VAT schemes for small businesses

In contrast to standard VAT accounting, there are several alternative ways you can account for VAT that could save you time and money – which is always a bonus when you’re a small business.

Cash accounting scheme

Under the Cash Accounting Scheme, businesses calculate their liability on the basis of payments made and received, rather than on the basis of invoices sent and received (i.e. the normal tax point rules don’t apply).

This is of course an advantage for businesses that are paid in arrears – something which is very common today.

It also has the effect of giving automatic relief for bad debts; if no payment is received from your customer, no payment of VAT will be due.

It also means it may be possible to time purchases in order to reclaim VAT relatively quickly, by making cash purchases just before the end of the VAT quarter.

There’s no need to apply for this scheme or to notify HMRC it is being used.

However, it’s important to track payments and receipts carefully, especially during a transition from the standard method to the cash method (or vice-versa).

Without care, it would be easy to pay VAT on an invoice under the normal rules, and then pay VAT again when the invoice is paid!

In the case of transactions with Europe, different rules apply. Find out more about VAT in international trade.

Annual accounting scheme

Under the Annual Accounting Scheme, you make just one VAT return per year.

Normally it would be convenient to coincide with your financial year (and it may act as an incentive to get on and complete the annual accounts at the same time).

Equal payments based on the previous year’s total VAT liability (or for new businesses, an estimate of future turnover), are made monthly, starting in month 4 through to month 12, with a final balancing payment in month 14. Alternatively, quarterly payments can be made.

There may be a cash flow advantage in this, especially if turnover is increasing or if there is a seasonal pattern to your trade, and the final payment is made one month later than usual.

Consider iScream Lollies, which makes 80% of its sales between April and September, and has a financial year from April to March.

The risk, as always with future tax liabilities, is that insufficient funds are set aside – although if turnover is not wildly different year on year, the regular pattern of payments should avoid any large liability arising.

Flat rate scheme

The Flat Rate Scheme appears at first sight to be attractively simple, but actually has a number of traps waiting for you, and the scheme is often misunderstood. In brief, it works as follows:

• A: prepare invoices as normal, adding VAT at 20%
• B: apply the relevant flat rate to this VAT-inclusive total (gross invoice amount)

Total B is the amount of VAT to be paid to HMRC. Expenses are ignored, except for capital expenditure of £2,000 or more, inclusive of VAT.

For example:

It may appear that the business has miraculously increased its income; but remember no input VAT is being reclaimed on expenses. The flat rate for your industry has been calculated as a typical ‘effective rate’ of VAT.

The flat rate to use is found in a table published by HMRC, with various percentage rates depending on the trade. Whether the rate for your own business will be advantageous will depend on your specific circumstances.

For example, two consultants might each have a part-time assistant; one firm employs the assistant, whereas the other uses the assistant on a self-employed basis.

Now suppose the assistant is VAT-registered; the second consultant will suffer VAT, but is unable to reclaim this.

The other consultant however will have no VAT cost on their employee.

This situation may also happen with rent; one business may lease a property which the landlord elects to tax, while another has a VAT-free rental (see note 1 below).

Points to note:

There are a number of complications in the Flat Rate Scheme which could easily catch out the unwary.

The flat rate applies not only to standard and reduced rate turnover, but also to zero-rated turnover, and exempt income, such as residential lettings.

This means that a trader with a buy-to-let property who moves to the Flat Rate Scheme is suddenly liable for VAT on his rental income.

The turnover calculated in the table above – when calculating VAT due for a period – is different from that for deciding eligibility for the scheme (see below).

Sales and purchases outside the UK, whether to the EU, or elsewhere, cause further complications. For further details on applying VAT internationally visit HMRC.

This scheme was introduced for the benefit of small businesses, to reduce their administration time and costs.

Whether this is the actual experience of small businesses, it’s a benefit to HMRC, who can now check VAT liabilities with a simple turnover-based calculation, instead of having to plough through dozens of expense receipts.

Sage Accounts software can help take out some of the stresses of VAT, such as submitting VAT straight from your software.

For you, however, in order to know whether the scheme is beneficial in purely financial terms, you need to compare the outcome from the Flat Rate Scheme with the outcome from using the normal rules; this means that it is necessary to calculate VAT in both the normal way, and using the flat rate; hardly a simplification.

As explained, there’s normally no claim for VAT on expenses within the Flat Rate Scheme. However, VAT on capital expenditure of £2,000 or more – inclusive of VAT (£1,702.13 + VAT) – can be reclaimed.

As an incentive for newly registered businesses, the flat rate is reduced by 1% for the first year of registration.

Careful – this applies to the first year of VAT registration, not the first year on the Flat Rate Scheme, so will only apply in full if the business enters the Flat Rate Scheme immediately on registration.

VAT scheme eligibility

For all the above schemes, there are maximum levels of annual turnover for eligibility. All three schemes can be used together (see note 2 below).

Notes:

1. Property rental is by default exempt from VAT. However, landlords of business property may elect to waive this exemption (which enables the landlord to reclaim input tax).
2. The Flat Rate Scheme has its own version of cash accounting.

Want to find out more about VAT Schemes?

In addition to the schemes explained here, there are special schemes for retailers and margin schemes for certain trades.

You can find out more about them at www.hmrc.gov.uk/vat