Many contractors are registered for VAT, and use the flat rate scheme (FRS). VAT registered businesses have to charge VAT on most types of sale, and can recover VAT on many types of cost. On the standard (non – FRS) VAT scheme, the VAT paid over to HMRC is the difference between the sales VAT on the sales invoices, and the purchase VAT on the relevant cost invoices.
The FRS works by simplifying things – all a business needs to do is add up its gross sales, and apply a flat rate percentage appropriate to the type of industry it is in. For example, many contractors use a rate of 14.5%.
For example: Invoice for £1,000; add VAT of £200. Total invoice £1,200
Pay to HMRC 14.5% of £1,200 = £174. Flat rate ‘surplus’ = £200 charged, less £174 paid out = £26.
So, over a period of time, provided the surpluses are greater than the purchase VAT (e.g. on accountants fees) that has been paid out, you will be better off on the FRS than on the standard scheme.
For example: Annual turnover £50,000, VAT charged for year = £10,000. Total turnover £60,000
Pay to HMRC 14.5% of £60,000 = £8,700. Flat rate ‘surplus’ = £1,300 for year.
So, provided the purchase VAT you can claim is less than £1,300, you’ll be better off on the FRS.
From April 2017, a new flat rate is being imposed on those businesses who have low costs, and therefore don’t have much purchase VAT to recover. This is called the Limited Cost Trader rate, and will apply to most contractors who supply mainly the services of their directors and shareholders. A limited cost trader is one who’s spend on goods is less than 2% of their annual turnover, or less than £1,000 per year, or £250 per quarter. The test has to be applied on each VAT return.
Goods do not include services such as accountancy and insurance, equipment such as laptops, food or drink for staff, motor and similar expenses, or promotional merchandise like branded gifts for clients. Also, the legislation does not permit a business to start selling goods on ebay or similar systems, just so it has purchased goods for resale sufficient to get around the legislation. The rule is that if buying and selling goods is not your main trade, buying these goods doesn’t count towards the total.
If you are a limited cost trader, then the new rate to use is 16.5%. This means that the ‘surplus’ generated is now so low, that if the business has any other costs with VAT included, such as accountancy or other professional fees, then it will be better off on the standard rated scheme.
For example: Annual turnover £50,000, VAT charged for year £10,000. Total turnover £60,000
Pay to HMRC 16.5% of £60,000 = £9,900. Surplus = £100 for year.
VAT on professional fees of £1,500 per year = £300. So better off recovering £300 through standard rated VAT returns, than doing FRS and only saving £100.
It will therefore be sensible for many FRS VAT businesses to consider if they would be better off using standard rated VAT and recovering the VAT on their costs.
Businesses using the standard rated scheme should remember that as they are recovering VAT on costs, they need to make sure that they keep VAT invoices for these costs. VAT invoices should be made out to the business or company rather than the individual, if a ‘customer’ is named. They should include a date, an amount, the amount of VAT and the VAT registration number of the supplier. If in doubt, ask for a ‘VAT receipt’ if you have the option.
Also bear in mind that some costs that include VAT are not eligible to have the VAT reclaimed by your business. Typical examples are VAT on entertaining expenses, and VAT on cars. You should always ask for a VAT receipt, but that does not guarantee the VAT will be reclaimable. HMRC ask that you keep receipts for a number of years as they are allowed to ask for evidence of them later.
Finally, users of the new rate will still get 1% off if they’re in their first year of VAT registration. Therefore, for a new business, a surplus may still be generated in that first year. Taken along with the simplified record keeping requirements, it may still be attractive to use the FRS for that first year only, then to move to the standard scheme later.
If you’d like more detail, HMRC’s notes on the new regime can be viewed here .