The short answer
On the Flat Rate Scheme you still charge customers 20% VAT, but instead of paying HMRC the VAT you charged minus the VAT you paid on costs, you pay a flat percentage of your VAT-inclusive turnover. The percentage depends on your trade, from 4% to 14.5%.
The catch is the limited cost trader rule. If you spend little on goods, you must use 16.5% whatever your trade. At 16.5%, the scheme takes almost all the VAT you charge, so it rarely saves money.
How the scheme works
- Charge customers
- 20% VAT
- Pay HMRC
- VAT charged − VAT on costs
- Reclaim VAT on costs
- Yes
- Records
- VAT on every sale and purchase
- Charge customers
- 20% VAT
- Pay HMRC
- Flat % × turnover including VAT
- Reclaim VAT on costs
- No, except capital items of £2,000+
- Records
- Mainly your sales
- Sales before VAT£60,000
- VAT charged at 20%£12,000
- Turnover including VAT£72,000
- Flat rate VAT£72,000 × 14.5%£10,440
The flat rate applies to the VAT-inclusive figure, not the price before VAT. That is easy to get wrong when you first estimate what the scheme is worth.
Flat rates by trade
HMRC sets a percentage for each type of business. You use the one that best describes your main activity. A selection is below; the calculator lists them all.
| Trade | Flat rate |
|---|---|
| Retailing food, confectionery, tobacco, newspapers or children's clothing | 4% |
| Pubs | 6.5% |
| Retailing not listed elsewhere | 7.5% |
| General building or construction services | 9.5% |
| Transport or storage, including couriers and taxis | 10% |
| Photography | 11% |
| Any other activity not listed elsewhere | 12% |
| Catering, including restaurants and takeaways | 12.5% |
| Hairdressing or other beauty treatment | 13% |
| Management consultancy | 14% |
| Accountancy, IT consultancy, legal, labour-only building | 14.5% |
| Limited cost trader (any trade) | 16.5% |
Lower rates go to trades that usually spend a lot on stock or materials, because they would reclaim more VAT under standard accounting. Higher rates go to service trades with few costs.
The limited cost trader test
Since April 2017 you must use the 16.5% rate if you are a limited cost business. You are one if the goods you buy for the business, including VAT, are either:
- less than 2% of your VAT-inclusive turnover, or
- more than 2% but less than £1,000 a year (£250 a quarter).
Only goods count, and only goods used wholly for the business. These do not count:
- services of any kind, such as software subscriptions, phone contracts, accountancy, rent or advertising;
- capital items, such as a laptop, camera or machine;
- food or drink for you or your staff;
- vehicles, vehicle parts and fuel, unless you are in the transport business;
- goods for resale, leasing or hire that are not your main business, and gifts or promotional items.
Why most freelancers fail it
A consultant or developer typically buys software and services, not goods. Even with thousands of pounds of costs, their goods may be close to zero, so they must use 16.5%. You have to check the test every VAT period, and you cannot buy goods you do not need just to pass it.
- Turnover including VAT£72,000
- 2% of that£1,440
- Minimum goods to passThe higher of £1,440 and £1,000£1,440
Who gains and who loses
The same scheme gives very different results depending on trade and costs. All figures are for a full year.
| Business | Standard VAT | Flat rate VAT | Difference |
|---|---|---|---|
| IT contractor, £60k sales, £3k costs, £600 goods (16.5%) | £11,500 | £11,880 | Costs £380 more |
| Same, first year of registration (15.5%) | £11,500 | £11,160 | Saves £340 |
| Same, with £1,500 of goods (14.5%) | £11,500 | £10,440 | Saves £1,060 |
| Hairdresser, £80k sales, £12k costs, £4k goods (13%) | £14,000 | £12,480 | Saves £1,520 |
| Builder, £80k sales, £30k costs, £25k goods (9.5%) | £11,000 | £9,120 | Saves £1,880 |
| Shop, £100k sales, £60k stock (7.5%) | £10,000 | £9,000 | Saves £1,000 |
“VAT kept” is not the same as the saving: a business on standard accounting would also reclaim VAT on its costs. The builder keeps £6,880 of the VAT it charges but gives up £5,000 of VAT it could have reclaimed, so it is £1,880 better off.
What counts as turnover
The flat rate applies to your whole VAT-inclusive turnover, including zero-rated and exempt sales. Under standard accounting those sales carry no VAT at all, so a business with a mix of sales can lose out.
- Flat rate turnover
- £60,000
- Flat rate VAT at 12%
- £7,200
- Standard VAT
- £9,500
- Result
- Flat rate saves £2,300
- Flat rate turnover
- £80,000
- Flat rate VAT at 12%
- £9,600
- Standard VAT
- £9,500
- Result
- Standard saves £100
Sales to customers outside the UK, some books and children’s clothes are typical zero-rated sales that catch people out. If a large share of your sales are zero-rated or exempt, the scheme is unlikely to help.
Capital purchases
On the Flat Rate Scheme you cannot reclaim VAT on normal costs, but you can reclaim it on a single purchase of capital goods costing £2,000 or more including VAT, such as a computer, a van or a piece of machinery. You claim it on your VAT return in the usual way.
A £2,400 computer carries £400 of VAT, which you reclaim on either scheme. The rule applies to a single purchase: several smaller items bought together do not count unless they are invoiced as one item, and services do not count however large.
The first-year discount
If you join the scheme in your first year of VAT registration, you can take 1% off your flat rate until the day before the first anniversary of your registration. A limited cost trader pays 15.5% instead of 16.5%.
The discount is small, but for some freelancers it is the only year the scheme saves money. In the IT example above, 16.5% costs £380 more than standard accounting, while 15.5% saves £340. Diary the anniversary: once the discount ends, compare again and leave the scheme if it no longer pays.
Joining and leaving
- To joinExpected taxable sales of £150,000 or less
Before VAT, over the next 12 months. Apply online or when you register for VAT.
- While on itCheck the limited cost test every return
Use 16.5% for any period in which you fail it, and your trade rate in periods you pass.
- Must leaveIncome including VAT over £230,000
In the last 12 months, or expected in the next 30 days alone.
- After leavingWait 12 months to rejoin
You can leave voluntarily at any time, but you cannot come back for a year.
You cannot use the scheme if you are in the VAT margin scheme for second-hand goods or the capital goods scheme, or if you are closely associated with another business. HMRC’s Notice 733 lists every condition.
Income Tax on the VAT you keep
The difference between the VAT you charge and the flat rate VAT you pay is extra income for your business. It is added to your taxable profits.
For the builder in the examples, the £1,880 saving is taxed like any other profit: a sole trader paying basic-rate tax and Class 4 National Insurance keeps about £1,391 of it after 20% Income Tax and 6% National Insurance. Remember this when you compare schemes: the real saving is after tax.
How to decide
- Work out whether you pass the limited cost test. If you do not, compare at 16.5% (15.5% in year one).
- Add up a typical year’s costs that carry VAT, including the VAT.
- Compare the VAT payable under each scheme using the calculator above.
- Allow for the Income Tax on any gain and the time you save on bookkeeping.
- Recheck every year, or sooner if your costs or sales mix change.
As a rule of thumb, the scheme suits trades with a low flat rate and steady spending on goods, such as builders, shops and hairdressers. It rarely suits consultants, developers and other professionals after the first year.
Your VAT return on the scheme
On the Flat Rate Scheme your VAT return is simpler than under standard accounting, but a few boxes work differently:
- Box 1 shows the flat rate VAT: your flat rate percentage times your VAT-inclusive turnover for the period.
- Box 4 is usually zero, unless you are reclaiming VAT on a capital purchase of £2,000 or more.
- Box 6 shows your flat rate turnover including VAT, not the net figure most businesses use.
You still need to keep a record of your sales, the flat rate you used for each period and how you worked out the limited cost test. Keep your purchase invoices too: you need them for capital purchases and to show the goods figure behind the test.
Year one and beyond
The scheme can look attractive when you first register and less so a year later. For the IT contractor in the examples, with £60,000 of sales, £3,000 of costs and £600 of goods:
- Flat rate VAT
- £11,160
- Standard VAT
- £11,500
- Result
- Flat rate saves £340
- Flat rate VAT
- £11,880
- Standard VAT
- £11,500
- Result
- Standard saves £380
You can ask HMRC to take you off the scheme at any time, and the change normally applies from the start of a VAT period. Set a reminder for the first anniversary of your registration, rerun the comparison, and move to standard accounting if it now costs less. Make sure your invoicing software is ready to record VAT on purchases from the day you switch.