The VAT Flat Rate Scheme

Recent changes to the Flat Rate Scheme and the special VAT rate have left many asking if their VAT bill is likely to go up or down…

FRS basics

Any type of business can use the Flat Rate Scheme (FRS) as long as their business’ annual turnover for the preceding twelve months is no more than £150,000. You only have to leave the FRS when your business income exceeds £230,000. Once you have joined the FRS you are able to charge all the usual VAT rates but rather than pay HMRC you would account for a lesser amount dependent on the nature of your business!

For example if Debbie runs a small business making business cards, she would charge her standard rate plus 20% VAT. However she might also make some zero-rated supplies where she charges no VAT. In the last quarter Debbie’s standard-rated turnover was £25,000 and zero-rated, £3,000. The total VAT she charged was £5,000, but she doesn’t have to pay all of it to HMRC. Instead, she applies the FRS percentage (which is 8.5%) to the whole turnover plus the VAT, i.e. £33,000 and pays £2,805 (£33,000 x 8.5%) to HMRC.

However it should be noted that because Debbie uses the FRS she can’t reclaim any VAT on her purchases…

The main reasons the FRS is used by most businesses is because it is a way to reduce your VAT bills. HMRC also pushes this scheme as the perfect way to simplify your VAT admin. The two main ways you save on VAT using this scheme are:

  • how much reclaimable VAT you miss out on by using the scheme
  • the FRS percentage.

The second factor is especially important for businesses like Debbie’s where sales are a mix of standard, zero-rated and exempt.

For example the facts are the same as in our previous example except that the figures for standard and zero-rated supplies are reversed, £25,000 zero-rated and £3,000 standard-rated. Debbie charges and collects VAT of £600, but must account for £2,850 under the FRS because the special VAT still applies to all her turnover. That leaves Debbie out of pocket by at least £2,250!

In terms of percentages, whether or not to use the FRS really depends on what percentage HMRC permits you to use. However, its list of trades is vague. This can lead to a business choosing an FRS percentage which HMRC later disagrees with and then demands more VAT. A perfect example is the way HMRC categorised all consultants as “management consultants” and mechanical engineers as “civil engineers”. After being criticised by tribunal judges it has changed it’s advice and those types of business can now use more favourable FRS percentages!

If HMRC does disagree with the FRS percentage they now say they won’t apply a different rate retrospectively so long as they find the business’ original choice to be reasonable. So, if there is a choice of FRS rates, it’s definitely a good idea to keep notes containing the reasons you opted for the rate you did!

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