To assist new founders with understanding their responsibilities with HMRC, we take a look at the difference between flat rate and standard VAT to help you work out which best suits the needs of your company.
Having a solid grasp of the difference between flat rate and standard VAT return is among the most important aspects of running a small company. HMRC takes non-compliance seriously, and the latest Finance Bill included penalties of £10,000 for owners avoiding VAT.
What is VAT?
Value-added tax (VAT) is a tax added to the majority of goods and services, paid for by your customers. To automatically qualify for VAT, your company must have annual “VATable” turnover of £85,000 and above. For example, domestic UK sales exceed £85,000.
As a qualifying sole trader, freelancer or self-employed business owner, it is your responsibility to add the national VAT rate to the price of your products and submit a VAT return to HMRC every quarter. A return must be sent even if no VAT is owed to the tax office.
The VAT return is a calculation of how much VAT is due from revenue minus how much VAT you can reclaim on business expenses. A completed return will either show how much you owe HMRC, or how much you can reclaim. If you can reclaim more VAT than you have brought in, HMRC will refund you the difference.
For most goods, VAT is currently set at 20 per cent. A reduced five per cent rate is added to home energy and, for example, goods such as children’s car seats. VAT is not added to property stamps, most food, children’s clothing or property and financial transactions.
Your business has annual turnover of £90,000, so you are required to submit a return every three months to HMRC using the 20 per cent rate.
- Sales in that period were £50,000, so the VAT owed is £10,000
- You are able to reclaim £1,000 VAT back on business expenses
- The total VAT owed to HMRC in that quarter is £9,000
Voluntary VAT registration
The tax office does allow companies below the threshold the register for VAT voluntarily, with a number of potential benefits to smaller firms.
VAT registration can reflect well for a business in terms of clients, investors and lenders, giving the impression of significant turnover. Some firms may also be hesitant to work with a non-VAT registered business, so business owners paying voluntarily can put their VAT number on invoices and websites, for example.
Voluntary registration can be backdated up to four years, provided HMRC can see the necessary evidence. However, small business owners should be aware of the negatives, such as the added administrative strain and the potential for a large VAT bill if more VAT is generated from sales than expenses.
What is the flat rate VAT scheme?
The flat rate scheme was introduced by HMRC to simplify VAT returns for small business owners, but also to offer the smallest firms the chance to profit. It is available for firms with an ex-VAT turnover of £150,000 or less.
Under the flat rate scheme, your business pays a fixed rate fee to HMRC. Unlike the standard scheme, you can’t reclaim VAT on your purchases – except for certain capital assets of above £2,000 – but you can keep the difference between the VAT on sales and what you pay HMRC.
In terms of your own invoices, you will still charge VAT as usual and clients will see no change.
The fixed VAT rate depends on the type of business you own. As a general rule, the more you spend on goods and materials, the lower your flat rate VAT will be.
View the full breakdown of flat rate VAT by business type on GOV.UK
For businesses considered “limited cost traders”, i.e. those spending little on raw materials, a higher flat rate of 16.5 per cent was introduced on 1 April 2017.
HMRC defines limited cost traders as:
- Those with VAT on goods of less than two per cent of VAT on annual turnover
- Those with VAT on goods of greater than two per cent of VAT, but under £2,000 per year
Read our previous article on further guidance on limited cost traders
Working out your flat rate
To calculate the VAT owed to HMRC, multiply your flat rate percentage with your VAT-inclusive turnover. VAT-inclusive turnover means all sales including the VAT paid on that income.
For companies within the first year as a VAT-registered business, a one per cent discount to the fixed rate is given by HMRC.
- If you are running a photography business and charge a client £500 for an event, you will invoice them for the £500 plus the national VAT rate of 20 per cent – totalling £600
- Your flat rate is only 11 per cent, but the business is only six months old, so reduce the rate to ten per cent
- You will pay HMRC ten per cent of £600 – or £60
Work out your own flat rate on GOV.UK
The difference between flat rate and standard VAT
The key difference between flat rate and standard VAT is in the multiplier added to your income for the VAT return.
The flat rate scheme considers how much you are likely to spend on raw materials, setting a rate based on your business type. It gives small firms beneath the entry threshold the chance to profit on VAT, and simplifies the relationship with HMRC.
However, whether you are using the flat rate scheme, or your company turnover qualifies for standard VAT, you always need to be charging 20 per cent VAT on all sales.
For small firms starting out and managing cash flow and overheads, the flat rate scheme might not be suitable and could limit the commercial success of your goods and services.
Now you’re aware of the difference between flat rate and standard VAT, find out everything you need to know about your first self-assessment.
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