Posted in: VAT
The VAT flat rate scheme is just one of the many VAT schemes for smaller businesses. The normal way the VAT system operates is to charge VAT on supplies (output VAT) and reclaim VAT on purchases (input VAT). This assumes your supplies and purchases are VATable.
So, let me give you an example of how normal VAT works in comparison to the VAT flat rate scheme.
Suppose Diane provides services of £2,000 at the standard rate of VAT, she would add an additional £400 (£2,000 x 20%) to her invoice. Diane also incurs costs of £600, which have had VAT added to them, so her costs are £500 net plus VAT of £100. Diane would have to pay HMRC £300 when she completes her VAT return.
With the VAT flat rate scheme (FRS) Diane would account for VAT in a different way. The way the scheme works is each industry sector has an assigned percentage, which represents their rate of VAT due based on the VAT inclusive turnover for different business types. You can find these rates here.
Suppose Diane was a journalist, her percentage would be 12.5%. If she were to opt for the FRS she would account for VAT on the above as follows.
In the above example the VAT due is the same – £300. However, quite often the scheme can work in your favour, reducing the VAT you would otherwise have paid.
When Diane prepares her VAT invoice under FRS, she still adds 20% VAT to her bill in the normal way, it’s just when she comes to doing her VAT return she can not reclaim the input VAT on her purchases, instead she applies a rate of 12.5% to her VAT inclusive supplies.
There are a couple of exceptions to reclaiming VAT on purchases.
The flat rate scheme can work in conjunction with the annual accounting scheme, but not the cash accounting scheme.
To be eligible to join the scheme your expected taxable turnover (exclusive of VAT) must be £150,000 or less in the next 12 months. The taxable turnover is anything that would be charged to the standard, reduced or zero rates of VAT. It excludes the sale of capital assets.
You must leave the scheme if you cease to be eligible. If in the last 12 months your turnover was more than £230,000 (including VAT), or you expect it to be in the next 12 months, you must leave the scheme.
You also can’t use the scheme if you have left the scheme in the last 12 months or have committed a VAT offence in the last 12 months.
The eligibility test is performed on every anniversary of joining the scheme.
For many startups, entering the FRS scheme probably isn’t a good idea, as they will tend to have increased startup costs and will not be able to reclaim the input VAT back on those. So if you’ve just started up a business it’s best to leave it a while until your costs settle down, then have your business appraised to see if it’s worth joining the scheme.
So what happens with reclaiming VAT on bad debts?
Suppose Diane’s debt turns bad and she is using the FRS. She charged £400 on her invoice, but she only paid £300 to HMRC in respect of that supply. How much can Diane reclaim?
You might think Diane can only reclaim the £300 she paid to HMRC, but in fact she reclaims the £400 invoiced amount.
There have been some recent changes to the VAT flat rate scheme. These changes will affect ‘limited cost traders’. A limited cost trader is defined as one whose VAT inclusive expenditure on goods is either:
Goods (in this context) must be used exclusively for the purpose of the business but exclude the following items:
Where a trader satisfies the above the flat rate percentage to be applied is 16.5% and takes effect from 1 April 2017.
Details can be found here: https://www.gov.uk/government/publications/tackling-aggressive-abuse-of-the-vat-flat-rate-scheme-technical-note/tackling-aggressive-abuse-of-the-vat-flat-rate-scheme-technical-note