The Flat Rate VAT scheme (FRS) is designed to make it easier for small businesses to fulfil their value-added tax (VAT) obligations.
The scheme is available to eligible small businesses, including limited companies and sole traders.
However, the Flat Rate VAT scheme isn’t necessarily right for everyone: depending on your costs, the standard unsimplified VAT system may be a better option.
And with the ‘limited cost trader’ changes in force since April 2017, the previous tax advantages of the FRS have been reduced for some businesses, meaning it’s more likely you may need to review whether the scheme still works for you.
What is the Flat Rate VAT scheme?
Under the standard VAT system, the amount a business usually pays to HMRC is the difference between the VAT it charges customers and the VAT it pays on business purchases. This is known as the standard VAT scheme.
Under the Flat Rate VAT scheme, businesses instead pay a fixed percentage of their VAT-inclusive turnover to HMRC. In certain circumstances, this can simplify administration and, historically, reduce the amount of VAT paid.
If a business joins the scheme, it keeps the difference between the VAT it charges customers and the flat-rate amount paid to HMRC. However, it generally gives up the right to reclaim VAT on most purchases.
VAT on certain capital assets costing more than £2,000 (including VAT) can still usually be reclaimed, even if the business is using the Flat Rate scheme.
To join the scheme, your VAT-exclusive turnover must be £150,000 or less. You must apply to HMRC to use the scheme.
How do you work out your flat rate?
The VAT flat rate you use usually depends on your business type.
Here are some examples of flat rates:
- Advertising (11%)
- Computer and IT consultancy or data processing (14.5%)
- Financial services (13.5%)
- Management consultancy (14%)
- Publishing (11%)
You also qualify for a 1% discount in your first year as a VAT-registered business.
Here’s an example of how the flat rate works in practice.
You’re a management consultant and invoice your client £500 plus VAT at 20%, giving a total of £600.
Your VAT flat rate is 14%.
The flat rate is applied to the VAT-inclusive £600, not the £500 net amount. This means you pay 14% of £600 to HMRC, which is £84.
You therefore retain £16 of the £100 VAT charged to your client, although under the Flat Rate scheme you generally cannot reclaim VAT on your normal business purchases.
Am I eligible for the Flat Rate VAT scheme?
Depending on the type of business you operate, there may be situations where you are not allowed to join the Flat Rate VAT scheme.
Provided you are already VAT registered, and your total VAT-taxable turnover is expected to be £150,000 or less (excluding VAT) in the next 12 months, you will usually be eligible to apply.
However, there are circumstances where joining is not permitted.
For example, if you were previously part of the scheme and left it within the last 12 months, you will not be allowed to rejoin. Similarly, if you have committed a VAT-related offence within the last year, such as tax evasion, you may be excluded.
Complications can also arise when your business is closely linked to another, so professional advice may be needed in such cases.
The scheme has additional eligibility conditions, so it’s worth checking the rules in advance.
Once you’re in the scheme, you generally have to leave if your total business income is more than £230,000 including VAT during the relevant 12-month period, subject to the detailed HMRC rules.
Beware of the “limited cost trader” rules
The Flat Rate VAT scheme has historically been beneficial for many small companies. However, following what the government described as “aggressive abuse” of the scheme, changes were introduced in April 2017.
As a result, businesses using the scheme must determine whether they are classed as a “limited cost trader”.
A business is classed as a limited cost trader if its spending on relevant goods is either:
- less than 2% of its VAT-inclusive turnover for the prescribed accounting period; or
- more than 2% of its VAT-inclusive turnover but less than £1,000 a year (adjusted for shorter accounting periods).
For these purposes, HMRC defines relevant goods as goods used exclusively for the business. Capital expenditure, food and drink for employees, vehicles, vehicle parts, fuel and most goods bought for resale, leasing or letting do not count towards the test in the circumstances specified by HMRC.
The changes were designed to prevent businesses from making artificial purchases simply to meet the 2% threshold. For some small companies, this has significantly reduced the attractiveness of the Flat Rate scheme.
While the FRS can still simplify VAT administration, it can also be more expensive. Limited cost traders must use a higher flat rate of 16.5%, so it’s sensible to ask an accountant to review whether the scheme remains suitable for your business.