How the Flat Rate Scheme (FRS) for VAT works

Introduced in 2002, the Flat Rate VAT scheme was put in place to provide smaller businesses with a simpler way of calculating their VAT liabilities. Here, we look at how the scheme works and explain how many contractor companies could pay less tax by switching from the standard VAT scheme.

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 actually 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 have a percentage of 14.5% (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 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 almost certainly eligible. Here are the main rules:

• 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, but you may be able to reclaim VAT on large single capital asset purchases worth over £2,000 in one single transaction (e.g. computer equipment).
• Your business can remain in the scheme until turnover is greater than £230,000 per year.

Would you benefit from joining the Flat Rate scheme?

This depends on your individual business, the VAT percentage used within your business sector, and the ratio of your expenses to your turnover.

We asked Emily Coltman, Chief Accountant at FreeAgent, if IT contractors were likely to benefit:

“The answer is that many limited company IT contractors could indeed benefit from joining the VAT flat rate scheme, because they have few costs, and therefore not much in the way of input VAT to reclaim if they were not using the scheme.”

New 16.5% percentage for Limited Cost Traders since 1st April 2017

New rules exist for companies which incur very low business expenses. They are no longer be able to use the established fixed rate percentages – but a new 16.5% percentage, which wipes out almost all of the tax advantage which previously existed for companies with minimal expenses. Find out more in our dedicated article here.

Further Information

Try FreeAgent’s flat rate scheme calculator, which will work out if you’re better off switching to the FRS or not, depending on the business sector you work within, and your own accounts.

HMRC’s official guidance is surprisingly accessible. You can find it here.