When you set up as a limited company contractor, there are several VAT schemes open to your business.
Although you are not obliged to register for VAT until your company turnover reaches £85,000 in a 12 month period (2020/21 tax year), the vast majority do regardless, as not only does VAT registration provide a more professional image on an invoice, but your company may actually be better off as a result.
HMRC operates a number of VAT schemes. Here is a very high-level summary of each one:
1. Standard VAT accounting
With the standard scheme, you account for VAT according to the invoice date, rather than the date VAT is received into your account (unlike the Cash Accounting scheme – below).
This isn’t necessarily advantageous from a cashflow point of view, as you’ll end up paying VAT back to HMRC before you’ve received the VAT yourself.
However, as you only pay VAT quarterly, you can accrue interest on any VAT collected prior to the VAT quarter end (although this may not be such an attractive incentive at the moment).
2. Cash Accounting scheme
With this method, you only pay VAT back to HMRC once you have actually received it from your client. This is particularly good for cashflow reasons and is therefore recommended for most contractors. The turnover threshold for the CAS is now £1.35m (more than adequate for most contractors).
However, joining the CAS means you can’t reclaim VAT on purchases until you pay your suppliers.
The scheme is easy to join, and you don’t need to inform HMRC.
3. Annual VAT accounting
This scheme allows businesses to submit just one annual VAT return rather than the usual four. They pay in instalments throughout the year, then a balancing payment at the end of the year.
This can help with cash flow and administration time, as businesses know what their liability will be on a monthly basis, but the balancing payment could come as a bit of a shock if trading has been particularly good. This is not widely used by IT contractor companies.
Your company can join the scheme if your estimated turnover is £1.35 million or less.
4. Flat Rate VAT scheme
With the flat rate VAT scheme, rather than accounting for the VAT on every payment received and made by your company, you pay a single flat VAT rate based on your turnover. The flat rate percentage varies according to industry types (for most IT contractors, the rate is 14.5%), and may be advantageous for contractors depending on how much their company spends on purchases.
You can apply if your annual taxable turnover (not including VAT) will be £150,000 or less, and your annual total turnover (including VAT) will be £187,500 or less. Additionally, you can benefit from a 1% reduction in your flat rate percentage in your first year of VAT registration.
You should note that, since April 2017, companies which fit the new definition of a ‘limited company trader’ (low expenses) have to use a punitive 16.5% fixed percentage when using the scheme, which has removed the tax benefit of joining the scheme for a large number of small companies.
Read our in-depth guide to the flat rate VAT scheme.
For the ultimate source for all things VAT-related, visit HMRC’s VAT pages.
Your company may well benefit from an alternative way of accounting for VAT, aside from the standard scheme. Your accountant should be able to advise you which method is best given your financial circumstances.