What is the Flat Rate VAT scheme, and how does this work in practice? The HMRC Flat Rate VAT scheme (FRS VAT) was initially introduced by HM Revenue & Customs in 2002. VAT is one of your main contractor taxes if you register for VAT. Under Flat Rate VAT for IT contractors and other contracting professionals, your business will pay a lower rate of VAT to HMRC, than under the Standard VAT Scheme.
Ordinarily, under the standard VAT scheme, the amount of VAT that a business pays or claims back from HM Revenue and Customs (HMRC) is the difference between:
- The VAT that is charged by the business to customers; and
- The VAT the business pays on their purchases.
Key features -Flat Rate VAT scheme
Some of the key features of the HMRC Flat Rate scheme are:
- Your business will pay a fixed rate of VAT to HMRC.
- The business gets to keep the difference between a) what your business charges your customers and b) pay to HMRC.
- You cannot reclaim the VAT on your purchases -except for certain capital expenditures that cost over £2,000.
The scheme aimed to simplify paperwork for small businesses when accounting for VAT.
Businesses with less than £150,000 VAT taxable turnover (excluding VAT) in a financial year are eligible for the Flat Rate Scheme. Once a business joins the scheme, it will not have to leave until its VAT-inclusive annual turnover exceeds £230,000.
Joining and leaving the HMRC Flat Rate scheme
How to join the Flat Rate VAT scheme
You can join the scheme online when you initially register for VAT. Alternatively, you can join when you are already VAT registered. You will apply to HMRC by completing form VAT600 FRS and either:
- Send it by post to BT VAT, HM Revenue and Customs, BX9 1WR (use this address rather than the address on the form).
You will receive confirmation that you have joined the scheme through:
- Your VAT online account (if applying online).
- Through the post (if you send the form through the post).
How to leave the FRS scheme
You can choose to leave the scheme at any time. In addition, you must leave if you are no longer eligible to be in it.
When leaving the scheme, you must write to HMRC VAT Registrations at BT VAT, HM Revenue and Customs, BX9 1WR, and they will confirm your leaving date.
After leaving the scheme, you must wait 12 months before applying to re-join.
How it works
Under the HMRC Flat Rate VAT scheme, a business registered for VAT and operating under FRS will charge VAT on its goods and services at the standard rate of VAT at 20% (on the net value of work).
However, under FRS (in the past), it would pay over a lower percentage (e.g., 14.5% for the IT consultancy sector -now 16.5% -see below), and you calculate the FRS VAT on the gross value of work. HMRC provide a list of Flat Rate VAT percentages.
Besides paying over a lower VAT rate, the business cannot reclaim the input VAT on its costs and expenses except on capital assets costing £2K or more.
Therefore, in most cases (previously), the VAT paid over would be 14.5% of the gross sales for an IT contractor.
When we look at how to calculate Flat Rate VAT, completing the bookkeeping and VAT returns under the VAT Flat Rate scheme is also very much simplified. The reason is that the business cannot reclaim the VAT on costs as mentioned above. Therefore, there is much less analysis work to do.
Our VAT guide covering VAT in more detail gives you a comprehensive insight into how VAT works.
Flat Rate VAT scheme -limited cost business
In April 2017, the rules for the HMRC Flat Rate scheme changed, and a new entity came into play known as the `limited cost trader’.
If a business falls under the limited cost trader classification, the Flat Rate scheme VAT percentage is a fixed rate of 16.5% (on the gross value of work). Under these rules, most of a contractor’s business expenses will not be classed as relevant goods (see below).
What is a limited cost business?
HM Revenue & Customs (HMRC) defines these as those whose gross expenditure on relevant goods is either:
- Less than 2% of their VAT-inclusive turnover; or
- Greater than 2% of their VAT inclusive turnover but less than £1,000 annually.
According to HMRC guidelines, the relevant goods should not include:
- Any services which are anything but not goods.
- Expenses like travel and accommodation.
- Food and drink which is eaten by yourself or your staff.
- Vehicle costs, including fuel, unless you are in the transport business using your own or a leased vehicle.
- Rent, internet, phone bills, and accountancy fees.
- Gifts, promotional items and donations.
- Goods you will resell or hire out unless this is your primary business activity.
- Training and memberships.
- Capital items, including office equipment, laptops, mobile phones and tablets.
Therefore, most contractors will likely be’ limited-cost traders’ due to the types of services that they provide.
How the FRS scheme compares to the standard VAT scheme
Let us now look at a Flat Rate VAT example and what the previous and current gains if you are operating under the Flat Rate scheme:
- Prior to the change in April 2017 -£10,000 monthly invoice + VAT (£2000) = £12,000 x 14.5% = £1,740.
£2,000 VAT charged – £1,740 FRS VAT = £260 gain per £10,000 invoiced to the customer.
- After the change in April 2017 -£10,000 monthly invoice + VAT (£2,000) = £12,000 x 16.5% = £1,980.
£2,000 VAT charged – £1,980 FRS VAT = £20 gain per £10,000 invoiced to the customer.
Therefore, the bookkeeping and VAT return completion is simplified under the Flat Rate Scheme. However, for each £10,000 you invoice, you only gain £20.
Flat Rate VAT for IT contractors and other independent contractors
When you are a limited company contractor you can choose whether you would like to register for Flat Rate VAT (subject to you falling under the threshold where you would not qualify for the scheme. The Flat Rate VAT return itself is much easier to complete and there is less analytical work to do. As most contractors will fall under the limited-cost trade bracket the rate for contractor Flat Rate VAT will be 16.5% of the gross invoice.
From the above, you can work out what you are gaining per month under the Flat Rate VAT scheme and compare it against the VAT that you incur per month accounting period on your expenses (that you can claim under the standard VAT scheme).
For example, if you charge £8,000 per month pre-VAT for your work. £20 / £10,000 * £8,000 = £16 gain per month under the HMRC Flat Rate scheme. If the VAT on your accountancy fees, mobile phone bill, and other VAT-inclusive costs add up to £100, for example, then you would be better off by £84 (£100 – £16) per month by being under the standard VAT scheme as opposed to the FRS scheme. As VAT is one of your contractor taxes, operating under the standard VAT scheme is one of our handy tax tips for contractors and small business owners.
As we mention earlier bookkeeping is not as straightforward under the standard VAT scheme because you must reclaim VAT on all your costs. Since 2019 however, we are now in times of Making Tax Digital. Therefore, most businesses use online software such as FreeAgent, which helps calculate the VAT on costs.
Finally, you only really need to know which costs include VAT (i.e., which receipts have UK VAT numbers on and are a VAT-inclusive cost) and then select the appropriate option for the VAT rate in the online software.
Link to Contractor Advice UK group on