The flat rate scheme (FRS) for VAT works well for businesses that have few expenses which incur VAT. This is why for contractors, it tends to be the most beneficial scheme to be on.
Under the FRS, you pay VAT as a fixed percentage of your VAT-inclusive (i.e. gross) turnover. The actual percentage applied depends on what business sector you work in. For example IT consultants is 14.5%, advertisers is 11%, financial services is 13.5% etc.
When registered under FRS, you would still charge your customer the standard 20% VAT when invoicing them, but you actually pay VAT to HMRC at the lower percentage applicable to your business sector, with the flat rate applied to the gross sale value, not the net.
The FRS means you generally are not able to reclaim any VAT you pay on expenses, however you may be able to claim back VAT on capital assets where the cost is more than £2,000.
An example of the benefit available:
An IT contractor earning £80,000 net over the course of a year.
The flat rate percentage applicable would be 14.5%
Gross VAT inclusive sales: £80,000 + 20% standard VAT = £96,000
VAT payable to HMRC: £96,000 x 14.5% = £13,920
Under standard VAT scheme:
If this IT contractor had say £3,000 (net of VAT) of expenses per year which incurred VAT, under the standard VAT scheme, he would pay –
VAT charged by him on sales: £80,000 x 20% = £16,000
VAT charged to him on expenses: £3,000 x 20% = £600
Net VAT payable to HMRC: £16,000 – £1,000 = £15,400
Net VAT saving made = £1,480
Please note on the example above, the expenses of £3,000 per year may seem low but this is a representation of what expenses will be incurred which have VAT applied to them. Expenses such as travel or mileage do not incur VAT and therefore would not be taken into account in the calculation.
For the first 12 months of VAT registration under the FRS, HMRC grant you a 1% discount on the flat rate percentage meaning a bigger benefit in the first year of registration. This means on the example above, in the first year, the saving would actually be £2,440.
To join the scheme, your “VAT taxable turnover” – excluding VAT – in the next 12 months has to be £150,000 or less.
The “VAT taxable turnover” is everything that you will charge to your customer that is liable for VAT. This includes standard, reduced rate and zero rated sales or supplies. VAT exempt supplies and sales of capital assets are excluded.
You can remain in the scheme until your total business income exceeds £230,000.