VAT schemes

Value Added Tax (VAT) part 2 – VAT Schemes

Part 2. – VAT schemes

Last month we discussed VAT. This month we are looking at the different VAT schemes available to smaller local businesses.

Delaying VAT registration

VAT registration is a legal obligation once a business breaches the £85,000 turnover threshold. This is an unavoidable fact. It’s not ideal for many local tradespeople such as builders, carpenters, plumbers etc as it instantly increases their prices by 20%, making them uncompetitive with their non-VAT registered competitors. It is possible to delay VAT registration by splitting the invoicing. For example, when a carpenter fits a kitchen, the carpenter provides the labour but B&Q may supply the kitchen. Say the cost of the labour is £2,000 and the cost of the kitchen units and accessories are £12,000, the carpenter then has two choices:

  1. The carpenter gets the kitchen from B&Q and invoices the customer for the full amount of £14,000.
  2. Or the carpenter invoices his customer £2,000 labour and B&Q invoices the customer for the £12,000 kitchen direct.

Under option 1 the carpenter’s turnover is £14,000 while under option 2 the carpenter’s turnover is £2,000. Some tradespeople prefer option 1 as they may be able to obtain a trade discount with B&Q thereby a little extra profit. Also they may wish to avoid the customer finding out that they are charging £2,000 for their labour. But the massive disadvantage of option 1 is that you have just increased your turnover by £14,000, edging you closer to compulsory VAT registration.

With option 2, the carpenter’s turnover for VAT-threshold purposes is just £2,000.

Once registered for VAT, there are several VAT schemes available:

  • Standard VAT Scheme
  • Flat Rate Scheme
  • Cash Accounting Scheme
  • Annual Accounting Scheme
  • Marginal Accounting Scheme

Standard VAT scheme

Under a standard VAT scheme, the business charges 20% VAT to its customers on its sales invoices and offsets the VAT it suffers on its purchase invoices from suppliers, paying HMRC the difference. Because this scheme can be an administrative and cash-flow burden on small business, HMRC have introduced several schemes designed to ease those burdens.

Flat rate scheme (FRS)

The FRS was HMRC’s attempt to simplify VAT administration for small businesses with a turnover below £150,000. Basically, the scheme works by the business charging customers the full 20% VAT on sales but only paying a specific % over to HMRC based on HMRC tables. For example, Sally runs an accountancy business, Sally is VAT registered but has a turnover less than £150,000 so has registered for the FRS. The accountancy FRS is 14.5%. For the first year of VAT registration businesses enjoy an additional 1% discount from date of VAT registration (not the date of joining the FRS scheme). But assume Sally has been VAT registered for two years so she pays the full 14.5% VAT to HMRC.

  • On a £100 sale Sally would invoice £100 plus VAT (£120)
  • But Sally would pay HMRC 14.5% on the GROSS invoice amount (£120 x 14.5% = £17.40)
  • So technically Sally has made an extra £2.60 profit. But this is added to her taxable profit, so she will suffer (Sole Trader) income tax/Class NI if appropriate or (Limited) corporation tax.

The upside is Sally can ignore accounting for VAT on all purchases (including capital assets under £2,000) thus reducing the administration burden. Should Sally buy a capital asset (e.g. a computer costing more than £2,000), she can reclaim the VAT on that single purchase under FRS.

For the list of different business FRS percentages, please follow the link below:
https://www.gov.uk/vat-flat-rate-scheme/how-much-you-pay

The FRS became profitable for consultants and contractors (which was not its original aim) so HMRC recently introduced the “Limited Cost Business” rate. Should an FRS business’s cost of GOODS sold (Materials to go into the job) be less than 2% of its turnover, or £1,000 if it is small turnover business then it is classed as a “Limited Cost Business”.

If your business is classed as a “Limited by Cost”, you must charge 16.5% on the gross invoice effectively putting you back to the standard 20%. For example:

Sally charges her client £100 plus VAT (£120).
Previously she would only pay £17.40 VAT to HMRC on 14.5% (as above).
But if Sally is now deemed as a “Limited by Cost” business then this changes to: £120 x 16.5% = £19.80

So, because of the recently introduced 16.5%, Sally would still benefit by 20p under FRS but this would be subject to tax on profit and she would not be able to reclaim the VAT that she may suffer on purchases such as rent, stationery, equipment (unless it’s a capital purchase over £2,000).

To help smaller businesses who may be experiencing cash-flow issues, HMRC introduced the Cash Accounting Scheme (see below). You can use the Cash Accounting Scheme in conjunction with the FRS but because the FRS is different to standard VAT scheme, it has its own FRS Cash Accounting scheme (see HMRC website for details).

Cash accounting scheme

Under a standard VAT scheme, VAT becomes due on the invoice date on both sales and purchases. That’s fine if you run a cash-based business and get paid for your sales instantly and VAT becomes due on your suppliers’ invoice date for purchases – especially if your supplier does their invoicing at the month end. But it is not so advantageous if you invoice your customers and they take 30 days or longer to pay. Worse still, if one of your customers becomes insolvent, it could take you six months or longer to get the VAT back.
This could hit smaller businesses’ cash flow hard so HMRC introduced the Cash Accounting Scheme (CAS) to move the VAT due date from the invoice date to the date you get paid by your customers and the date you pay your suppliers. Providing your turnover is less than £1.35m, you can use CAS. You do not have to register with HMRC. You can just start using it, but take care when changing schemes that all VAT is correctly accounted for. You must come out of the scheme should your turnover exceed £1.6m.

Annual accounting scheme (AAS)

Again, to reduce the VAT administrative burden on small businesses HMRC introduced the Annual Accounting Scheme (AAS). Should your business regularly receive VAT rebates, then AAS is not for you, the idea being to remove the need for submitting quarterly VAT returns and just submit one VAT return per year. Under AAS you must still pay quarterly VAT bills based on either last year’s annual VAT or estimated annual VAT. Each VAT quarterly payment will be for the same amount i.e. a quarter of annual estimated or prior year VAT. Then, at the end of the VAT year, the business will submit its VAT return with an adjusting payment or rebate due. The following year’s VAT payment estimates will be based on the latest VAT return submitted.

Like CAS, to join the AAS the business turnover must be below £1.35m but unlike CAS you do have to apply to HMRC to join the scheme either online or by post using VAT600AA or VAT600AA/FRS if you are in the Flat Rate Scheme as well. There is no de-register limit to AAS, but you do have to de-register if you become illegible e.g. insolvent.

Marginal Rate Scheme (MRS)

The VAT marginal rate scheme is only applicable to certain trades such as antique dealers, second-hand shops, used-car dealers etc. You do not have to apply to HMRC to use the MRS, but you do have to be very careful to maintain proper accounting records. Basically, MRS is about paying VAT on the Margin (Profit) you make. For example, Jim is a used car dealer and does the following –

Buys a car for £1,500 (no VAT)
Sells a car for £2,000 (no VAT)
So Jim has made £500 (no VAT)

Under MRS Jim would pay HMRC VAT on the £500 margin he has made on the deal. To do this he would either divide £500 by six (£83.33) or multiply £500 by 16.6667% (£83.33). So, after accounting for VAT, Jim’s profit is on the car was £416.67.

Users of MRS must be very careful to maintain adequate records such as stock books in line with HMRC rules and they can not use MRS if they have paid VAT on the purchase. This means many MRS users tend to run two VAT schemes in parallel – standard rate scheme and a marginal rate scheme.

As always, this article is intended to provide an overview of the different basic VAT schemes available. VAT is a very complicated subject. There is more detail and more schemes available on the HMRC website. Before taking any action, please discuss with your accountant. Some VAT schemes may be appropriate for one business but inappropriate for another.

Burton Mail – Wednesday 6 July 2018. Next month we will move away from the technical and look at the relevance of some of the sayings one regularly hears on TV business programmes like “turnover is vanity, but profit is sanity”.