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VAT Flat Rate Scheme 14th September 2012

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.

Output VAT (£2,000 x 20%) 400
Less: input VAT (£500 x 20%) -100
VAT due 300

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.

Output VAT (£2,400 x 12.5%) 300
Less: input VAT 0
VAT due 300

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.

  • Capital assets costing more than £2,000
    If a trader purchases a capital asset with a VAT inclusive value of £2,000 or more, s/he will claim full input VAT in respect of that capital asset. When s/he sells the asset output VAT is charged in the normal way on the disposal. The sale of the asset will be excluded from flat-rate turnover and the VAT accounted for separately.
  • Pre-registration input VAT
    If a trader reclaims input tax in respect of pre-registration capital assets, when that capital asset is sold it must be excluded from flat-rate turnover and VAT must be accounted for on the disposal at the full VAT rate.

The flat rate scheme can work in conjunction with the annual accounting scheme, but not the cash accounting scheme.

Eligibility

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.

Bad Debts

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.

Update

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:

  • less than 2% of their VAT inclusive turnover in a prescribed accounting period
  • greater than 2% of their VAT inclusive turnover but less than £1,000 per annum

Goods (in this context) must be used exclusively for the purpose of the business but exclude the following items:

  • capital expenditure
  • food or drink for consumption by the flat rate business or its employees
  • vehicles, vehicle parts and fuel (except where the business is one that carries out transport services – for example a taxi business – and uses its own or a leased vehicle to carry out those services)

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