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February 10th 2021

VAT schemes for small businesses

The use of certain VAT schemes can produce cash flow benefits and, in some cases, a reduced VAT bill for some businesses. This article gives practical tips on each scheme, including pitfalls for certain transactions.

The three main VAT schemes that are available to small and medium enterprises (SMEs) are:

  • flat rate scheme;
  • cash accounting scheme; and
  • annual accounting scheme.

The initial challenge is to establish who might be eligible to use the schemes. The joining thresholds for the annual and cash accounting schemes are the same; i.e. taxable sales in the next 12 months are expected to be less than £1.35m excluding VAT. The flat rate scheme threshold is much lower and expected taxable sales in the next 12 months must be less than £150,000 excluding VAT.

Flat rate scheme: still relevant?

If you use the Flat Rate Scheme, you charge VAT to your customers (“output VAT”) and pay VAT to your suppliers when you buy goods or services from them (“input VAT”) in the normal way.

But when it comes to preparing your VAT return and paying VAT to HMRC you do things slightly differently. Instead of adding up all the VAT you charge and taking away the VAT you can reclaim, you add up all your sales – including any VAT charged to your customers – and pay a percentage of those sales to HMRC. The percentage you pay depends on what your business’s trade is, unless you’re a “limited cost trader”.

With the Flat Rate Scheme, you can’t normally claim back any of the VAT you paid on purchases, apart from if you buy a capital asset that cost £2,000 or more including VAT.

On the Flat Rate Scheme, you pay a percentage of your total sales to HMRC when filing your VAT Return. HMRC has set percentages depending on what your business does.

During the first year that your business is registered for VAT (which is not necessarily the same as the first year you’re on the VAT Flat Rate Scheme), you get a 1% discount on the percentages – so you would use, for example, 9% instead of 10% for advertising.

However, if you’re a limited cost trader, you must use 16.5% instead of your trade’s percentage!

HMRC says the Flat Rate Scheme makes record-keeping simpler because you don’t have to work out what VAT you can claim on your purchases. The Flat Rate Scheme can also save you money, though it’s not designed with this in mind. This tends to depend on what sector you’re in, how much VAT you pay out on your costs, and whether or not your business is a limited cost trader.

The limited cost trader rules, which came into effect 1 April 2017, have destroyed the tax-saving advantages traditionally enjoyed by many traders who used the flat rate scheme. Coupled with the fact that increasing numbers of VAT-registered SMEs now keep their VAT returns electronically - making the whole VAT return process much easier - the benefits of the flat rate scheme seem to have eroded significantly in recent years.

Cash accounting scheme

The main advantage of the cash accounting scheme is that output tax is not declared on a VAT return until payment has been made by a customer, rather than the earlier sales invoice date. This outcome means that bad debt relief is automatic for scheme users because output tax is never declared on unpaid sales invoices. The downside, though, is that users cannot claim input tax until suppliers are paid.

The scheme might not be suitable for a business that has a lot of zero-rated or exempt sales where there is no output tax liability, especially if it pays suppliers very slowly. Some businesses have sales where the VAT liability can fluctuate (e.g. builders who so some zero-rated work on new houses but standard rated work on commercial properties) so the scheme’s cash flow benefits should be regularly checked.

Leaving the cash accounting scheme

As with the flat rate scheme, the exit threshold is higher than the joining figure. A business needs to leave the scheme at the end of a VAT period if total taxable sales have exceeded £1.6m excluding VAT in the previous 12 months. This means either:

  • Output tax needs to be accounted for on debtors in the VAT period when the business leaves and input tax claimed in creditors; or
  • VAT can instead be dealt with on these invoices in the following two quarters on a transitional basis; i.e. when customers pay, and suppliers are paid (See HMRC Notice 731 para 6.4.)

When the six month period has expired, there might be scope to claim bad debt relief on any sales invoices that are still unpaid (HMRC Notice 700/18 para 2.2); i.e. avoiding the need to declare output tax on the next return.

Annual accounting scheme

It is easy to dismiss the benefits of the annual accounting scheme, which basically means that only one VAT return is submitted each year instead of four or 12. Many clients like to know their VAT liability on a quarterly basis and we encourage this as well because it gives reassurance that records are being kept up to date. But there are worthwhile benefits of the annual accounting scheme that might be relevant for some businesses:

  • Default surcharges: if a business has regularly incurred default surcharges, the annual VAT return means only one instead of four potential surcharges. The annual return is also due two months after the end of the annual period;
  • Flat rate scheme users: a business can use the flat rate scheme and annual accounting schemes at the same time. A flat rate scheme user will therefore only need to carry out the ‘limited cost trader’ test on an annual basis;
  • Annual accounts: It makes sense for the annual VAT accounting year to coincide with the financials year. This will make it easy to check, for example, that declared sales in Box 6 of the VAT return (the outputs box) are compatible with the declared sales in the annual accounts of the business in question.

A business that is registered for VAT as a group or part of a division cannot use the annual accounting scheme. And once a business has left the scheme, it cannot re-join for at least 12 months.

The other key issue is that scheme users must make monthly payments on account, which are based on the liability shown on the previous annual return. these payments can be made as nine monthly or three quarterly payments, and must be paid by direct debit, standing order or other electronic means. Each of the nine payments is equal to 10% of the previous year’s annual VAT liability. The balance owed is payable two months after the end of the accounting year. If the payments on account are too high, the overpayment will be refunded by HMRC.

As a practical tip to help cash flow, if a business expects to pay less VAT in the current year compared to last year, which will be quite common in the current economic climate, it should write to HMRC to adjust the payments (HMRC Notice 732 para 4.7).

For help with your VAT affairs, contact us today.

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