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Flat Rate VAT changes explained

by | Dec 19, 2018 | Tax

Flat Rate VAT Update – July 2020

As part of the measures to support businesses during the Coronavirus pandemic, the government has announced six months cut in Flat Rate VAT for the hospitality industry. This includes hotels catering businesses, restaurants, takeaways and pubs. The reduction came into force from 15 July 2020 and will last until 12 January 2021. Here is HMRC’s Flat Rate VAT table by industry category For some first-year contractors and freelancers, the Flat Rate VAT scheme is a no-brainer, as it allows them to take advantage of an extra tax discount and reduce costs they otherwise could not have reclaimed via standard VAT, and it considerably simplifies bookkeeping. Hence, saving quite a lot of time. However, this isn’t the case for every small business, as financial needs and business characteristics may differ considerably. The below guide explains how Flat Rate VAT works while illustrating some of the elements which could help you decide if it is the right VAT option for your business.
The additional 1% discount proves to be quite significant in terms of your take-home pay and tax savings.

What is Flat Rate VAT and how could you benefit from it?

Standard VAT vs Flat Rate

The standard scheme enables businesses to claim back some of the VAT costs they amass through purchases of business goods. Meaning, purchases they were charged VAT for. More about this topic in our complete standard VAT guide.

Limited Cost Traders

IT contractors, consultants or other types of freelancers are usually classed as low expenditure businesses, i.e. * Limited Cost Traders, and thus, have a limited ability to reclaim VAT paid on their much lower scale purchases. In this case, Flat Rate VAT becomes an attractive solution, as it allows Limited Cost Businesses to pay HMRC a lower tax rate from the 20% VAT they invoice their clients with. Therefore, you could earn a little extra just by being registered for VAT.

What measures define a Limited Cost Business status?

The following conditions set by HMRC define when a Limited Cost Trader or a Limited Cost Business status applies. Less than 2% – Your total expenditure on goods is less than 2% of your total turnover. Less than £1,000 – Your expenditure on goods is more than 2% of your total turnover; however, it is less than £1,0000 a year.

Additional Tax Discount

Another important benefit the Flat Rate VAT scheme offers, is a further 1% tax discount on your first year as a VAT registered. As demonstrated in our Flat Rate example calculation below, the additional 1% discount proves to be quite significant in terms of your take-home pay and tax savings.

What is the Flat Rate VAT threshold?

You must register for the standard VAT scheme if your annual turnover exceeds £85,000. Concurrently, the Flat Rate VAT scheme, will also be available for you to register, if your turnover is within the £150,000 or less threshold. That is the total amount of your sales figures, excluding the VAT amount you would add to invoices when charging your clients. Bear in mind that once your annual turnover exceeds £230,000, you will automatically move back to the standard VAT scheme.

How is Flat Rate VAT calculated?

To better understand the flat rate calculation and how much you would pay to HMRC or keep as an additional income, we will use the following example.

Flat Rate VAT calculation

On a £1,000 sales invoice, an IT consultant would charge 20%, or £200 on top of the sale price, for VAT. That is: £1,000 + 20% VAT. However, with the Flat Rate rules, a lower percentage of VAT is payable to HMRC. Traditionally, this was approx. **14.5% of the gross sales, so in this case, it would be the amount of £174 (14.5% of £1,200). Therefore, by the old flat rate, you would earn an additional £26 just by being VAT registered!

What is the current Flat Rate of VAT?

From 1 April 2017, the Government introduced a new rate of 16.5% for Limited Cost Businesses. Despite the 2% increase in VAT rate, the flat rate scheme can still present a viable option, due to the first year VAT registered 1% discount. Therefore, using the below-adjusted calculation, it would mean £14 of savings on every £1,000 invoiced.

Flat Rate VAT adjusted calculation

Invoice Charged + VAT: £1,000 + 20% VAT = £1,200. Amount of VAT paid to HMRC: (16.5%-1%) out of £1,200 = £186. Flat Rate VAT savings: £200 (20% VAT) – £186 = £14

Where does this leave businesses without a first-year discount?

As the majority of contractors and freelancers would be caught up in this new ruling, the benefit they previously enjoyed from being on the flat rate scheme would be severely reduced as a consequence. The previous 14.5% flat rate calculation would be increased to 16.5% and therefore would only generate savings of an additional £2 for every £1,000 charged, per the above example.

What are your options?

If you have been registered for more than one year the following options are available.

Remain on the flat rate scheme

Despite the financial benefit, remaining on the flat rate scheme is still a good idea if you want to keep your administration and bookkeeping burden to a minimum each quarter.

Switch to the Standard VAT

Scheme Switching to the standard scheme will allow you to reclaim VAT on your purchases. It’s likely that you will incur VAT on various business purchases and this, in many cases, will actually reduce your VAT liability more than what it would have been on the current Flat Rate scheme.

De-Register for VAT

If the only reason for registering for VAT was the financial benefit enjoyed by being on the Flat Rate scheme, de-registering for VAT is a viable option. However, if there are purchases that have VAT on them, the ability to reclaim these will be lost.

What Should I Do?

With the rules becoming more complex, there is not a ‘one size fits all strategy’ for everyone. Therefore your individual circumstances are going to be even more central to determining the best strategy for your business. If you are unsure of the best way forward or would like any further guidance, please contact us for further assistance and advice.

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