Managing VAT can be a daunting task for small business owners. From tracking input and output VAT to submitting quarterly returns, it’s easy to feel buried in paperwork. But here’s the good news: HMRC offers a simpler solution that could revolutionise your approach to VAT compliance.
Enter the VAT Flat Rate Scheme—a program tailored for businesses like yours, designed to simplify tax management while maintaining accuracy and compliance. This guide will explain everything you need to know about the scheme, helping you determine if it’s the right fit for your business.
What is VAT and Why Does it Matter?
Before exploring the flat rate scheme, let’s first cover the basics. Value Added Tax (VAT) is a consumption tax applied to most goods and services in the UK. Businesses are required to register for VAT once their taxable turnover exceeds £90,000 within a 12-month period.
Under the standard VAT scheme, businesses charge VAT on sales (output VAT) and pay VAT on purchases (input VAT). The difference between the two is then paid to HMRC.
While straightforward in theory, this process demands meticulous record-keeping and can become a significant administrative burden, especially for smaller businesses.
To find out more about VAT use our thorough guide about VAT here
What is VAT Flat Rate Scheme?
The VAT Flat Rate Scheme simplifies VAT management for eligible small businesses. Instead of calculating the difference between input and output VAT, you pay HMRC a fixed percentage of your total VAT-inclusive turnover.
Here’s how it works: You continue charging customers the standard VAT rates (20%, 5%, or 0%, depending on your products or services). However, when submitting your VAT return, you apply your industry-specific flat rate percentage to your total sales, including VAT.
Example of the VAT Flat Rate Scheme in Practice
Imagine you run a graphic design business and are eligible for the VAT Flat Rate Scheme with a flat rate percentage of 11%. During one quarter, your total VAT-inclusive turnover is £10,000. Instead of calculating the input and output VAT separately, you apply the 11% flat rate to your total turnover.
Here’s the calculation:
- Total VAT-inclusive turnover: £10,000
- Flat rate percentage: 11%
- Flat rate VAT to pay HMRC = £10,000 × 11% = £1,100
You would pay £1,100 to HMRC under the scheme, regardless of the actual VAT you've charged customers or paid to your suppliers. This streamlined approach saves time and simplifies the accounting process, especially for businesses with relatively low VAT reclaimable expenses.
How Does the Flat Rate VAT Scheme Work?
The flat rate scheme offers a simple and efficient approach to VAT:
- Charge VAT as usual: Continue charging VAT at the standard rate on sales to your customers.
- Apply your flat rate percentage: Determine your VAT liability by applying your industry-specific flat rate percentage to your total turnover.
- Retain the difference: Any excess between the VAT you collect from customers and what you owe to HMRC becomes additional profit.\
- Enjoy simplified returns: Completing your VAT returns is quicker and easier under this streamlined system.
Important Considerations
With the flat rate scheme, reclaiming VAT on most purchases is not allowed. The sole exception applies to capital assets costing £2,000 or more (VAT included). As a result, expenses such as office supplies, marketing materials, and smaller equipment purchases do not qualify for VAT refunds.
Flat Rate Scheme Percentages by Industry
Your flat rate percentage depends on your business sector. Here are some common examples:
Service-Based Industries:
- Accountancy or bookkeeping: 14.5%
- Legal services: 14.5%
- Management consultancy: 14%
- Computer and IT consultancy: 14.5%
Creative and Marketing:
- Advertising: 11%
- Photography: 11%
- Entertainment or journalism: 12.5%
Retail and Manufacturing:
- General retail: 7.5%
- Food retail: 4%
- General manufacturing: 9.5%
Construction and Property:
- General building services: 9.5%
- Estate agency: 12%
- Labour-only construction: 14.5%
Hospitality (rates vary by period due to COVID-19 support):
- Restaurants and takeaways: Currently 12.5%
- Hotels and accommodation: Currently 10.5%
Limited Cost Trader Rate
In 2017, HMRC introduced the "limited cost trader" category to combat misuse of the VAT Flat Rate Scheme. A business is classified as a limited cost trader if the cost of its goods is either:
- Less than 2% of its turnover, OR
- Less than £1,000 annually (if costs exceed 2% of turnover).
Limited cost traders are subject to a flat VAT rate of 16.5%, regardless of their industry. This higher rate primarily impacts service-based businesses that purchase minimal physical goods.
Eligibility Criteria for the VAT Flat Rate Scheme
To participate in the scheme, your business must meet the following criteria:
Eligibility Requirements:
- Be registered for VAT.
- Have a projected VAT-taxable turnover of £150,000 or less (excluding VAT) over the next 12 months.
Exclusions: You are not eligible to join if you:
- Exited the scheme within the last 12 months
- Were involved in a VAT-related offence during the past 12 months
- Have close ties to another business
- Recently joined a VAT group or capital goods scheme within specified periods
- Use margin schemes for second-hand goods
Exit Requirements:
You are required to leave the scheme if:
- Your VAT-inclusive turnover surpasses £230,000 within a 12-month period.
- You no longer meet the eligibility criteria.
- You decide to switch back to standard VAT accounting.
- Find out more about how to deregister from VAT here
Benefits of the VAT Flat Rate Scheme
Streamlined Administration
One of the biggest benefits is the reduction in paperwork. With less time spent managing individual VAT transactions, you can dedicate more energy to running your business. VAT returns are transformed from tedious reconciliations into simple, straightforward calculations.
Predictable Cash Flow
Understanding exactly how much you’ll owe HMRC simplifies financial planning. With clear visibility into your VAT liability, you can budget with confidence, free from the uncertainty of fluctuating input VAT claims.
Check if your cashflow is healthy on your new business here.
Potential Cost Savings
The flat rate scheme can lead to significant VAT savings for many businesses, especially those with low input VAT costs compared to their turnover. By applying a fixed percentage to your total sales, the difference between the VAT you collect from customers and the amount you pay to HMRC can effectively boost your profits.
First-Year Discount
If you’re a newly VAT-registered business, you’re eligible for a 1% reduction on your flat rate percentage during your first year of VAT registration. For instance, if your industry rate is set at 12%, you’ll only pay 11% in your first year.
What are the disadvantages of flat rate?
Limited Input VAT Recovery
One major disadvantage of the flat rate scheme is the inability to reclaim VAT on most purchases. If your business incurs substantial VAT-able expenses, you could end up paying more tax under this scheme compared to the standard VAT scheme.
Limited Cost Trader Penalty
Service-based businesses with minimal goods purchases are subject to a burdensome 16.5% rate, often rendering the scheme financially unviable.
Limited Flexibility
Joining the scheme requires a minimum commitment of 12 months. Once enrolled, you cannot switch in and out based on changing circumstances each quarter.
How Much Can You Save with the VAT Flat Rate Scheme?
The financial impact of VAT schemes varies widely depending on a business's type and spending habits. Businesses that benefit the most typically share these characteristics:
- Low input VAT costs compared to their turnover
- Service-based operations with minimal expenditure on equipment
- Simple business models without intricate VAT complexities
Take, for example, a marketing consultant operating under an 11% flat rate scheme who generates £100,000 in sales, which includes £20,000 in VAT charged to clients. Under the flat rate scheme, they would pay £11,000 to HMRC. With minimal VAT-able expenses, this consultant would retain £9,000 (£20,000 - £11,000), whereas under standard VAT accounting, they might have to remit the full £20,000 minus small input VAT claims.
This scenario highlights how the flat rate scheme can be advantageous for businesses with low VAT-related costs and simpler operations.
Frequently Asked Questions
How much discount is the VAT flat rate scheme?
The VAT flat rate scheme includes a 1% discount for the first year of VAT registration, providing additional savings for newly registered businesses.
How often do I need to check if I'm a limited cost trader?
The limited cost trader test must be applied every time you submit a VAT return. Your status may vary from quarter to quarter, depending on your spending patterns.
Can I claim the first-year discount as a limited cost trader?
Yes, limited cost traders still receive the 1% discount during their first year of VAT registration, reducing their rate from 16.5% to 15.5%.
What happens if I exceed the £230,000 threshold?
You must leave the scheme and return to standard VAT accounting. HMRC requires notification within 30 days of exceeding the threshold.
Can I switch between different flat rate percentages?
If your business activities change significantly, you may be able to use a different percentage. However, you'll need HMRC approval and must demonstrate that the new rate better reflects your business activities.
How Debitam Can Help You Navigate VAT Compliance
Debitam’s team of accounting experts is dedicated to helping small businesses stay VAT compliant while uncovering opportunities to save money. Our services include in-depth VAT scheme analysis, guidance on flat rate schemes, compliance support, and regular reviews to ensure you’re always using the most advantageous VAT options. Simplify your tax responsibilities and boost efficiency—Get in touch with Debitam today!
