Flat Rate VAT - Accounting Implications

Typically, a VAT-registered business will charge VAT when it makes a sale to a customer, and pay VAT on purchases. That business then usually pays (or claims back) from HMRC the difference between the VAT charged and the VAT paid. However, for some businesses, there is an alternative way to deal with VAT in the UK - the Flat Rate Scheme ("FRS").

What is the VAT Flat Rate Scheme?

Under the Flat Rate Scheme, a business continues to charge VAT to customers at the relevant rate (e.g. businesses selling standard-rated goods continue to charge 20% VAT), and continues to pay VAT on purchases at the relevant rate.

However, for VAT reporting purposes, the business will pay a fixed rate (as a percentage of turnover) of VAT to HMRC amd VAT on purchases (i.e. Input Tax) is not taken into account. In other words, the business keeps the difference between what it charges customers and pays to HMRC (i.e. the business keeps the difference between the amount of VAT charged on its invoice and the fixed rate of VAT applied under the Flat Rate Scheme).

Note that certain capital asset purchases over £2,000 can still be taken into account for Input Tax.

HMRC highlights several benefits to the Flat Rate Scheme, including:

• Simplified record-keeping, as businesses should not have to keep detailed records of sales and invoices;
• The use of fixed-rate percentages that are lower than the standard rate of VAT; and
• Better cash flow management

While the Flat Rate Scheme can also be used with the Annual Accounting Scheme, it cannot be used with the Cash Accounting Scheme or Retail Schemes.

Eligibility

You can join the Flat Rate Scheme if are VAT registered, and your VAT taxable turnover is expected to be £150,000 or less (excluding VAT) in the next 12 months. VAT taxable turnover is the total of everything sold that isn’t VAT exempt.

You will no longer be eligible for the scheme if the total value of your income for the year ending is more than £230,000 (including VAT), or you expect it to be more than £230,000 in the next 12 months.

There are also a number of conditions in place as to when businesses can’t use the Flat Rate Scheme (for example, if your business left the scheme in the last 12 months). A full list can be found on HMRC’s website.

What rate applies to my business?

You pay VAT as a fixed percentage of your VAT inclusive turnover. The actual percentage depends on your business - see HMRC’s FRS percentages for more information. It is important to also note that you are also eligible for a 1% discount in your first year of being a VAT-registered business. For example, if your flat rate is 14.5%, your business would actually use a rate of 13.5% in the first year.

Limited Cost Trader

In order to tackle abuse, HMRC introduced a new category of trader, called a Limited Cost Trader, with a Flat Rate of 16.5% in April 2017. This is the case for businesses with goods that cost less than either:

• 2% of your turnover
• £1,000 a year (if your costs are more than 2%)

For more information, have a read of our articles on Limited Cost Trader and how it impacts the VAT report. In addition, HMRC has a calculator that can tell you if you are a limited cost business.

What are the Flat Rate VAT accounting implications?

As stated above, if you’re registered for the Flat Rate Scheme, you continue to invoice customers as normal and apply the rate of VAT you would ordinarily use.

The way that our system calculates Flat Rate vat is based on a methodology that calculates the difference (i.e. the profit or loss) from using the Flat Rate Scheme (FRS) compared to Standard VAT. Our method of calculation allows you to know exactly if its worthwhile being on the FRS scheme or not. Generally, if you have a lot of sales and few expenses, then it will be of benefit to use the FRS (on the assumption that you are not considered a Limited Cost Trader - see above). Conversely, if you have a higher proportion of vatable expenses, then it may make more sense to not use the FRS.

Let’s look at a few examples of how the Flat Rate Scheme impacts accounts preparation on AccountsPortal.

Example 1

Your company does not use the Flat Rate Scheme. You raise an invoice for £1,000 plus VAT at 20% (i.e. a total invoice amount of £1,200).

The standard journal entry to record this would look something like:

• Dr Accounts Receivable 1,200
• Cr Sales 1,000
• Cr VAT 200

Assuming no other invoices were raised, or purchases made, this would mean you would have £200 to pay to HMRC at the end of your VAT period.

Example 2

Your company uses the Flat Rate Scheme and applies an 11% flat rate. This time, you raise an invoice for £1,000 plus VAT at 20% (i.e. a total invoice amount of £1,200).

The journal entry to record this would look something like:

• Dr Accounts Receivable 1,200
• Cr Sales 1,000
• Cr Sales (Profit from the Flat Rate Scheme) 68
• Cr VAT 132

Although the invoice total is still £1,200, because your company is registered under the Flat Rate Scheme, when it comes to the end of your VAT period, you only owe HMRC £1,200 x 11% = £132. The remaining £68 (i.e. the £200 from Example 1 minus £132 from example 2) is actually a “profit” made from using the Flat Rate Scheme. This effectively increases your sales (and gross profit, etc) by £68.

Notice that as long as the company's flat rate is below the invoice rate (in this case 11% is below 20%), then it will 'profit' from using the FRS.

As mentioned above, it gets a bit more complicated when you take expenses into account. This is because businesses can claim back the VAT on purchases if they are a typical VAT-registered business, but they cannot claim said input tax if on the Flat Rate Scheme.

Whew! Like I said, although the FRS appears to be more simple, the reality can be very different!

When shouldn’t you use the VAT Flat Rate Scheme?

Although there are some benefits to the Flat Rate Scheme, it has its fair share of downsides, and there are plenty of instances when it might not be beneficial for a business to sign up to the scheme.

For example, businesses that usually claim input tax may not benefit from the Flat Rate Scheme. Equally, added complexities may arise for businesses who buy and sell goods from outside the UK.

Generally, if you have a lot of sales and few expenses, then it’ll likely be beneficial to use the Flat Rate Scheme, as long as you don't fall under Limited Cost Trader status. Conversely, if you have a higher proportion of VATable expenses, then it may make more sense to not use the Flat Rate Scheme.

It’s always best to speak to your accountant or tax adviser before registering for VAT or changing from one VAT scheme to another - it's critical to understand the picture as a whole before making any decisions.

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Further Reading

Spring Statement 2022: What it means for small businesses

How to manage the final hospitality VAT rate increase in AccountsPortal

Ten Purchases You Didn't Know Were Tax-deductible