The Flat Rate VAT Scheme Demystified

Before delving into the nuances of the Flat Rate VAT Scheme, it’s worth looking at what Standard Rate VAT is and how it works when you’re charging it on the services or goods that you sell.

Value Added Tax (VAT) is a consumption tax that’s applied to both the sale and purchase of most goods and services by VAT-registered businesses, known as output VAT and Input VAT. VAT is percentage-based so the higher the price for the item being purchased, the more VAT is paid at the current 20% rate.

What is Output VAT?

When a VAT-registered business sells its services or goods, VAT is levied on the cost at 20%. The business will then pay forward the VAT collected to HMRC. Some goods or services are VAT-exempt or ‘outside the scope’ of VAT, and VAT is not charged on those.

What is Input VAT?

Input VAT is the VAT a business pays when it purchases goods or services from another business that have VAT levied on them. Unlike Output VAT, Input VAT can be reclaimed.

Whatever the difference is between the Output and Input VAT paid by a business is the VAT liability owed to HMRC. If the amount of Input VAT is higher than Output VAT, a VAT credit or refund will usually be due.

Your business must be registered for VAT when taxable turnover exceeds £90k. If your taxable turnover is below this amount, you don’t need to charge VAT on the services or goods that you sell.

Businesses can register for VAT voluntarily with a turnover below £90k, and there are some benefits to this including improved credibility for your business and the ability to reclaim the VAT that you have spent on purchases from other VAT-registered businesses.

What are the Challenges and Drawbacks of VAT?

VAT can be a challenging prospect for small businesses in a number of ways. It’s relatively complex and VAT needs to be calculated, collected and paid to HMRC. It can be difficult to remain compliant and fastidious record-keeping is key to accuracy, as well as an understanding of VAT rules and rates.

It can also negatively impact demand as it increases the cost for the services or goods that you sell. Some small businesses may consider reducing their prices to stimulate demand and keep cashflow coming in.

But there is an easier way for small businesses to deal with VAT, and this is where the Flat Rate VAT Scheme comes in.

What is the Flat Rate VAT Scheme?

The Flat Rate VAT Scheme was designed to address some of the challenges small businesses face with Standard Rate VAT. It makes the process of charging and reclaiming VAT much simpler by allowing businesses to apply a fixed rate percentage to their gross turnover to calculate their VAT liability rather than calculating it at transaction level.

The VAT percentage that you levy through the Flat Rate VAT Scheme varies depending on the sector that your business operates in with rates between 0% and 14.5%. If you spend less than 2% of your annual turnover on goods, or less than £1k if your costs are more than 2% of turnover, you’re classed as a Limited Cost Business and pay a rate of 16.5% VAT.

You’re eligible to join the scheme if your business is VAT-registered and you expect your annual turnover to be under £150k over the next 12 months, but you must leave the scheme if turnover exceeds £230k, or if you expect it to exceed this amount.

The key differences between the Flat Rate VAT scheme and the Standard Rate VAT scheme are below:

  • A fixed rate percentage is applied to gross turnover to calculate VAT liability with Flat Rate
  • The difference between what you pay to HMRC in VAT and what you charge your clients or customers is additional turnover for the business
  • You can’t reclaim VAT on your business costs, except for certain capital assets that cost £2,000 or more
  • You receive a 1% discount on your fixed rate percentage for the first year of Flat Rate VAT registration

What are the Benefits of the Flat Rate VAT Scheme?

The Flat Rate VAT Scheme makes VAT accounting much simpler and quicker for VAT-registered businesses. Due to applying a fixed rate percentage to gross turnover, things are much more straightforward. Less paperwork and calculations are needed reducing the drain on your time which can be better focused on core business activities instead of VAT admin. Less calculations also decreases the chances of errors and potential future HMRC attention.

There are also potential cost savings as the Flat Rate VAT percentage will be lower than under the standard scheme, plus there’s a 1% discount for the first year of registration. It also enables businesses to price their offering more competitively due to the lower VAT percentage which can help to boost sales and growth.

The Flat Rate Scheme also makes it easier to predict your VAT liability. Constant monitoring of input and output VAT is not necessary, and with a better idea of what your VAT liability will be, you can budget more accurately and set aside funds to cover your VAT payments.

There are many advantages to the Flat Rate VAT Scheme, but it does have some limitations such as not being able to reclaim back any Input VAT except for purchases of capital assets costing £2k or more inclusive of VAT. As such, it might not be right for all businesses as suitability depends on your individual circumstances.

Factors to be considered include the industry/sector that you operate in, your company turnover and how much your business spends on goods. It’s also worthwhile checking the amount of VAT that could be reclaimed under the Standard Rate Scheme and comparing how much VAT your business would pay through the Flat Rate VAT Scheme before deciding if it’s right for you, and this is something our accountants can advise you on.

If you have any queries about the Flat Rate VAT Scheme please call 0330 024 0406 to speak to an accountant or request a call back here.