Although most UK businesses operate via the standard VAT scheme, some limited companies may be better off by using the flat rate VAT scheme, which came into force in 2002. However, you should be aware of punitive ‘limited cost trader’ rules, which came into force in 2017, and make the flat rate scheme non-viable for many small companies.
Flat Rate VAT – The basics
The flat rate scheme makes the calculation of VAT far simpler than the standard scheme. Although you charge clients and customers the standard 20% VAT rate on all invoices, you repay VAT on an annual basis of 14.5% if you are an IT contractor (or the relevant percentage according to your occupation or profession – see here for the HMRC table).
Whether or not you are financially better off by operating through the flat rate VAT scheme or not will depend on your own circumstances. If you buy a lot of equipment, for example, you may not benefit, as you cannot reclaim the VAT on purchases.
Limited cost trader excludes many small companies
In an effort to reduce the tax benefit of using the FRS for companies who have low annual expenses, since April 2017 businesses deemed to be ‘limited cost traders’ are no longer be able to use beneficial flat percentage rates. Instead, they have to use a fixed 16.5% rate – meaning that any benefit of joining the FRS no longer exists, and the standard VAT scheme is the better bet.
Are you a limited cost trader?
A limited cost trader is defined as a business that has a VAT inclusive expenditure on goods of less than 2% of its VAT inclusive turnover in the relevant accounting period, or greater than 2% of its VAT inclusive turnover but less than £1000.
If you’re not sure whether or not your company is affected, you can use this online HMRC test.
The definition of goods includes items used solely for the purposes of the business but does not include capital expenditure, food and drink, and vehicle-related costs (for businesses involved in transport). These exceptions were introduced to prevent businesses from buying everyday items or one-off purchases to raise their costs above the 2% level.
The following classic contractor services are excluded, as they are not ‘relevant goods’:
- Accountancy fees
- Advertising costs
- ‘Anything provided electronically’ – e.g. downloads!
- Software you have downloaded, or bespoke software
- Office rent
HMRC have issued some guidance that might be helpful in determining what items qualify as goods. For example, any item that is used fully or partly by a business owner or employee in their private capacity, such as stationery that could be used in the office or at home, cannot be considered to be goods.
In the case of capital expenditure, this can include the cost of any goods that have been purchased for use in the business over a reasonable period of time, such as, for example, a piece of office furniture, a mobile phone, a computer or printer.
These items can be considered as goods for the purposes of the FRS scheme, even if they are not treated as capital assets for wider accounting purposes.
How much worse off are you if you’re a ‘limited cost trader’
Under the limited cost trader rules, many contractors who were previously using flat rates of between 12 and 14.5%, depending on their sector, now find themselves at the new 16.5% rate.
In financial terms, this represents a significant tax hit for many – but the Government has argued that those affected have been using the FRS purely to save tax, rather than due to the simpler accounting the scheme provides.
For example, if your turnover for the year prior to April 2017 was £75,000, your VAT-inclusive turnover would be £90,000. If you’re a typical contracting company, you would repay 14.5% x £90,000 = £13,050.
Since the new rules came into effect in April 2017, if you’re a ‘limited cost trader’, you will now pay 16.5% x £90,000 = £14,850 – an increased tax hit of £1,800.
Flat Rate VAT Scheme – Notes
These notes and the following example calculation apply to businesses that are not caught by the Limited Cost Trader rules.
- In your first year of registration, you receive an extra 1% reduction in the flat rate percentage you apply. In the case of most contractors, if you are not a ‘limited cost trader’, you will repay 13.5% to HMRC.
- You can join the scheme if your annual taxable turnover (excluding VAT) will be £150,000 or less, and your annual total turnover (including VAT) will be £187,500 or less.
- If you outlay £2,000 or more on a single capital asset (including VAT) you can claim the input tax on your VAT return in the normal way.
- Although you pay back a lower percentage under the scheme, you should continue to invoice clients at the standard VAT rate (currently 20%).
- Your company can elect to leave the flat rate scheme at any time.
- You can continue in the flat rate scheme unless your turnover breaches the £230,000 mark.
Flat Rate VAT Scheme – Example
Here is an example for a limited company with gross client billings of £40,000, and VAT on expenses incurred of £500.
Standard VAT Calculation
Total Billings @ £40,000
Output VAT @ 20% = £8,000
(minus) Input VAT @ £500
Total VAT Payable would be £7,500
Flat Rate Scheme
Total Billings @ £40,000
Output VAT @ 20% = £8,000 (Added to total for purposes of calculating flat rate VAT)
Total VAT payable would be 14.5% of £48,000 = £6,960
This example uses the 14.5% percentage applied to IT contractors since 4th January 2011. Other professions and occupations may have different rates.
(Don’t forget that you have a 1% reduction in the percentage you pay to HMRC for the first year using the flat rate scheme).
In general, if you are unlikely to make many purchases through your limited company, you may well be better off by joining the flat rate VAT scheme.
Always check with your accountant before deciding which scheme to join.
For more information, consult HMRC’s guide to the flat rate VAT scheme, which includes all the current flat rate percentages.