VAT flat rate scheme – playing the percentages

HMRC has updated its guide to the flat rate scheme (FRS) and the special VAT rate that some types of business use, plus the steps it will take if you use the wrong rate. Are these changes likely to increase or lower your VAT bill?

FRS Basics

Businesses of all types can use the VAT flat rate scheme (FRS). You can join it if your 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 in the FRS you continue to charge your customers the usual rates of VAT, but instead of paying it to HMRC you account for a lesser amount according to the nature of your business.

Example: Barry runs a small print shop. Most of his sales are standard-rated, on which he charges 20% VAT. But he also makes some zero-rated supplies where no VAT is charged. In the last quarter Barry’s standard-rated turnover was £25,000 and zero-rated, £3,000. The total VAT he charged was £5,000, but Barry doesn’t have to pay all of it to HMRC. Instead, he applies the FRS percentage (which for the print trade 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.

Trap: Because Barry uses the FRS he can’t reclaim VAT on purchases, except in very limited circumstances.

Key factors

While HMRC promotes the FRS as a way to simplify VAT admin, the main reason it’s used by most businesses is to reduce their VAT bills. The two key factors to saving VAT are:

• how much reclaimable VAT you miss out on by using the scheme (see the Trap above); and
• the FRS percentage.

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

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. Barry charges and collects VAT of £600, but must account for £2,850 under the FRS because the special VAT still applies to all his turnover. That leaves Barry out of pocket by at least £2,250.

Percentages

It’s easy to see why the decision to opt to use the FRS can depend on what percentage HMRC says you should use. The trouble is that its list of trades is vague. This can lead to a business choosing an FRS percentage which HMRC much later disagrees with and consequently demands extra VAT. For example, it categorised all consultants as “management consultants” and mechanical engineers as “civil engineers”. After being criticised by tribunal judges it has changed its advice and those types of business can now use more favourable FRS percentages .

Tip: HMRC now says that where it disagrees with the FRS percentage used it won’t look to apply a different rate retrospectively as long as the original choice made by the business was reasonable. Therefore, if there’s a choice of possible FRS rates it’s a good idea to keep notes about why you opted for the one you did by referring to HMRC’s guidance available on the GOV.UK portal.

Some consultants and engineering businesses will be better off because they can now use a lower FRS VAT rate. If you use the wrong FRS rate you won’t be asked to pay any VAT underpaid as long as you took reasonable care in choosing the rate. Therefore, read HMRC’s guidance on FRS rates thoroughly.