Value Added Tax (VAT) is levied on almost all goods and services that are supplied in the UK. It is a nearly universal tax on business transactions. Here we explain how VAT works, how to register, and the benefits of the cash accounting scheme.
Rates of VAT
The standard rate of UK VAT is currently 20%, although there are also 5%, 0% and ‘exempt’ rates which are used for other purposes.
How to register for VAT
If you are a limited company contractor, you are obliged by law to register your company for VAT if your turnover has exceeded £90,000 over the past 12 months (from April 1st 2024), or if you expect to breach this threshold in the next 30 days alone.
Most contractors register for VAT as soon as they begin working, as there are several benefits to doing so.
It may provide your company with a more professional image to clients and agents, and enable you to reclaim the VAT on purchases.
How does Value Added Tax work?
As a limited company contractor, your company will pay VAT on any purchases it makes (input VAT) and will charge VAT on all sales to other companies, such as professional services (output VAT).
If you charge more output VAT than you spend in input VAT each quarter, you must pay HMRC the difference.
On the ‘standard’ VAT scheme, you account for VAT as soon as you create an invoice (i.e. you may have to repay the VAT to HMRC amount before you actually receive payment from a client).
For cash flow reasons, you may elect to join the cash accounting scheme (see below), whereby you only account for VAT once you have been paid. You should check with your accountant which VAT scheme is most beneficial to you.
What is the Cash Accounting VAT scheme?
Under the standard VAT scheme, you repay the VAT element charged on all your invoices to HMRC each quarter, whether or not your clients have paid you.
Of course, if you suffer late payment problems, or if a client defaults completely, your cash flow management can suffer. This situation can only be made worse if you have to repay the VATable element of each invoice to HMRC in advance of being paid.
For many businesses, the Cash Accounting Scheme for VAT can solve these cash flow concerns, as you only account for VAT once your invoices have been paid.
Importantly, it should be noted that you cannot use the Cash Accounting Scheme alongside the Flat Rate VAT scheme, which contains its own cash-based turnover method.
The pros and cons of the Cash Accounting Scheme
As mentioned earlier, the primary benefit of joining this scheme is that it can significantly improve cash flow – especially if you have experienced slow-paying customers or clients.
You only account for VAT once you receive payment; if you suffer a bad debt, no VAT is payable.
Although not a significant consideration for many IT contractors, you cannot reclaim any VAT paid on purchases until you have paid for the relevant goods or services.
How do you join the Cash Accounting Scheme?
If your turnover during the coming 12 months does not exceed £1.35m, your business can join the scheme. Companies can remain within the scheme until their turnover reaches £1.6 million.
There are no forms to fill in; you can switch from standard to cash accounting for VAT from the start of any given VAT quarter (or from the date you started trading).
Your business can leave the scheme voluntarily at the end of any given VAT quarter.
Read the official HMRC guide to the Cash Accounting Scheme here.
Paying VAT
All VAT-registered businesses must add standard VAT at the prevailing rate to all invoices they produce.
Most contractors (or their accountants) will receive a quarterly VAT reminder. Your basic VAT calculations and payment should be returned to HMRC no later than one month following the end of your VAT quarter.
Most contractor accountants will take care of VAT calculations on your behalf. They will either let you know your VAT liability to pay directly to HMRC, or in some cases, you will send the funds to your accountant to settle with the tax authorities on your behalf.
You (or, more likely, your accountant) must be signed up to HMRC’s VAT Online service to submit quarterly VAT returns, get reminders of when your VAT is due, and set up a direct debit to automatically take your due taxes out of your business bank account.
If you pay by direct debit, you will also get an extra week to pay.
Most online accounting systems (such as FreeAgent) allow you to submit your quarterly VAT returns from within the software package, which is an excellent feature.
Making Tax Digital (MTD) for VAT
Since April 2022, all VAT-registered businesses – including those below the £90,000 threshold – must follow the Making Tax Digital rules. This means you must:
Keep digital VAT records using compatible software (e.g. FreeAgent, Xero, QuickBooks).
Submit VAT returns directly from your software via HMRC’s MTD portal – you can no longer type figures into the old online VAT form.
Maintain digital links between your records and VAT return calculations to ensure accurate and timely reporting.
If you are newly VAT-registered, you must sign up to MTD before filing your first return. Your accountant can usually handle the setup and ensure your software is fully compliant.
Other VAT schemes
In addition to the Standard and Cash Accounting schemes, HMRC also operates several other options for specific situations:
Annual Accounting Scheme – file one VAT return per year with advance payments.
VAT Retail Schemes – simplified methods for businesses making a large number of low-value retail sales.
Margin schemes – for second-hand goods, works of art, antiques and collectables.
You may also be interested in registering to join the Flat Rate VAT scheme, which could save you money if you do not claim a great deal of input VAT.
However, this benefit has been removed for many contractors since April 1st, 2017, due to new ‘limited company trader’ rules.
If your company is eligible to join the Flat Rate Scheme, it will receive a discount on the usual flat rate percentage during the first year of registration, which could result in a significant tax saving.
This article provides a high-level outline of VAT. For more details, please read HMRC’s VAT pages.
