Value Added Tax – VAT guide for IT contractors

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 for it, and the benefits of the cash accounting scheme.

Most IT contractors operate through their own limited companies and provide services to VAT-registered clients, such as recruitment agencies and end clients.

In these situations, charging VAT does not normally make the contractor more expensive for the client because the business receiving the invoice can reclaim the VAT.

This is why many contractors register for VAT voluntarily even before reaching the registration threshold. In addition to reclaiming input VAT on purchases, some VAT schemes can produce a small financial benefit for contractor businesses.

Rates of VAT

The standard rate of UK VAT is currently 20%, although there are also 5%, 0% and ‘exempt’ rates which apply to certain goods and services.

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 give your company a more professional image with clients and agents and enable you to reclaim VAT on purchases.

Should contractors register for VAT if they are below the threshold?

Many limited company contractors choose to register for VAT voluntarily, even if their turnover is below the compulsory registration threshold.

One reason is that most contractor clients are VAT-registered businesses. Because these businesses can reclaim VAT, adding VAT to invoices does not usually increase the real cost of the contractor’s services.

Voluntary VAT registration can also allow the contractor to reclaim VAT on equipment, software, training, and other business purchases.

In some cases, registering for VAT may also allow the contractor to use schemes such as the Flat Rate Scheme, which historically allowed some contractors to retain a small portion of the VAT charged to clients.

For these reasons, many accountants recommend that contractors consider registering for VAT early in their trading.

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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. This means you may have to pay the VAT to HMRC 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.

Example: VAT for a contractor invoice

Suppose a contractor invoices a recruitment agency £5,000 for services in a quarter.

• Invoice amount: £5,000
• VAT at 20%: £1,000
• Total invoice to client: £6,000

The contractor collects the £1,000 VAT on behalf of HMRC. When the quarterly VAT return is submitted, the contractor pays HMRC the VAT collected minus any input VAT on business purchases.

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 experience late payments or a client defaults completely, your cash flow management can suffer. This situation can only be made worse if you have to repay the VAT on each invoice to HMRC before payment is received.

For many businesses, the Cash Accounting Scheme can solve these cash flow concerns, as you only account for VAT once your invoices have been paid.

Importantly, the Flat Rate VAT Scheme already uses its own cash-based method for calculating VAT, so businesses using the flat rate scheme do not join the Cash Accounting Scheme separately.

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 VAT at the prevailing rate to all invoices they produce.

Most contractors (or their accountants) will receive a quarterly VAT reminder. Your VAT return and payment must normally be submitted to HMRC no later than one month and seven days after 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.

Most online accounting systems (such as FreeAgent) allow you to submit your quarterly VAT returns directly from within the software package.

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 system.
• Maintain digital links between your records and VAT return calculations.

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.

For full details, see HMRC’s VAT schemes guidance.

Why many contractors choose the Flat Rate VAT scheme

Historically, the Flat Rate VAT scheme was very popular with contractors because it allowed them to keep a small portion of the VAT they charged to clients.

However, since the introduction of the Limited Cost Trader rules in April 2017, many IT contractors now fall into the 16.5% flat rate category, which removes most of the financial advantage.

Despite this change, the scheme can still simplify VAT administration for some businesses and may still produce savings in certain circumstances.

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.

If your company is eligible to join the Flat Rate Scheme, it will receive a discount on the standard flat rate percentage during the first year of registration, which could result in tax savings.

This article provides a high-level outline of VAT. For more details, please read HMRC’s VAT guidance.