THE ADVANTAGES AND DISADVANTAGES OF FLAT RATE VAT

The Advantages and Disadvantages of Flat Rate VAT

VAT, it’s one of those agonising details that every new business has to get to grips with when starting out. Like many details it’s not much fun to go through, but getting it right is incredibly important starting with the issue of using flat rate VAT.

All about VAT

First, what is VAT, and what does it actually involve? We’ve all heard of it, but many of us don’t know the intricacies of how it works.

Value Added Tax is the standard charge that we pay on most goods and services in the UK. For the most part, you won’t notice it’s there because it’s added automatically as part of the price. It comes at three rates

  • Standard: Currently set at 20%
  • Reduced: Currently 5%
  • Zero: Currently 0%

Other items may be exempt from VAT, but don’t be fooled into thinking 0% and VAT exempt are one and the same thing; they are not. You can still claim back VAT with 0% VAT item – you can’t do this with VAT exempt items.

What is FRS

The amount a business ends up paying to HMRC or claiming back depends on the difference between how much VAT you charge on your services and the VAT it pays on its own services. With a flat-rate scheme, you pay a fixed rate to HMRC, you keep the difference between what you charge your customers and what you pay to HMRC and you can’t claim VAT on purchases except for a few capital assets over £2,000.

To join the scheme, your business must be turning over less than £150,000 which many start-ups are.

WHY USE IT?

One good reason to use it is because it’s simpler. As an early stage start-up, you want to keep administration and bookkeeping duties as simple as possible to avoid making mistakes and to free you up to concentrate on the more important business of building your enterprise.

However, many see this as a way of scoring a few valuable cash advantages.

When you use the FRS, you ignore the VAT incurred on purchases when reporting VAT payable, except on any capital items which cost £2,000 or more. You simply multiply your gross turnover (including VAT charged at normal rates) by the FRS percentage in your sector.

These rates are:

  • Business services not listed anywhere else: 12%
  • Estate agents or property management businesses: 12%
  • Journalism, media or entertaining: 12.5%
  • Management consultants: 14%
  • Accountancy and legal services: 14.5%
  • Computer or IT consultants: 14.5%

If you don’t incur too many expenses and you’re in a sector with a low FRS you’ll end up paying less to HMRC than you would outside the sector. The advantages have been so great that many businesses have registered for VAT voluntarily before they reach that threshold.

It can be particularly useful if you’re going to be making a lot of purchases during the taxation period. Because you can charge 20% VAT on your services you’ll be paying back a much smaller percentage – just how much smaller will of course depend on the sector you’re working in, so check your rates on our list.

On the other hand, it might not work out well if you’re buying goods which are mostly exempt from VAT or charged at that 0% rate we mentioned earlier. This will include goods such as food, gold, books, clothing and drugs which are all charged at 0%. Items such as art, sport, finance and postal services, meanwhile, are VAT exempt.

BAD NEWS…

However, there is bad news. The Government has changed the rules to prevent what it sees as abuse of the system. From April 2017, the rules changed to make it slightly less attractive. If you’re a low-cost trader, you’ll have to use an FRS of 16.5% which is likely to impact a lot of small businesses and start-ups.

You’ll be counted as a low-cost trader if your expenditure on goods and services is less than 2% of your gross turnover or if it is less than £1,000 per year. This threshold ignores expenditure on capital items such as motoring expenses, food or drink.

16.5% on gross purchases equals 19.8% on net which means you’re left with much less credit.

To decide whether to register for the FRS scheme you will need to do some quick calculations to see if you’ll end up paying more or less. However, as a general rule of thumb for start-ups projected to turnover less than £150,000 – as many are in their first years of business – this is a potentially lucrative option. In those early years, you’ll need every advantage you can get, and this represents a good opportunity to streamline your cash flow.