Could you be paying too much?
The benefits and burdens for contractors of the flat rate VAT scheme
Could you be paying too much VAT?
Welcome to another edition of our regular ebriefs, designed to keep you up to date with issues affecting contractors and freelancers – helping you to make the right decisions, every step of the way. In this edition, Paul Gough, Managing Director of InTouch Accounting, the personal online accounting adviser for contractors and freelancers, looks at the pros and cons of adopting a flat rate scheme, and explains more about how the scheme could affect your take home pay
What is the flat rate scheme all about?
The flat rate scheme, or FRS, was introduced by HM Revenue and Customs (HMRC) in 2002, as a way to simplify accounting for small businesses. In short, in order to calculate the amount of VAT paid to HMRC, the income of a business, including any output tax, is applied to a flat rate percentage. With a few exceptions, input VAT on purchases is ignored. And the result: a very simple VAT accounting process, making completion of the VAT return easy to do, and easy to verify.
Who uses the flat rate scheme and why?
The scheme is open to businesses whose annual taxable turnover or estimated turnover is less than £150,000. Once you’ve joined the scheme you can stay until your turnover exceeds £230,000 including VAT.
It was very quickly established that, for many contractors (those who fit within the threshold), accounting for VAT on the flat rate scheme actually produced a lower VAT liability than when VAT was accounted for on the normal basis. And so, an opportunity to “profit” from the simplified scheme quickly emerged and the scheme became the norm – with most contractors adopting it as their chosen method for accounting for VAT.
But, as with many aspects of accounting and tax, a standard solution is not always the right solution
Why could FRS be a burden to me?
Too often advisers adopt a standardised approach to dealing with contractors and fail to consider, on an individual case basis, whether or not the standard solution is in fact appropriate. Providers of accounting software solutions may not raise this issue with you at all.
Are you exporting goods or receiving rental or investment income?
Under the FRS, with a few exceptions all of your income is included in the calculation. This means that income that may not be normally subject to VAT output is still included in the flat rate calculation.
A good example is if you work abroad for a non-business customer (such as an individual) and zerorate your services. In this case, there is no VAT. However, under the FRS you would still calculate the percentage on that zero rated income and pay that to HMRC.
But it’s worth noting that when you provide your services to a “commercial entity” it is the place of supply that is important. The place of supply is where the customer belongs, and if that is outside of the UK then this work is outside the scope of VAT and is not included.
Similarly, other zero-rated sales and exempt sales are included. So, make sure you watch out where you export goods, or receive rental and some investment income; you could end up paying more VAT on the flat rate scheme than under the standard scheme. And, if you sell capital assets and you previously reclaimed VAT, then you must account for the VAT on sales on the standard basis even though you use the flat rate scheme
Do you know if the right rate of VAT is being applied to you?
The second danger is that, too often, the percentage selected as the flat rate is a default rate, without thought to the nature of the services being supplied. This is often the fault of the accounting services provider who packages a service together, without applying thought to the individual circumstances of a contractor, and the work undertaken. With the flat rate varying, sometimes the standard flat rate applied is not the right rate, leading to a higher level of VAT liability
Are you sure that VAT is being recovered when it should be?
The third danger is that input VAT is not recovered when it could be. Where contractors purchase capital assets and the cost exceeds £2,000 (including VAT), the input tax can still be recovered and deducted from the flat rate calculation. Attention to the detail is important. This can often be overlooked because such purchases don’t happen very often.
And, if you buy items and sell them on – which does sometimes happen when you incur costs for your client and recharge them – the VAT on the costs you incur cannot be reclaimed.
Do you incur unusually high volumes of input VAT on purchases?
The final danger is that if you incur higher than usual volumes of input VAT, by hiring other contractors (who are VAT registered) as sub-contractors for example, then this will significantly increase your VAT suffered. Under the FRS you will be unable to reclaim this back from the VAT man, as it does not qualify for inclusion. The “lost” VAT element will increase your costs and reduce your profitability.
So, if you are one of the many contractors using the flat rate, take a few minutes to just think:
- Are you paying VAT on income when you don’t need to?
- Are you applying the right percentage rate?
- Do you recover input VAT when you ought to, or are you missing out on reclaiming significant input tax on purchases?
- Do you incur unusually high volumes of input VAT on purchases?
Are there any benefits to using the flat rate scheme?
While we have mentioned some of the disadvantages to using this system for VAT, the good news is that there are also significant advantages to using the flat rate scheme:
- Less VAT payable in your first year
- If you’re in the first year of VAT registration, you get a one per cent reduction in your flat rate percentage – and this applies until the day before your first anniversary of being VAT registered.
- More time to spend on your business
- Because you don’t need to record VAT suffered on every purchase (as with standard VAT accounting), you’ll incur lower administration and processing costs – giving you more time to focus on your business, rather than on the onerous VAT administration process.
- Fewer risks and less chance of making a mistake
Also, with fewer rules, there’s less chance of making mistakes on your VAT return using the scheme, reducing the risk of accidentally claiming input VAT which you’re not entitled to – and, therefore, reducing the risk of an investigation by HMRC.
You could even profit from the scheme
With FRS you pay a percentage of turnover whereas, with standard VAT accounting, you pay VAT on the difference between sales and purchases. So, while you continue to charge clients the standard rate of 20% VAT, you don’t have to give that percentage to the VAT man. For IT contractors, for example, the norm is 14.5% VAT, but the FRS rate differs from sector to sector.
But, make sure you calculate your flat rate turnover correctly and avoid paying a penalty to HMRC
If you accidentally leave items out and end up paying too little VAT, you could incur a penalty from HMRC. So, make sure you work out your flat rate turnover correctly – or speak to a specialist personal online accounting adviser who will help you to avoid any tricky situations with HMRC.
What should I include in my flat rate turnover?
- Sales of capital expenditure goods – unless you reclaimed the VAT on their purchase
- Takings for zero-rate, standard-rate and reduced-rate supplies and VAT inclusive sales, including second hand goods
- The value of exempt supplies – like rent or lottery commission
- The value of supplies to other European Union countries
What should I exclude from my flat rate turnover?
- Private income
- Bank interest received on your business account
- Sale proceeds from goods you own, but which haven’t been used in your business
- Any sales of gold covered by the VAT Act
- Non-business income and supplies outside the scope of UK VAT
- Sales of capital expenditure goods where you have reclaimed the VAT on their purchase
- Services purchased outside of the UK, where there’s been a reverse charge
- Disbursements – costs payable by clients that you’ve paid on their behalf and invoiced on to your client
Special rules apply if you sell capital assets. If you use the flat rate scheme, you can’t normally claim back the VAT you spend on capital assets you buy for your business. But, subject to certain tests, if you are spending £2,000 or more on individual assets you may be able to claim back the VAT.
At InTouch Accounting, we work with contractors every day, helping them to understand their options, make the right decisions for their businesses and avoid unwanted surprises. So, whether you’re new to contracting or you’re looking for more from your accountant, speak to us about how we can help you reduce the administration burden … and possibly even your VAT bill.