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Choosing the right VAT scheme is an important step for small business owners and can have a considerable effect on their cash flow.
Which VAT scheme should I use?
There are three main VAT schemes available to small businesses:
• The flat rate scheme
• The annual accounting scheme
• The cash accounting scheme
Whether or not these schemes are suitable for your business will depend on a number of factors. We have listed below the main points of each scheme. If you think any of these schemes might be beneficial, please get in touch with us and we can look into this further.
The flat rate scheme
HMRC recently introduced the criteria of a ‘limited cost business’ whereby if your goods cost less than either:
- 2% of your turnover
- £1,000 a year (if your costs are more than 2%)
Then this means you pay a higher rate of 16.5% of your gross, VAT-inclusive sales price as VAT. In most cases, this means that there is no cash advantage to the FRS, unlike before this rule was introduced when many consultants with little to no costs made additional income charging 20% but then paying over to HMRC a much lower percentage.
The purpose of this VAT scheme is to simplify the way a business accounts for VAT and so reduce the cost of complying with their VAT obligations. However, businesses most often make decisions based on cold hard cash and most businesses that sign up for the flat rate scheme do so in order to save money on their VAT bill. The scheme is especially useful for businesses with minimal VAT on business expenses (input tax) to reclaim.
Businesses can only apply to use the flat rate scheme if they expect their annual taxable turnover in the next 12 months to be no more than £150,000, excluding VAT. Normally the VAT businesses pay to HMRC is the difference between the VAT they charge customers and the VAT paid on purchases.
Using the flat rate scheme, a business simply pays VAT as a fixed percentage of the total VAT-inclusive turnover. The actual percentage depends on the type of business. The amount of VAT paid on business expenses becomes irrelevant. Businesses that make a substantial amount of exempt or zero-rated sales and/or purchase a lot of standard-rated goods and services are unlikely to benefit by joining the scheme.
Apart from the cash benefit, it is useful to bear in mind the other advantages of using the scheme:
- Saves time and smoothes cash flow;
- A first year discount of 1%;
- Significantly fewer rules to follow and peace of mind as there’s less to get wrong;
- More certainty as to what percentage of takings will be due to HMRC;
- Can significantly reduce stress for small business owners;
- Removes the need to calculate VAT on purchases thereby avoiding many potential pitfalls.
Businesses currently using the scheme are advised to regularly review whether the scheme continues to be of benefit. If not, they should notify HMRC of their intention to leave the scheme.
A limited cost trader test was introduced in April 2017. Businesses that meet the definition of a 'limited cost trader' are required to use a fixed rate of 16.5%. The highest 'regular' rate is 14.5%. If you meet the definition of a limited cost trader then this would usually mean it may be more beneficial to leave the scheme and account for VAT using traditional VAT accounting.
Cash Accounting Scheme
Another popular small business scheme is the Cash Accounting Scheme. Under standard VAT accounting, VAT is payable on sales whether or not the customer has paid and can lead to a need to claim bad debt relief. Under this scheme, VAT does not need to be paid over until the customer has paid. If the customer does not pay, then the VAT is not payable. This clearly has cash flow benefits for traders who sell on credit. By contrast, using standard VAT accounting a business pays VAT on their sales whether or not they have been paid by their customer.
A business can enter this scheme provided the estimated VAT taxable turnover for the next VAT year is not more than £1.35 million. It can continue to use the scheme until the VAT taxable turnover exceeds £1.6 million.
Where a business is registered under the cash accounting scheme it is important to remember that VAT cannot be claimed on purchases and other inputs until payment has been received. This is different from standard VAT accounting when the VAT can be reclaimed upon receipt of a valid tax invoice.
Businesses can’t use the flat rate scheme together with the cash accounting scheme. However, the flat rate scheme has its own cash-based method for calculating turnover.
Annual Accounting Scheme
The Annual Accounting Scheme is also aimed at smaller businesses. It can either be combined with the flat rate scheme or used by a business that uses standard VAT accounting. The scheme is open to businesses with a taxable turnover up to £1.35 million.
The annual accounting scheme reduces administration time and the associated cost of preparing and submitting quarterly VAT returns. The scheme can also help a business manage cash flow.
Businesses that use the scheme are only required to file one VAT return at the end of each year.
They will usually make nine interim VAT payments during the year, based on their estimated total liability for the year, followed by one balancing payment with the return.
This ensures that a business can maintain a smooth cash flow position as instalment payments of the expected VAT liability are made on account. This means that the business is not faced with a large VAT bill at the end of the year. The payments must be paid by direct debit, standing order or other electronic means.