Insights

Previously, some smaller SME businesses with annual sales of less than £150,000 have found the flat rate VAT scheme beneficial and regarded it as a chance to make some financial savings. This may no longer be the case as this article outlines.

In 2017, changes to the flat rate VAT scheme were introduced, with the addition of a limited cost trader category and a new 16.5% rate of tax. This reduces the savings achievable and so now may be a good time to review whether the flat rate VAT scheme is still a good option for your business, or whether traditional VAT accounting is a better approach.

Understanding the VAT flat rate scheme

The flat rate scheme first launched in 2002 and initially, it was adopted by very few SMEs. Originally designed for businesses with annual taxable sales of less than £100,000 excluding VAT, it was promoted as being time, rather than tax saving. It reduced the amount of record keeping needed. There was no requirement to keep input tax records and the VAT return applied a specific flat rate scheme percentage based on trading activity to gross business income. For many business owners, the scheme wasn’t tax efficient because the VAT paid out to HMRC would frequently exceed the level claimed in purchases.

In 2003, the legislation changed and the scheme became more attractive. The annual joining threshold was increased to £150,000. A 1% discount was introduced for the first year of VAT registration and tax rates were reduced in many categories.

However since this time, joining thresholds have remained frozen and current rates of inflation mean the scheme is increasingly less cost effective. Added to this, working practices have changed significantly. Today most businesses are using an online accounting system – Xero, Sage or QuickBooks, they scan receipts and they can often easily submit their own returns electronically. Finally, another factor. If a business is receiving VAT exempt rental, this is included in the flat rate scheme turnover figure and then a business could end up having to pay out VAT on income they haven't charged it on.

Worked example – Implications of the flat rate VAT scheme

Here is a very simple example to illustrate these points. Barbara is a freelance copywriter who earns £100,000 per year plus VAT. She has been using the flat rate scheme and her only ongoing business expense is train fares, which are zero rated, plus fees paid to various supplier contractors who are not VAT registered.

This brings Barbara into the limited cost trader category for VAT purposes and the current flat rate of VAT to be charged is 16.5%. According to HMRC, you are a limited cost business if the amount you spend on relevant goods including VAT is either:
less than 2% of your VAT flat rate turnover
greater than 2% of your VAT flat rate turnover but less than £1,000 per year

In 2016, Barbara’s VAT bill was £14,400 using the 12% flat rate.

In 2023, her VAT bill increases to £19,800 - because she must use the new 16.5% rate assigned to limited cost businesses.

Barbara’s business is paying out more VAT through the flat rate scheme than if she were on the traditional VAT scheme.

Our advice to businesses that remain on the flat rate scheme is to consider the financial implications carefully and be prepared to switch across to traditional VAT accounting if needed. If your business would like regular VAT support or advice for specific VAT queries, please contact us via partners@rjp.co.uk.