If your business mainly supplies services and you use the VAT flat rate scheme, you might assume that you’re stuck using the VAT rate for limited cost traders. How can you manage your expenses so that it doesn’t apply and thereby reduce your VAT?

Flat rate scheme recap

HMRC created the flat rate scheme (FRS) to simplify VAT admin and record keeping for small businesses. You can join the FRS if you expect your business turnover in the next twelve months not to exceed £150,000 excluding VAT. You’re allowed to stay in the FRS until your turnover exceeds £230,000 including VAT. You must check your income each year on the anniversary of when you started to use it.

Trap. Turnover for the purposes of checking if you must leave the FRS is measured differently from normal turnover for VAT purposes. Turnover for the FRS excludes sales and other supplies which are exempt or outside the scope of VAT, e.g. supplies of services to VAT-registered businesses in the EU, but includes zero-rated and reduce-rated sales, e.g. sales outside the EU.

Flat rate advantage

If you use the FRS you must charge your customers VAT at usual rates but account to HMRC at a different rate set according to the type of business you run. This means you collect more VAT from your customers than you have to pay to HMRC, but there’s a quid pro quo. You must account for VAT on income that is normally VAT exempt and, subject to a few exceptions, you aren’t entitled to reclaim VAT on purchases.

Trap. Overall, most businesses – especially those that made minimal purchases, typically those selling services – made a healthy profit from using the FRS. To eliminate the financial advantage to so-called limited cost traders HMRC created a new FRS rate in 2017. The rate is 16.5% and applies to any business which doesn’t buy “relevant goods” costing either at least £1,000 including VAT per annum (or £250 per VAT quarter) or 2% of their VAT-inclusive turnover. The test for checking if you’re a limited cost trader should be carried out each VAT return period, which for most businesses means quarterly.

Tip. It may be possible to organise your purchases to avoid being categorised as a limited cost trader. This will allow you to apply a more advantageous FRS rate which can reduce your VAT bill.

Example. Acom Ltd supplies IT services. The normal FRS rate for this type of business is 14.5%. Its quarterly turnover including VAT is £52,000. To avoid being categorised as a limited cost trader it must purchase relevant goods each quarter costing at least £1,040 including VAT (2% of its sales). It expects to make purchases of £3,600 over the course of the year. If it spread the purchases equally, i.e. £900 per quarter, it would be a limited cost trader in each quarter. In a year it would therefore have to account to HMRC for VAT of £34,320 (£52,000 x 4 x 16.5%).

If instead Acom was able to organise its purchases to be, say, £1,100 in three quarters and £500 in one, it would only be a limited cost trader for one VAT return period. Its VAT bill would be £31,200 ((£52,000 x 3 x 14.5%) + (£50,000 x .16.5%)), which would leave it £3,120 better off.

Tip. The strategy for any business that is a borderline limited cost trader is to plan purchases so that in as many VAT periods as possible the £250 or 2% of turnover purchase limits are met.

As a borderline limited cost trader, plan your purchases with the aim of increasing them above the £250 and 2% of turnover limits in as many VAT quarters as possible by reducing purchases in other quarters. This can cut thousands from your VAT bill over the course of a year.

This article has been reproduced by kind permission of Indicator – FL Memo Ltd. For details of their tax-saving products please visit www.indicator-flm.co.uk or call 01233 653500.