Using the VAT Flat Rate Scheme

The VAT Flat Rate Scheme (FRS) was introduced in 2002 to simplify VAT accounting for small businesses. The way it works is that output VAT (the VAT you charge your customers) is charged at the standard VAT rate (20%, as of March 2014), with the amount of VAT you subsequently pay to HMRC being worked out as a percentage of your VAT inclusive turnover. The percentage that is applied to your VAT inclusive turnover depends on the business area in which you are operating. For IT contractors, for example, it is 14.5%. You can get a full list on the HMRC website.

Trying to decide whether or not to use the VAT Flat Rate Scheme (FRS) is a question that most IT contractors (and other small business owners) have to ask themselves at some stage. At first glance, for IT contractors who have very few expenses (purchases on which VAT can be claimed), joining the scheme seems like the obvious choice, and for many, it probably is.

It is, however, worth looking carefully at all the figures before deciding to join the scheme. How the scheme works is demonstrated in the following example (note: a percentage of 14.5% is being used here, but you could substitute a different percentage for a different business sector).

Net Invoice Amount = £10000

VAT Charged = £2000 (20% of £10,000)

Gross Amount = £12000

VAT Payable = £1740 (14.5% of £12000)

Difference between VAT charged and VAT payable = £260

Here, the IT contractor would have made £260 in profit (this would then be subject to corporation tax though - so take 20% (ie £52) off that figure to get the real profit).

Bank interest

However, if the IT contractor has a lot of money in his/her company bank account, and earns interest from that money, then the interest may have to be added* to the gross amount to which the 14.5% is applied. Let us say, for example, that the contractor earns £100 per month in interest. The figures will now be:

What is Input and Output VAT?

VAT that is charged by Business A and paid by its customers is known as "output VAT". VAT that is paid by Business A to Business B on supplies that Business A receives from Business B is known as "input VAT".

Net Invoice Amount = £10,000

VAT Charged = £2000 (20% of £10,000)

Gross Amount = £12000 + £100 = £12100

VAT Payable = £1754.5 (14.5% of £12100)

Difference between VAT charged and VAT payable = £245.5

The IT contractor would now have made £245.5, which is still pretty good. Don't forgot though that this means two lots of tax are effectively being charged on the bank interest. Because bank interest is paid gross by the bank, it is subject to corporation tax at 20%, and it is also subject to the 14.5% VAT because of the VAT Flat Rate Scheme.

Zero rated and exempt supplies

If the contractor also has other revenue generated by VAT exempt or zero rated supplies, these will also need to be included in the VAT calculation. So, for example, if £3000 per month is generated by supplies to other European countries, the figures would become:

Net Invoice Amount for UK Supplies= £10,000

VAT Charged = £2000 (20% of £10,000)

Gross Amount = £12000 + £100 + £3000 = £15100

VAT Payable = £2189.5 (14.5% of £15100)

Difference between VAT charged and VAT payable = -£189.5

Now the figures have been completely turned on their head. If you add to this the fact that most contractors have at least one or two purchases per month on which VAT can be claimed, you can see that the contractor in our example would be better off not being in the VAT FRS.

Although for most contractors, joining the VAT FRS is probably a worth while thing to do, it is important for contractors to take advice from their accountants before joining the scheme - just to make sure it is the right decision for them.


*As of May 2011, there is some debate as to whether bank interest should be included in the VAT Flat Rate Scheme calculation. More information can be found here.

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