UK VAT Schemes explained: Standard VAT, Flat Rate and Cash Accounting
VAT is one of those taxes that many business owners prefer not to think about until their turnover starts getting dangerously close to the registration threshold. Then suddenly there are questions about VAT registration, VAT returns, input VAT, output VAT, Flat Rate percentages and whether that invoice you sent three months ago but still have not been paid for means you somehow owe HMRC money you have not actually received.
Welcome to VAT.
The good news is that VAT in the UK is not simply one accounting system that every VAT-registered business has to use in exactly the same way. There are several VAT schemes available, including Standard VAT Accounting, the VAT Cash Accounting Scheme, the Flat Rate Scheme and the Annual Accounting Scheme. Which one makes the most sense depends on your turnover, the type of business you operate, who your customers are, how much VAT you incur on business expenses and even how quickly your customers pay you.
There is another misconception worth clearing up immediately: reaching the compulsory VAT registration threshold is not the only reason to become VAT registered. In some circumstances, voluntary VAT registration can make financial sense long before your business is legally required to register.
When do you have to register for VAT in the UK?
The compulsory VAT registration threshold is currently £90,000 of VAT taxable turnover. A business will normally need to register if its taxable turnover for the previous rolling 12-month period exceeds £90,000.
The words rolling 12 months are important. This is not simply your company financial year, the calendar year or the tax year. Your taxable turnover needs to be monitored continuously.
There is also a forward-looking VAT registration test. If you expect your VAT taxable turnover to exceed £90,000 in the next 30 days alone, different registration timing rules can apply. This is particularly relevant when a business wins a large contract or suddenly experiences a significant increase in sales.
And importantly, the £90,000 threshold relates to VAT taxable turnover, not simply every pound that arrives in your business bank account. Different types of supplies can receive different VAT treatment, so a business approaching the threshold should establish what actually counts towards it rather than relying solely on the balance shown in its accounting software.
Why would anyone register for VAT voluntarily?
At first glance, voluntary VAT registration can sound slightly odd. Why volunteer for another tax return, more record keeping and the responsibility of collecting tax for HMRC when you are not legally required to do so?
Because sometimes the numbers work.
A business with taxable turnover below £90,000 can apply for voluntary VAT registration, provided the relevant conditions are satisfied. Whether this is beneficial often depends heavily on who the business sells to.
If most of your customers are VAT-registered businesses that are themselves entitled to recover VAT, adding VAT to your invoices may have much less commercial impact than it would if you mainly sell to members of the public.
Imagine your service costs £1,000. Once VAT registered, assuming the standard 20% rate applies, the invoice could become £1,000 plus £200 VAT. A VAT-registered business customer that is entitled to recover that £200 may ultimately still view the underlying service as costing £1,000.
A private customer sees things rather differently.
They see £1,200.
That difference is one of the most important considerations when deciding whether voluntary VAT registration is worth it. A B2B consultancy, contractor or transport business may be in a very different position from a hairdresser, tradesperson or retailer whose customers are predominantly members of the public.
VAT registration can also allow a business to recover eligible input VAT on business purchases and expenses, subject to the normal VAT recovery rules. In some circumstances, VAT on certain costs incurred before registration can also be recovered once the business becomes VAT registered.
However, VAT registration should never be viewed as free money. Once registered, the business takes on VAT responsibilities, including maintaining appropriate VAT records, submitting VAT Returns and paying the VAT due to HMRC. The commercial effect on pricing should therefore be considered before voluntarily registering rather than afterwards.
Why voluntary VAT registration can make sense for drivers and couriers
Voluntary VAT registration can be particularly interesting for certain drivers, couriers and transport businesses operating below the £90,000 compulsory registration threshold.
The key question is usually: who pays you?
Consider a self-employed driver or small Limited Company generating £60,000 of taxable turnover each year while providing services to a larger VAT-registered company. If the contract allows the driver to charge the agreed fee plus VAT, voluntary registration may be worth examining.
Where the customer is entitled to recover that VAT, adding VAT to the invoice may not represent the same commercial disadvantage as it would when dealing with private customers. The driver may then also be able to recover eligible input VAT and consider whether one of the alternative VAT accounting schemes produces a better overall result.
There is, however, a very important detail to check before voluntarily registering: is your agreed price VAT-exclusive or VAT-inclusive?
If you currently charge £1,000 and your customer will accept an invoice for £1,000 + VAT after registration, that is one calculation. If the customer tells you that the agreed £1,000 is the final price and any VAT has to come out of it, that is a very different calculation.
VAT registration itself does not create profit. The potential benefit comes from how registration interacts with your pricing, customers, expenses and chosen VAT scheme.
Flat Rate Scheme: why drivers and couriers should know about it
The VAT Flat Rate Scheme was designed to simplify VAT accounting for smaller businesses.
Under normal VAT accounting, a business calculates output VAT on sales, deducts recoverable input VAT on eligible purchases and pays the difference to HMRC. The Flat Rate Scheme approaches the calculation differently.
You still charge your customers the normal VAT rate applicable to your supplies, but instead of deducting input VAT on most individual expenses, you calculate the amount payable to HMRC by applying a Flat Rate percentage to your VAT-inclusive turnover.
The percentage depends on the type of business.
HMRC’s Flat Rate category for “Transport or storage, including couriers, freight, removals and taxis” is currently 10%. Businesses using the Flat Rate Scheme may also receive a one percentage point reduction in their Flat Rate percentage during the first year after VAT registration, where the relevant conditions are met.
This is where the scheme starts to become interesting.
Suppose a qualifying transport business invoices a VAT-registered customer £1,000 plus £200 VAT. The customer pays £1,200 in total. At a 10% Flat Rate percentage, the Flat Rate VAT calculation on that £1,200 would be £120.
That difference is one reason the Flat Rate Scheme can be attractive to some businesses with relatively low levels of recoverable input VAT.
But this is also where stopping after one attractive example can become expensive.
The 16.5% Limited Cost Business rule
The Flat Rate Scheme includes the limited cost business, sometimes called limited cost trader, rules. A business that spends relatively little on HMRC-defined “relevant goods” may have to use a Flat Rate percentage of 16.5%, rather than its normal sector percentage.
This can dramatically change the calculation.
The definition of relevant goods is also more restrictive than many business owners expect. You cannot simply assume that every expense appearing in your Profit and Loss account counts towards the test.
Vehicle costs and fuel are particularly important for drivers. HMRC generally excludes vehicles, vehicle parts and fuel from relevant goods, but there is an exception where the business is in the transport sector and uses its own or a leased vehicle to provide the service. HMRC specifically gives fuel used by a taxi business as an example.
This is why a driver should never choose the Flat Rate Scheme purely because somebody said: “Drivers only pay 10%.”
The correct question is whether your particular business qualifies for that percentage once the limited cost rules and your actual expenditure are considered.
The Flat Rate Scheme also has an entry threshold. Broadly, you can join if you expect your VAT taxable turnover, excluding VAT, to be £150,000 or less during the next 12 months, assuming the other eligibility conditions are met.
Standard VAT Accounting: simple logic, even if the bookkeeping is not always simple
Under Standard VAT Accounting, the basic calculation is straightforward. You calculate the output VAT due on your taxable sales and deduct the input VAT that you are entitled to recover on qualifying business purchases. The difference is then paid to HMRC, or in some cases the VAT Return can result in a repayment.
For businesses with significant VAT-bearing costs, Standard VAT Accounting can be particularly attractive because eligible input VAT is dealt with directly.
A business buying substantial amounts of stock, materials, equipment or VATable services may therefore find Standard VAT Accounting more suitable than the Flat Rate Scheme.
Under the Flat Rate Scheme, VAT on most everyday purchases is not separately reclaimed. There is an exception for certain qualifying capital expenditure goods costing £2,000 or more including VAT, where the relevant conditions are met.
This is why asking “Which VAT scheme is best?” without looking at the business itself is almost meaningless.
The useful question is: which VAT scheme works best for this business, with these customers, these expenses and this cash flow?
Accrual VAT versus Cash Accounting: when do you actually pay the VAT?
This distinction can have an enormous effect on cash flow.
Under normal VAT accounting, sometimes informally described as accrual or invoice-based VAT accounting, the timing of VAT is governed by the VAT tax point rules. In practical terms, this can mean that VAT becomes due for reporting before your customer has actually paid you.
Imagine issuing an invoice for £12,000, including £2,000 VAT. Your customer is delighted with the work and repeatedly assures you that “payment should be with you on Friday”.
They simply neglect to specify which Friday.
Depending on the tax point, you may still have to account for that £2,000 of output VAT on your VAT Return even though the customer’s money has not reached your bank account.
For businesses with slow-paying customers, this can create a genuine cash-flow problem.
The VAT Cash Accounting Scheme approaches the timing differently. Broadly, you account for output VAT when your customer actually pays you. The other side of the arrangement is that you generally recover input VAT on purchases when you actually pay your supplier.
For a business routinely giving customers 30, 60 or longer payment terms, this can make cash flow considerably easier to manage. You are less likely to find yourself effectively financing a VAT payment to HMRC while waiting for your customer to settle the invoice.
Eligible businesses can generally use VAT Cash Accounting if their estimated VAT taxable turnover for the next 12 months is £1.35 million or less, subject to the scheme’s other conditions.
It is also worth distinguishing VAT Cash Accounting from the general cash basis used for Income Tax by many Sole Traders. The names sound similar, but they are separate tax concepts with different rules.
And if you are using the Flat Rate Scheme, there is a separate cash-based method available within that scheme rather than simply combining two independent VAT schemes.
What about the VAT Annual Accounting Scheme?
The VAT Annual Accounting Scheme is another option available to eligible businesses.
Instead of submitting the usual number of VAT Returns throughout the year, the business submits one annual VAT Return and normally makes advance VAT payments during the year, followed by a balancing payment or repayment once the annual return has been completed.
For some businesses, this can reduce administration and make VAT payments more predictable.
A business can generally join the Annual Accounting Scheme if its estimated VAT taxable turnover is £1.35 million or less, provided the other eligibility requirements are satisfied.
That does not mean one VAT Return a year is automatically better. A business that regularly expects VAT repayments, for example, needs to think carefully about the cash-flow consequences of waiting longer to submit its return.
As usual with VAT, “simpler” and “better” are not necessarily the same thing.
VAT is about much more than adding 20% to an invoice
Another common misconception is that VAT simply means adding 20% to everything you sell.
The standard VAT rate in the UK is indeed 20% for many goods and services, but the VAT system also includes reduced-rated, zero-rated and exempt supplies, as well as transactions that may fall outside the scope of UK VAT. Certain industries also have their own specialist VAT rules and schemes.
This is why two businesses with exactly the same £80,000 annual turnover could reach completely different conclusions about voluntary VAT registration.
One might provide services almost entirely to VAT-registered companies, incur significant VAT on business expenses and find voluntary registration commercially sensible. Another might sell mainly to private consumers who cannot recover VAT, meaning registration could make its prices less competitive or force the business to absorb VAT within its existing prices and reduce its margin.
The turnover figure matters, but it is only part of the picture.
The more useful questions are: Who are your customers? How much VAT do you incur on your expenses? How quickly do customers pay you? And which VAT accounting method produces the best result for your particular business?
Choosing a VAT scheme should be a decision, not an accident
VAT registration in the UK does not necessarily begin on the day a business crosses the £90,000 compulsory registration threshold. For some businesses, voluntary VAT registration below the threshold can make commercial sense, particularly where customers are predominantly VAT registered themselves.
Drivers, couriers and transport businesses may want to examine the Flat Rate Scheme and its 10% transport category, but the limited cost business rules must be checked before assuming that the headline percentage will apply.
Businesses with substantial VATable expenses may find Standard VAT Accounting more attractive because of input VAT recovery. Businesses struggling with customers who take months to pay may benefit from examining the VAT Cash Accounting Scheme. Those looking to reduce the frequency of VAT administration may consider Annual Accounting.
VAT is therefore not simply a switch that gets turned on when turnover reaches £90,000. Choosing how VAT is accounted for can have a real impact on cash flow, administration and the financial performance of a business.
If you are approaching the UK VAT registration threshold, considering voluntary VAT registration or are already VAT registered but are unsure whether you are using the most appropriate VAT scheme, Bilinscope Ltd, a professional UK accounting team, can review your turnover, customers, expenses and business model and help you understand which VAT accounting approach fits your circumstances.
Because one of the most expensive VAT mistakes is not necessarily putting the wrong number in a VAT Return.
Sometimes it is spending years using a VAT scheme simply because someone once told you: “That’s what everyone uses.”
