The Flat Rate Scheme (FRS) is a simplified VAT accounting scheme for small businesses, whereby a business applies a single VAT percentage to their VAT inclusive sales and pays that amount over to HMRC. FRS lightens the administrative burden on business as there is no requirement to record the VAT on sales and purchases in their accounting records.
What is the Flat Rate Scheme?
Let's have some context:
In the VAT quarter period ended 30th June, Contractor Ltd has a VAT inclusive turnover of £36,000. The company’s flat rate percentage is 10% and it will, therefore, pay over to HMRC VAT of £3,600.
Under the Flat Rate Scheme, a business cannot recover any VAT incurred on costs other than on capital expenditure costing £2,000 or more including VAT.
The flat rate percentage used depends on the type of business activity and ranges from 4% - 16.5%. Details of all the rates can be found here. When electing to use the FRS, a business must select which business sector best applies to them because selecting the wrong one could lead to them using the wrong percentage to calculate VAT due. If HMRC considers the percentage too low, it could lead to them charging interest and penalties. Too high a percentage will lead to the business overpaying VAT.
What is the turnover threshold for the Flat Rate Scheme?
Only businesses with a VAT exclusive turnover of less than £150K p.a. can join the Flate Rate Scheme.
Businesses who register for VAT and join the FRS receive a 1% reduction from the flat-rate percentage for their trade sector for the first year from the date of their VAT registration.
Flate Rate Scheme for limited cost businesses
On 1st April 2017, a new 16.5% was introduced in respect of ‘limited cost’ businesses. This applies to a business with a VAT inclusive expenditure on relevant goods which is either:
- less than 2% of their VAT inclusive turnover in a prescribed accounting period; or
- greater than 2% of their VAT inclusive turnover but less than £1,000 per annum if the prescribed accounting period is one year
Where a business satisfies either of these conditions it will be a limited cost business. Unfortunately, many contractors may fall within this category, which has caused some to opt to leave the Flate Rate Scheme and return to normal VAT accounting because they find that they pay more VAT remaining within the FRS.
Relevant goods must be used exclusively for the purposes of the business and there must be no private use of such goods. In VAT Notice 733, HMRC lists the goods that are not included as relevant goods and examples of expenses that are relevant goods.
Pros and cons of the Flat Rate Scheme
Advantages to the Flat Rate Scheme include:
- Reduced time in completing a VAT return;
- As VAT can't be recovered on business expenses, there is no need to consider whether VAT is reclaimable on purchases;
- If used in conjunction with the annual accounting scheme, it can result in significant VAT compliance cost savings.
Disadvantages to the Flat Rate Scheme include:
- Businesses in certain sectors which attract a higher flat rate percentage may pay more VAT than under normal VAT accounting arrangements;
- Businesses that receive regular VAT repayments may not benefit as they can't recover VAT incurred on expenses;
- Introduction of Making Tax Digital may restrict the benefit of simplified accounting due to the requirement to keep documents in digital format.
When should you leave the Flat Rate Scheme?
A business can opt to leave the FRS at any time. Leaving the scheme, however, is mandatory if, on the anniversary of joining, a business’s VAT inclusive turnover in the last 12 months was greater than £230K or it expects it to be in the next 12 months. Also, if there are reasonable grounds to believe the turnover will exceed £230K in the next 30 days, then a business must exit the FRS.
Who can’t join the Flat Rate Scheme?
A business is not eligible to join the Flat Rate Scheme if it satisfies any of the following criteria:
- It is not currently VAT registered, although it can apply to join when submitting its VAT registration application;
- It stopped using the FRS within the last 12 months;
- It has received a compound penalty or a penalty involving dishonest conduct or been convicted of a VAT related offence within the 12 months prior to application;
- It is closely linked to or associated with another business during the last 24 months.
There are a number of other criteria which are concerned with other VAT schemes and VAT groups which, as a general rule, will not affect contractors.
Details of how to join or leave the Flat Rate Scheme can be found here.