Value Added Tax (VAT) is levied on almost all goods and services that are supplied in the UK. It is an almost 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 £85,000 over the past 12 months (from April 1st 2023), or if you expect to breach this threshold in the next 30 days alone.
The threshold increases to £90,000 from April 2024.
Most contractors register for VAT as soon as they start working, as there are a number of benefits for doing so; it may provide your company with a more professional image to clients and agents and will enable your company to claim back 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 everything it sells to other companies – such as professional services (output VAT).
Each quarter, if you have charged more output VAT than you have spent in input VAT, 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 before, the main benefit of joining this scheme is that it can greatly improve cash flow – especially if you have experienced slow-paying customers or clients.
You only account for VAT once you receive payment, and if you suffer a bad debt, then no VAT is payable.
Although not a great consideration for many IT contractors, you cannot reclaim any VAT paid on purchases until you have actually 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. Businesses can remain within the scheme until their turnover reaches the £1.6m mark.
There are no forms to fill in; you can simply 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 it produces.
Most contractors (or their accountants) will receive a VAT reminder every quarter. 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 for you to pay direct 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 in order to submit quarterly VAT returns, get reminders of when your VAT is due, and to set up a direct debit to automatically take your due taxes out of your business bank account. If you do pay by direct debit, you will also get an extra week to make the payment.
Most online accounting systems (such as FreeAgent) will let you submit your quarterly VAT returns from within the software package, which is an excellent feature.
Flat Rate VAT?
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, although 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.
