How is flat rate VAT calculated?
Traditionally, contractors have always benefited from registering on the flat rate scheme. This is because VAT would be collected on a sales invoice at 20%, but a lower percentage paid to HMRC. It resulted in most contractors earning a little extra just by being registered for VAT.
For example, on a £1,000 sales invoice, an IT consultant would charge £20%, or £200 on top for VAT. However, on the flat rate rules, a lower percentage is payable to HMRC. Generally, this would be approx. 14.5% of the gross sales, so £174 (14.5% of £1,200).
Therefore the client would earn an additional £26 just by being VAT registered!
From 1 April 2017, the Government introduced a new rate of 16.5% for businesses with limited costs. These businesses are referred to as ‘limited cost traders’ and are defined by HMRC as follows:
Traders where VAT inclusive expenditure 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 if the prescribed accounting period is one year.
Goods, for the purposes of this measure, 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 that uses its own or a leased vehicle to carry out those services).
These exclusions are part of the test to prevent traders from buying either low-value everyday items or one-off purchases in order to inflate their costs beyond 2%.
Where does this leave contractors?
As the majority of contractors 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 the best options?
If you are new to contracting the flat rate scheme can still present a viable option. This is because the first year discount is still available to limited cost traders in the first year of registration. Therefore, using the above example, it would mean £14 of savings on every £1,000 invoiced.
If you have been registered for more then 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 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 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 you 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.