Is the VAT flat rate scheme costing you money

The VAT flat rate scheme has been around for a long time now, but there is still a surprising amount of confusion around how exactly it works and whether it’s a good idea.

On the face of it it’s a compelling set-up. Businesses get to charge 20% to their customers, but only pay over between 4 and 14.5% of their sales – great – you get to make between 6 and 15.5% additional margin, right? WRONG!

This is a common misconception and its easy to see how this might happen. With modern accounting systems often they will take care of the flat rate scheme automatically and so lots of businesses on it never really get to grips with the mechanics of what is happening. To understand it we really need to do a quick refresher on how the VAT flat rate scheme works.

Refresher on how the flat rate scheme works

So, you’ve just made a sale for £100. How does that look from a VAT perspective. Lets assume that on the flat rate scheme percentage is the “Any other activity not listed elsewhere” of 12%. Well for both the VAT flat rate scheme, and the normal VAT scheme, its quite simple – you add 20%. In this case additional VAT needs to be charged of £20.

So far, relatively simple, but here’s where the two schemes start to diverge.

Assuming there were no costs associated with this sale, for simplicity sake, the business on the normal VAT regime would simply pay over to HMRC the £20

On the flat rate scheme the business doesn’t pay over the £20. Right now I imagine a few of you are thinking to yourselves, the answer is £12, being 12% of the £100 sale. The answer, however, is actually £14.40.

How you may ask?

The 12% that is advertised on the HMRC website is applied to the GROSS sales figure, so in this case its 12% of £120, not 12% of £100. Here is where much of the confusion arises.

If you wanted to compare the flat rate to the standard VAT rate of 20% the rate, in this case, is more like 14.4%, not 12% (I’ve done the calculation for all the categories below)

Still, you’re making an additional 5.6%, in this example, right. Sadly, wrong again!

You see what you sacrifice by going on to the VAT flat rate scheme is the ability to reclaim the VAT you incur on expenses – and this is where the real issue lies.

Expenses and the VAT flat rate scheme

(Warning, this is going to get a bit technical and numerical – sorry – its unavoidable)

When you have expenses in a business they will typically be Vatable expenses. This means, under normal VAT circumstances you can reclaim this VAT back from HMRC.

With the flat rate scheme you can’t claim any of this VAT back – its covered by the lower rate.

My question to businesses is are you sure this is a good deal?. You see, in the above example HMRC assumes, via the flat rate, that you will be incurring expenses or around £28 excluding VAT, or £33.60 including VAT. How do I know that?

Well you’ve received £120 of cash from your sale, including VAT, but you’ve paid over to HMRC £14.40. That leaves £5.60 “profit”. HMRC view this “profit” as covering the VAT on the expenses you can no longer claim for. That works out to be £28.00 worth of expenses (exc VAT).

If you are incurring less than £28.00 of expenses then you may be making a profit on the flat rate scheme, but if you are incurring more that £28.00, you could be paying a higher rate of VAT than if you were just on the normal, non-flat rate scheme.

[Phew – you’ll be pleased to know that that’s the hardest part of this post]

How does this look for an entire business

Now I can hear what you are thinking to yourselves – how do I know what costs I incur for the £100 sale? How do I work out what costs per sale are – some costs cover all my sales (rent for example)

Well you don’t need to – in fact its more useful to look at an entire year.

Below is a table showing what the effect is on an entire year if the sales was, say, £130,000, Vatable expenses of £20,000

What you can see is that at this level, its only worth being on the flat rate scheme if your vatable expenses are lower than £36,400.

So is the VAT flat rate scheme a good idea or not

As with so many questions when it comes to tax: It depends.

It really depends on your own business – what your income is and what your expenses are.

Let’s not forget the question over whether your customers are also VAT registered – if they are you should be able to pass on the VAT charged without much effort. If they are not – if your customers are the general public and not businesses, you may find you cannot pass on the VAT you charge as they can’t claim it back. To those sorts of customers VAT charged is just a price increase! (This is a big subject and would need a whole other post to cover).

To this end, if you are not really interested in the mechanics of the numbers and just want an answer, we’ve built you a handy tool to calculate whether the flat rate scheme is a good idea for you or not. It’s a general guide, and I would discuss the matter with your accountant before making any decisions, but if you’re interested then plug in your numbers and see what response you get. Typically, however, it can be beneficial where your costs are relatively low compared to your income.

What can I do?

If it looks as though the flat rate scheme is no longer right for you then then luckily you are able to leave the scheme at any point – you just need to contact HMRC to let them know.

Other things to consider

Its worth pointing out that there are benefits to the flat rate scheme, beyond just saving some money. The flat rate scheme does simplify matters somewhat. It can lower the administrative burden on the business, however, given you need to keep records for company accounts/corporation tax/income tax purposes it unlikely to make much of a difference

Appendix – Flat rate adjusted to be comparable with the Standard VAT rate