How the Flat Rate Scheme (FRS) for VAT works for contractors

Introduced in 2002, the Flat Rate VAT scheme was implemented to provide smaller businesses with a more straightforward method for calculating their VAT liabilities.

Here, we examine how the scheme works and explain how some companies could pay less tax by switching to the standard VAT scheme, and how the ‘limited cost trader’ rule may cancel out the benefits for small firms.

The basics

Under the standard VAT scheme, you need to calculate how much VAT you have charged on invoices during each quarter, then subtract any VAT you have paid on any services or products you have purchased via the company during the same period. The difference is then payable to HMRC.

Under the Flat Rate VAT scheme, you apply a fixed-rate percentage to your turnover, and pay this amount to HMRC each quarter, rather than working out your precise tax liability in the way described above.

The scheme was designed to make VAT accounting simpler for smaller firms.

Although you continue to charge VAT at the standard 20% rate to your clients/customers, the amount you will repay to HMRC each quarter varies according to the business sector you are in.

For example, many professional service providers, such as accountants, architects, surveyors, and IT contractors/consultants, commonly fall under a percentage of 14.5%, depending on the precise nature of their activities (you can read more about the calculation, and what percentages apply to other sectors on the HMRC site here.)

Significantly, during your first year of registration, you’ll receive a 1% discount on the standard percentage, so that IT contractors will pay 13.5% during the first 12 months.

Is your business eligible?

If you’re a limited company professional contractor, then your business is technically eligible to join the scheme. However, many contractors gain little or no benefit due to the limited cost trader rules introduced in 2017.

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The main eligibility rules are as follows:

• Your estimated VAT taxable turnover (before VAT is applied) over the next 12 months will be £150,000 or less.
• Your business won’t generally be able to reclaim any VAT if you join the scheme. However, you may be able to reclaim VAT on a single capital asset costing £2,000 or more, including VAT (e.g., computer equipment purchased in a single transaction).
• Your business can remain in the scheme until its annual turnover exceeds £230,000.

Since April 2017, changes to the Flat Rate VAT scheme have meant that many service-based contractors no longer achieve a tax saving under the scheme.

As a result, many contractors now use the standard VAT scheme instead, or remain on the Flat Rate scheme for the first year to benefit from the 1% introductory discount.

When does the Flat Rate VAT scheme still make sense?

Although the scheme is no longer beneficial for most contractors, there are still limited situations where it may be worth considering.

Some contractors incur sufficient spending on qualifying goods to avoid being classed as a limited cost trader, although this is relatively uncommon in IT and professional services.

Others may have a business model that includes a mix of goods and services, which can affect the limited-cost trader calculation.

In practice, the Flat Rate scheme is most commonly used by contractors only in their first year of VAT registration, when the 1% discount applies. Even then, it is essential to compare the numbers carefully, as the benefit may still be marginal.

The 16.5% limited cost trader rate

If your business has low annual costs, you may fall into HMRC’s limited cost trader category. This applies if, in a VAT period, your spend on relevant goods is:

• Less than 2% of your VAT-inclusive turnover, or
• More than 2% but less than £1,000 per year (£250 per quarter).

Relevant goods are items you use exclusively for your business – not services.

For example, printer paper and ink, specialist tools, or trade-specific equipment could qualify. Costs that don’t count include accountancy fees, advertising, software, rent, utilities, and food or drink.

Because most contractors buy few qualifying goods, many automatically fall into this category.

If you are classed as a limited cost trader, you must use the 16.5% rate instead of the standard sector rate (14.5% for most service-based contractors).

Unfortunately, this removes almost all of the tax advantage of the Flat Rate Scheme.

Flat Rate VAT vs standard VAT: a practical comparison

Under the standard VAT scheme, contractors can reclaim VAT on most business expenses, including accountancy fees, software subscriptions, equipment, and other services.

For contractors with even modest ongoing costs, this often results in a lower overall VAT bill than paying a flat percentage of turnover under the Flat Rate scheme.

Once the limited-cost trader rate applies, the Flat Rate scheme often results in a higher payment to HMRC than the standard VAT method. This is why many contractors choose to leave the Flat Rate scheme once the first-year discount period has ended.

Cashflow considerations

One remaining advantage of the Flat Rate scheme is cashflow simplicity. Because VAT payments are based on turnover rather than detailed expense tracking, some businesses find quarterly VAT returns easier to complete and forecast.

However, this is a cashflow and administrative benefit rather than a tax saving, and it should be weighed carefully against the risk of paying more VAT overall.

Leaving the Flat Rate VAT scheme

You may choose to leave the Flat Rate VAT scheme voluntarily at any time. HMRC can also require you to leave if your turnover exceeds the exit threshold or if you no longer meet the eligibility criteria.

If your VAT-inclusive turnover exceeds £230,000 in a 12-month period, you must leave the scheme. You will then return to the standard VAT method from the start of the next VAT period.

Compliance considerations

Since the introduction of the limited cost trader rules, HMRC has paid closer attention to Flat Rate VAT claims. Sector misclassification and incorrect treatment of qualifying goods are common causes of compliance checks.

For this reason, it is essential to ensure your sector classification is accurate and that any claim to avoid the limited cost trader rate can be properly justified.

Further information

You can check your status using HMRC’s Flat Rate VAT tool.

Ask your accountant to compare your position under the standard VAT scheme – particularly if you’re not a limited cost trader, as switching may save you money.