is their problem.
TL;DR. In this case they've simply assumed that you're VAT-rated, so the fault is entirely theirs. Issue them a credit note for the difference (or just refuse the PO until they send a corrected one) and explain that you're not registered for VAT. Keep copies of those emails for at least 5 years in case the VAT man comes a callin'
As to whether to start issuing them invoices with VAT (knowing that they're happy to pay it), the answer to that is a very very firm 'no'. You would be breaking the law and exposing yourself to considerable legal jeopardy.
You must not charge VAT if your business is not registered for VAT. However, VAT registered businesses must charge VAT on their taxable supplies of goods and services and can reclaim the VAT they have paid that relates to the supplies on which they have charged VAT.
A penalty is payable by anyone who issues an invoice showing VAT when they are not registered for VAT: paragraph 2, Schedule 41, Finance Act 2008. The penalty can be up to 100% of the VAT shown on the invoice. There is a minimum penalty of 10% of the VAT even if there is an unprompted disclosure to HMRC of a careless mistake, as distinct from deliberate and concealed conduct.
What Happens if I Charge VAT and I’m not VAT Registered? Putting Matters Right
To put matters right, you should do two things. First, you should issue a credit note and also a refund to the customer for the VAT involved and explain to them that they should correct their VAT account if they have claimed an input tax deduction for the VAT you have mistakenly charged them.
Second, and at the same time, you should make an unprompted disclosure to HMRC explaining what has happened and the action you are taking to correct the situation. You should also explain how the situation arose and hope that only the minimum 10% penalty is charged. Do keep in mind that HMRC has the power to recover the VAT wrongly charged as a debt due to the Crown: paragraph 5, Schedule 11, Value Added Tax Act 1994. Also, HMRC can charge interest until the VAT is paid over to HMRC: section 74(4) Value Added Tax Act 1994.