The VAT Flat Rate Scheme (FRS) was introduced by HMRC to simplify the process of paying VAT and reclaiming VAT for small businesses. However, following changes introduced in April 2017, the FRS is often not as beneficial for contractors, consultants and small businesses as the standard method.
What is the FRS?
The FRS was introduced by HMRC to simplify the process of paying and reclaiming VAT for small businesses. On the standard scheme, businesses need to add up the VAT they have charged to clients and deduct the VAT they have paid on goods and services purchased. The difference is then payable to HMRC.
With the FRS, businesses pay a fixed rate of VAT to HMRC. The business then keeps the difference between what they charge their customers and what they pay HMRC. Under the FRS, businesses do not reclaim VAT on their purchases (except certain capital assets).
Brian is a Management Consultant VAT registered under FRS. His flat rate percentage is 16.5%. His billable hours total £10,000 in his inniAccounts records for the period.
He’ll invoice £12,000 for the period (£10,000 + 20% VAT) for his services.
His turnover totals £12,000 so the amount he pays HMRC under the FRS is:
£12,000 x 16.5% = £1,980
He’s therefore collected £2,000 in VAT but paid only £1,980 to HMRC. The difference is Brian’s to keep* and it covers the VAT he has incurred on his day to day expenses and purchases without having to account for VAT on each expense in detail on his VAT return.
*this is treated as turnover and attracts the applicable level of corporation tax.
Limited cost traders
In April 2017 new changes to the FRS were introduced to restrict potential abuses by ensuring all businesses are paying the appropriate VAT. At the heart of the reform was the introduction of a new flat rate category; the Limited Cost Trader. This new category introduces a 16.5% rate for businesses with limited costs.
A limited cost trader is a business whose VAT inclusive expenditure on goods is either:
- less than 2% of their VAT inclusive turnover
- less than £1,000 in total, per year
The key change is the definition of goods. When working out the amount spent on goods, it cannot include purchases of any capital expenditure (i.e. asset purchases), food or drink, or vehicles and fuel. This definition also excludes the purchase of services such as hosting fees, subscriptions to online journals, phones, email, insurances, accountancy fees, associate fees.
This change leaves most limited cost traders on the FRS out of pocket each VAT quarter.
With a £50,000 turnover (inc VAT), the FRS would leave Brian with approximately £80 to cover the VAT on all his expenses.
Considering that the VAT on his accountancy fees alone is at least £180 annually – this would leave him out of pocket.
On the standard VAT method, Brian would be able to claim the VAT back on not just his accountancy fees but on all his VAT inclusive expenses.
You can learn more about the changes to the flat rate scheme here.