The Flat Rate scheme for VAT was originally introduced by HM Revenue & Customs (HMRC) in 2002. The aim here was to simplify paperwork for small businesses when accounting for VAT.
Businesses that turn over less than £150,000 excluding VAT in a financial year are eligible for the Flat Rate Scheme. Once in the scheme, the company will not have to leave until their VAT inclusive turnover exceeds £230,000.
Under the VAT Flat Rate scheme, a business would charge VAT at the standard rate of 20% (on the net value of work). However, it would pay over a lower percentage (e.g., 14.5% for the IT consultancy sector), and this you calculate this on the gross value of work.
Completing the bookkeeping and VAT returns under the VAT Flat Rate scheme is also more simplified. The reason for this is because the business cannot reclaim VAT on costs.
My VAT guide covering VAT in more detail gives you an overall insight into how VAT works.
Limited cost trader
In April 2017, the rules 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 16.5% (on the gross value of work). Under these rules, the majority of a contractors business expenses will not class as relevant goods (see below).
What is a limited cost trader?
HMRC defines Limited cost traders 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 per year
The relevant goods, according to HMRC guidelines, should not include:
- any services which are anything but not goods
- expenses like travel and accommodation
- food and drink ate 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 main business activity
- training and memberships
- capital items for example office equipment, laptops, mobile phones and tablets
Therefore, due to the services that contractors provide, it is likely that most will be `limited cost traders’.
How the VAT Flat Rate Scheme compares to the normal scheme
Therefore, let us look at the previous gains and the 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 Flat Rate 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 Flat Rate VAT = £20 gain per £10,000 invoiced to the customer.
Therefore, under the Flat Rate Scheme, the bookkeeping and VAT return completion is more simplified. However, now for each £10,000 that you invoice, you only gain £20.
From the above, you can work out what you are gaining per month under the VAT Flat Rate scheme and compare it against the VAT that you incur per month on your expenses (that you can claim under the `normal’ 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 VAT 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 normal VAT scheme as opposed to the VAT Flat Rate scheme. In general, operating under the normal VAT scheme is one of my handy tax tips for contractors and small business owners.
As mentioned, the bookkeeping is not as straightforward under the normal scheme because you need to reclaim VAT on all of your costs. Since 2019 however, we are now in Making Tax Digital. Therefore, most business are using online software such as FreeAgent, and this helps calculate the VAT on costs. You only really need to know which costs do 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 LinkedIn https://www.linkedin.com/groups/4660081/