Can you legally make money from VAT?

Introduction

The Flat Rate Scheme (FRS) was introduced in April 2002 to make VAT accounting for small businesses simpler.

If your VAT taxable turnover is less than £150,000, you can simplify VAT accounting by calculating your VAT payments as a percentage of your total VAT-inclusive turnover. Although you cannot reclaim VAT on purchases - it is taken into account in calculating the flat rate percentage - FRS can reduce the time you need to spend accounting for and working out your VAT. Even though you still need to show a VAT amount on each sales invoice, you don't need to record how much VAT you charge on every sale in your accounts. Nor do you need to record the VAT you pay on every purchase.

If you register for FRS in your first year of VAT registration, you can take advantage of a one per cent reduction in your flat rate percentage.

What is the FRS for VAT?

Under standard VAT accounting, the VAT you pay to HM Revenue & Customs (HMRC) or claim back is the difference between the VAT you charge your customers and the VAT you pay on your purchases.

Using FRS you pay VAT as a fixed percentage of your VAT inclusive turnover. The actual percentage depends on your type of business.

Who can join FRS?

You can join the Flat Rate Scheme and so pay VAT as a flat rate percentage of your turnover if:

Your estimated VAT taxable turnover - excluding VAT - in the next year will be £150,000 or less.

Your VAT taxable turnover is the total of everything that you sell during the year that is liable for VAT. It includes standard, reduced rate or zero rated sales or other supplies. It excludes the actual VAT that you charge, VAT exempt sales and sales of any capital assets.

Your estimated total business income - including VAT - in the next year will be £187,500 or less.

Your total business income is the total value - including VAT - of everything you supply, including exempt and non-business income, but does not include income from the sale of any capital assets.

Generally you don't reclaim any of the VAT that you pay on purchases, although you may be able to claim back the VAT on capital assets worth more than £2,000.

Once you join the scheme you can stay in it until your total business income is more than £225,000.

Who can't join FRS?

You can't join if:

your total turnover is over £187,500 per year
you were in the scheme and left during the previous 12 months
you are, or have been within the previous 24 months, registered for VAT as the division of a larger business, or as part of a group, or you are eligible to do so
you use one of the margin schemes for second-hand goods, art, antiques and collectibles, the Tour Operators' Margin Scheme, or the Capital Goods Scheme
you have been convicted of a VAT offence or charged a penalty for VAT evasion in the last year
your business is closely associated with another business

The pros and cons of FRS

Benefits of using FRS

Using the scheme can save you time and smooth your cash flow. It offers these benefits:
You don't have to record the VAT that you charge on every sale and purchase, as you would with standard VAT accounting.

This can mean you spending less time on the books, and more time on your business. You do need to show VAT separately on your invoices, just as you do for normal VAT accounting.

A first year discount.

If you are in your first year of VAT registration you get a one per cent reduction in your flat rate percentage until the day before the first anniversary you became VAT registered.

Fewer rules to follow.

You no longer have to work out what VAT on purchases you can and can't reclaim.

Peace of mind.

With less chance of mistakes, you have fewer worries about getting your VAT right.

Certainty.

You always know what percentage of your takings you will have to pay to HMRC.

Potential disadvantages of using FRS

The flat rate percentages are calculated in a way that takes into account zero-rated and exempt sales. They also contain an allowance for the VAT you spend on your purchases. So FRS might not be right for your business if:
you buy mostly standard-rated items, as you cannot generally reclaim any VAT on your purchases
you regularly receive a VAT repayment under standard VAT accounting
you make a lot of zero-rated or exempt sales.


Working out your flat rate percentage and the VAT you pay

Working out your flat rate percentage

There is a range of flat rate percentages corresponding to different business sectors. You must choose the sector best describing your main business activity for the coming year. You must only use one percentage. So if you work in more than one business sector, you must use the one representing the greater part of your turnover. You then apply that percentage to your total turnover.

Discount in your first year of VAT registration

There's a one per cent reduction in the flat rate percentages for your first year of VAT registration. So if you are in your first year of VAT registration, you can reduce the flat rate percentage for your sector by one, until the day before the first anniversary of your VAT registration. This discount applies even if the flat rate percentage for your sector changes during your first year of registration.

Working out how much VAT you pay using your flat rate percentage

You calculate your VAT payable to HMRC by applying your flat rate VAT percentage to your 'flat rate turnover'. If you are still in your first year of VAT registration, remember to reduce your flat rate percentage by one.

Your flat rate turnover is all the supplies your business makes including all:

VAT inclusive sales for standard rate, zero rate and reduced rate supplies
sales of exempt supplies, such as rent or lottery commission - you don't have to make any partial exemption calculations
sales of capital expenditure goods - unless you have previously reclaimed the VAT, in which case they must be accounted for at the standard rate and not the flat rate.
sales to other EU countries
bank interest received on a business account
sales of second-hand goods - but if you sell a lot of these, you may be better off leaving FRS and using a margin scheme.

Don't include:

services you've purchased from outside the UK that you've had to reverse charge
disbursements - costs you pass on to your clients that meet the necessary VAT conditions
private income, for example income from shares
the proceeds from the sale of goods you own but which have not been used in your business
any sales of gold that are covered by the VAT Act, Section 55
non-business income and any supplies outside the scope of UK VAT
sales of capital expenditure goods on which you have claimed back the VAT you paid


FRS percentage rates from 1 December 2008

Accountancy or book-keeping 11.5
Advertising 8.5
Agricultural services 7
Any other activity not listed elsewhere 9
Architect, civil and structural engineer or surveyor 11
Boarding or care of animals 9.5
Business services that are not listed elsewhere 9.5
Catering services including restaurants and takeaways 10.5
Computer and IT consultancy or data processing 11.5
Computer repair services 10
Dealing in waste or scrap 8.5
Entertainment or journalism 9.5
Estate agency or property management services 9.5
Farming or agriculture that is not listed elsewhere 5.5
Film, radio, television or video production 9.5
Financial services 10.5
Forestry or fishing 8
General building or construction services* 7.5
Hairdressing or other beauty treatment services 10.5
Hiring or renting goods 7.5
Hotel or accommodation 8.5
Investigation or security 9
Labour-only building or construction services* 11.5
Laundry or dry-cleaning services 9.5
Lawyer or legal services 12
Library, archive, museum or other cultural activity 7.5
Management consultancy 11
Manufacturing that is not listed elsewhere 7.5
Manufacturing fabricated metal products 8.5
Manufacturing food 7
Manufacturing yarn, textiles or clothing 7.5
Membership organisation 5.5
Mining or quarrying 8
Packaging 7.5
Photography 8.5
Post offices 2
Printing 6.5
Publishing 8.5
Pubs 5.5
Real estate activity not listed elsewhere 11
Repairing personal or household goods 7.5
Repairing vehicles 6.5
Retailing food, confectionary, tobacco, newspapers or children’s clothing 2
Retailing pharmaceuticals, medical goods, cosmetics or toiletries 6
Retailing that is not listed elsewhere 5.5
Retailing vehicles or fuel 5.5
Secretarial services 9.5
Social work 8
Sport or recreation 6
Transport or storage, including couriers, freight, removals and taxis 8
Travel agency 8
Veterinary medicine 8
Wholesaling agricultural products 5.5
Wholesaling food 5
Wholesaling that is not listed elsewhere 6
*"Labour-only building or construction services" means building or construction services where the value of materials supplied is less than 10 per cent of relevant turnover from such services; any other building or construction services are "general building or construction services"


What to do if your flat rate percentage changes

If the Table of flat rates changes, you must use the new percentage for your sector from the date it comes into force. If HMRC changes your sector or it is affected by a change in your business activity you should refer to VAT Notice 733.

If the rate changes during a VAT accounting period, you will have to do the following calculations for that period:

apply the old percentage rate to your flat rate turnover from the start of the period up to the day before the rate changes
apply the new percentage rate to your flat rate turnover from the first day of the new rate to the end of the period
add the two figures together to produce the total VAT you owe to HMRC for the period

Cash-based turnover method

This method allows you to account for your VAT liability when you receive payment. It does not affect the time of supply (tax point). So if your flat rate percentage changes, you must apply the rate that was in place at the time of supply and not the rate that is in place when payment is received.

Invoicing, record-keeping and VAT returns

Invoicing

Although you only have to pay HMRC a percentage of your turnover, you must still show VAT at the appropriate normal rate (standard, reduced or zero) on the invoices you issue.

Record-keeping

Once you are using the scheme, you must keep a record in your VAT account of the flat rate calculation that you do for each VAT period showing:

the flat rate turnover that you used to calculate your flat rate VAT payment (or if the percentage changed during the period, the turnover figures used for each part of the period)
the flat rate percentage you used (or if the percentage changed during the period, the percentages used for each part of the period)
your VAT due.

Completing your VAT Return

FRS does not have its own VAT Return, so you must complete a standard return in a different way.

Claiming back VAT on capital assets

If you use FRS, you can't normally claim back the VAT you spend on capital assets you buy for your business. This is already taken into account in the flat rate percentage for your type of business. However, you may be able to claim back the VAT on certain capital asset purchases with a VAT-inclusive price of £2,000 or more. You make these claims by putting the amount of VAT you were charged in Box 4 of your VAT Return.

These are the rules for claiming back VAT when you buy capital assets:

It must be a single purchase of capital goods with a VAT-inclusive price of £2,000 or more.

That doesn't mean you are restricted to claiming back the VAT on a single item - for example, you could buy a server, work stations, monitors keyboards and mice as long as you buy them at the same time from the same supplier and the price is more than £2,000 including VAT.

It must be a purchase of capital goods, not services.

Capital goods are goods you can use in the business but are not used up by it - for example, a van, computer or bottling machine are capital goods, but not the fuel, printer ink or bottles that go in them. A van leased or hired to you is a continuous supply of services, but one bought on hire purchase is considered a supply of capital goods.

You can't claim back VAT on goods that you intend to either resell, or incorporate into other goods to supply on to someone else.

You can't claim back VAT on goods that you will let, lease or hire out - for example, a bouncy castle.

You can't claim back VAT on goods that you intend to use up (consume) within a year.

Building materials and work are not capital goods. You can't claim back the VAT if you have building work done (even if it includes expenditure on materials), and you can't claim back the VAT if you buy building materials yourself for someone else to build with.

As long as all the other conditions are met, you can claim back all the VAT even if the goods will have some private use. For example, if you buy a van but employees are allowed free use at weekends to move private belongings, you can still claim back all the VAT.

There is an upper limit on claims for certain items.

If you buy something that falls within the Capital Goods Scheme you must write and tell HMRC and leave FRS immediately. Goods that fall within the Capital Goods Scheme are computers or items of computer equipment with a VAT-exclusive price of £50,000 or more, or land and buildings, civil engineering works and refurbishments with a VAT-exclusive value of £250,000 or more.

Selling a capital asset

If you meet all the conditions and claim back the VAT on a capital asset, then when you have finished with the asset and sell it, you must charge VAT at the full standard rate - not at your flat rate percentage.

Farmers, barristers and florists and FRS

Farmers

If you're a farmer, there is a separate Agricultural Flat Rate Scheme, which is an alternative to registering for VAT. You don't charge VAT, but you can add - and keep - a flat rate addition of four per cent on sales that you make to VAT-registered customers. The flat rate addition isn't VAT, but compensates you for some of the VAT that you pay on your purchases.

Barristers

Barristers and advocates who use FRS and who share premises with others may need to use special accounting rules.

Florists

Florists using FRS who are members of organisations such as Interflora, Teleflorist or Flowergram must use special methods to account for their sales and purchases.

Joining and leaving FRS

How to join FRS

You can join the FRS at the beginning of any VAT accounting period.

You can download and complete an application form from the HMRC website and send the form to:

HM Revenue & Customs
Imperial House
77 Victoria Street
Grimsby
DN31 1DB

Get form VAT 600FRS 'Flat Rate Scheme application'

Get form VAT 600 AA/FRS for joining the Annual Accounting Scheme and the Flat Rate Scheme at the same time.

Find advice on completing your application form in VAT Notice 733.


How to leave FRS

You may leave the scheme at any time by telling HMRC - you will normally leave at the end of your next VAT accounting period, but you can leave the scheme at any time. HMRC will confirm the date you left the scheme in writing.

You must notify HMRC if there are significant changes to your business which may affect your eligibility to use the scheme.

You must leave the scheme if:

on the anniversary of your joining the scheme your previous year's VAT-inclusive turnover was more than £225,000
you think your turnover in the next 30 days alone will be more than £225,000
you start to use one of the other special schemes such as one of the margin schemes for second-hand goods, art, antiques and collectibles, the Tour Operators' Margin Scheme, or the Capital Goods Scheme
you become part of a larger group or division or become eligible to do so

You may also be taken off the scheme by HMRC if they find you have calculated your VAT incorrectly or that you have become ineligible but have not told them.

If you leave FRS, you can't rejoin it for at least 12 months.


FRS and other VAT schemes

Annual Accounting Scheme

You can use FRS together with the Annual Accounting Scheme.

Using annual VAT accounting, you make nine monthly or three quarterly interim payments throughout the year. You only need to complete one VAT Return at the end of the year when you either make a balancing payment or receive a balancing refund.

You can join FRS and the Annual Accounting Scheme at the same time using a single application form.

Get form VAT 600 AA/FRS for joining the Annual Accounting Scheme and the Flat Rate Scheme at the same time.

Cash Accounting Scheme

You can't use FRS with the Cash Accounting Scheme.

Instead, the Flat Rate Scheme has its own cash based method for calculating the turnover. There is more about the cash based turnover method in VAT Notice 733.

Retail schemes

You can't use FRS with the retail schemes, but if you are a retailer, FRS has its own retailer's method for calculating the turnover.



Example Calculation

P is a book-keeper. His flat rate percentage is 11.5. His annual turnover, bank interest and purchases are:

Sales of £25,000 of services + 15% vat = £,500 Gross

Bank interest £500

Purchases of £3,500 as expenses

Purchase of £4,600 computer equipment (£4,000 +15% VAT) (capital)

Using a Flat Rate of 11.5%

Box 1 £2,932.50 (£25,000 + £500=£25,500 x 11.5%)

Box 2 None

Box 3 £2,932,50

Box 4 £600

Box 5 £2,332.50

Box 6 £29,250 (£28,750 + £500)

Box 7 £7,500

Box 8 None

Box 9 None

FRS Profit

If your Flat Rate Scheme percentage is - for example - 11.5% then you or your company will be making 3.5% (4.5% in the first year) profit from VAT by being in the scheme.

This will appear as extra sales in your profit and loss account, so you will pay income or corporation tax on this extra income.

You need to carefully examine how much of your purchases are standard-rated and how much of your sales are either zero-rated or exempt before concluding that FRS would benefit you.

You can find full information on the scheme on the HMRC website.

Top ten tips

First year discount

Don’t forget you are entitled to an extra 1% discount on your relevant flat rate percentage in your first year of VAT registration. For a business with sales of £187,500 (scheme maximum), this saving is worth an extra £1,875 in a full year.

Capital expenditure

A feature of the scheme is that a business does not reclaim input tax unless it relates to capital expenditure costing more than £2,000 including VAT. So make sure you consider this when buying new machinery or a van for their business.

Annual category review

The chosen flat rate category needs to be reviewed each year, on the anniversary date of when you first joined the scheme. If a business has two or more activities, which come within different flat rate categories, then the chosen category is the one with the highest level of turnover. The mix of turnover again needs to be reviewed each year.

All income is included

A downside of the scheme is that the flat rate percentage is applied to any zero-rated or exempt income of the business. This can create a big problem because tax is then being paid on income where no VAT has been charged to customers. A business that has an unpredictable level of zero-rated income e.g. a builder carrying out some work on new houses is probably best advised to steer clear of the scheme.

Winners and losers

Some taxpayers will pay less tax by using the scheme and others will pay the same amount or more. It all depends on the nature of trading of the business in question. For example, I do most of my business travel by rail (no VAT on train fares) so I am sacrificing less input tax by using the scheme than a someone who goes everywhere in a low economy car.

Bank interest received

As explained above, the flat rate scheme needs to be applied to any exempt income, which includes bank interest earned by the business. However, interest received from a private bank account is excluded and there is no need to worry about dividend income. The latter income is outside the scope of VAT rather than exempt.

Services to overseas customers

There are many situations where work carried out for an overseas customer does not produce a UK charge of VAT because the place of supply is outside the UK e.g. accountancy services for a business customer in another EU country. The good news is that income from such supplies is outside the scope of UK VAT and does not need to be included in the flat rate calculation.

Acquisitions from other EU countries

When a UK business acquires goods from another EU country, it normally accounts for acquisition tax in Box 2 of its return and then claims the same amount as input tax in Box 4 (assuming the goods are wholly used for taxable rather than exempt supplies). For scheme users, the Box 2 entry still applies but not the Box 4 entry unless the acquisition relates to capital expenditure costing more than £2,000 including VAT (as explained above).

Cash based method – a scheme user can either account for tax based on the invoice date of his sale – but the more preferable route is to gain a cash flow advantage by using the cash based turnover method i.e. no tax is paid until payment has been received from a customer.

Annual accounting scheme

There is an incorrect assumption that the scheme cannot be used simultaneously with other schemes. That is incorrect – there is no problem with jointly using both the flat rate scheme and annual accounting scheme. So as well as simplified VAT accounting, you only need to work out the figures once a year rather than every three months!

I would be pleased to answer any question you have upon FRS and its implementation.