VAT registration and the flat rate

Disclaimer: I’m not an accountant, this is not tax advice, this contains assumptions and simplifications. Also, apologies to the accountants I know for mangling accounting theories and terms.

When the time comes to register for VAT, there are two schemes available to register for: The standard VAT scheme, and the flat rate VAT scheme.

The purpose of VAT is for HMRC to charge tax on all the value you add in the course of your business.

The standard rate VAT scheme requires you to charge VAT on all your sales, and in return you can reclaim VAT on all your purchases. This requires you to keep track of the VAT on your expenditure. At the end of this exercise, you should have collected VAT on behalf of HMRC equivalent to your expenditure less your purchases. You then pay this difference to HMRC.

The flat rate scheme is supposed to be simpler. This requires you to charge VAT on all your sales, and you then pay a proportion of your VAT-inclusive turnover to HMRC. The proportion you pay depends upon your industry. For IT consultancy this rate is 14.5%, and for your first year there is a 1% discount on the rate you pay.

At first glance, the flat rate scheme sounds attractive. 14.5% is certainly less than 20%, so it sounds like an incentive to go on the simpler scheme. A 1% discount sounds like an additional bonus. So what are the downsides of the flat rate scheme? The biggest difference is that you aren’t able to reclaim the VAT on your expenditure (except for certain capital purchases over £2000, but let’s try and keep this simple). So which scheme should you choose? Let’s work out which is better.

First, let’s make some assumptions and definitions:

  • All our example company’s expenditure will be VAT rated at 20%
  • All our example company’s sales will be VAT rated at 20%
  • The flat rate is 14.5%
  • There is no capital expenditure on which VAT is reclaimable
  • We’ll call our gross sales figure S
  • We’ll call our gross expenditure figure E
  • We’ll call our profit P, this being the value we’re left with after selling our goods & services, paying our expenditure, and dealing with VAT. Pf is profit on the flat rate scheme, Ps is profit on the standard scheme.

On the flat rate scheme, we charge VAT on our sales (S), we pay VAT on our expenditure (E), and we get to keep 85.5% of our sales-plus-VAT.

Pf = (S * 1.2) * 0.855 – E * 1.2

On the standard scheme, we get all the VAT on our expenditure back, and while we charge VAT on our sales, we don’t get to keep it!

Ps = SE

So how do these schemes compare in two extreme scenarios: When a company has no expenditure, and when a company’s expenditure is equal to its sales?

When we have no expenditure (i.e. E = 0):
Pf = S * 1.2  * 0.855 = S * 1.026
Ps = S

So in this contrived scenario the flat rate scheme is equivalent to a 2.6% income bonus! What about when expenditure is equal to sales (i.e. E = S)?

Pf = (S * 1.2) * 0.855 – S * 1.2 = -0.174 * S
Ps = SS = 0

So in this scenario the flat rate will leave you 17.4% worse off!

A consultant will at first glance appear to be closer to the first scenario than the second, as there are no goods being resold to lose VAT on. However, it’s not like there is no expenditure, such as accountants, telephone costs, hotel costs.

So the next question for enquiring minds is at what expenditure/sales ratio are the two schemes equal? Knowing this ratio will allow us to estimate what our own future ratio might be, and therefore which scheme might be better for us.

So if the expenditure/sales ratio, E/S = x, we want to solve x where Pf = Ps.

E/S = x
E = S * x

Pf = Ps
(S * 1.2) * 0.855 – E * 1.2 = S – E
(S * 1.2) * 0.855 – S * x * 1.2 = S – S * x
1.2 * 0.855 – x * 1.2 = 1 – x
1.2 * 0.855 – 1 = x * 1.2 – x
0.026 = x * 0.2
0.13 = x

So for any expenditure/sales ratio below 0.13 we expect the flat rate scheme to be more beneficial for us, up to 2.6% better than the standard scheme.

For any expenditure/sales ratio above 0.13 we expect the flat rate scheme to be worse for us.

Hopefully this will help others decide which scheme may be better for them, and there is enough information to adjust for different flat rates for different industries and introductory discounts.

Happy VATting!

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