What is the VAT flat rate scheme?

How does the flat rate scheme work?

You still charge your customers VAT at the normal rate and issue normal VAT invoices. What changes is what you pay HMRC: instead of the VAT charged less the VAT on your costs, you pay a single percentage of your gross turnover. The percentage depends on your trade sector, and the current figures, along with the turnover limit for joining, are on gov.uk.

The trade-off is that you cannot reclaim VAT on most purchases. The percentage is set below the standard rate precisely because it assumes some input VAT you are giving up. The exception is a single capital asset purchase above a set amount, on which VAT can still be reclaimed.

There is a first-year discount for businesses new to VAT registration, and a 'limited cost business' rule that applies a higher percentage to businesses that spend very little on goods. That rule caught a lot of service businesses when it was introduced, and it is the first thing to check before joining.

A worked example

A marketing consultant invoices £10,000 plus £2,000 VAT in a quarter, £12,000 gross. Her only costs with VAT on them were software and a laptop bag, carrying £150 of input VAT.

On the standard scheme she pays HMRC £2,000 less £150: £1,850. On the flat rate scheme her sector percentage, applied to the £12,000 gross, comes to £1,560, and she gives up the £150 reclaim. She is £290 better off on the flat rate, and the return is one multiplication.

Two years later she takes on a subcontractor and starts buying equipment, and her quarterly input VAT is £900. Now the standard scheme costs £1,100 and the flat rate still £1,560. The scheme that suited her at the start is costing her £460 a quarter, and she should leave.

Who is it good for, and who should avoid it?

• —Good for service businesses with low costs, few VAT-able purchases, and a dislike of bookkeeping. Check the limited cost business rule first, because it may remove the benefit.
• —Poor for anyone who buys a lot of goods or equipment, anyone making zero-rated sales, and anyone whose customers are not VAT-registered, because the VAT charged is a real price increase with no matching reclaim.
• —Review it every year. The scheme that saved money at the start quietly costs money once the business grows, and leaving is straightforward.