The VAT scheme you choose affects how much you pay HMRC and how you account for VAT on business costs.
Under standard VAT accounting, you deduct eligible purchase VAT from the VAT charged to customers. Under the Flat Rate Scheme, you usually pay HMRC a fixed percentage of your VAT-inclusive turnover.
The flat rate method looks simpler. However, it does not always produce a lower bill. Business activities, expenses, and your eligibility to benefit from the limited cost method are all factors that affect the outcome.
Make comparisons using both approaches using your own figures before deciding.
How standard VAT accounting works
Under standard accounting, you calculate the VAT charged on sales and subtract the VAT you are entitled to reclaim on purchases.
Suppose your business charges customers £5,000 in VAT during a quarter. It also pays £800 in recoverable VAT on business expenses.
The VAT payment is:
£5,000 − £800 = £4,200
Not all amounts declared as expenses by a business will be eligible for recovery. The purchase must fall under VAT recovery rules and usually requires an official VAT invoice. If there is a cost with private use included, you normally claim the business portion only.
How the VAT Flat Rate Scheme works
The Flat Rate Scheme changes how you calculate your payment to HMRC.
You still charge customers the correct VAT rate. For example, a business making standard-rated sales normally adds 20% VAT to its invoices. This flat rate percentage is used for the HMRC calculation and not as the VAT rate displayed to the customer. This will then be used on your total VAT turnover.
This distinction matters. A flat rate of 14.5% does not mean you retain 5.5% of your sales by subtracting it from 20%. The two percentages apply to different amounts.
You also generally cannot reclaim VAT separately on everyday purchases under the scheme. There is an exception for certain capital goods.
Which businesses can join the Flat Rate Scheme?
Your business must be VAT registered. The estimated VAT taxable turnover should be £150,000 or under, without VAT included, for the next 12 months.
Other restrictions apply. These include rules for businesses closely associated with another business and those using certain other VAT schemes.
You must apply to HMRC and use the agreed start date.
The joining limit is separate from the VAT registration threshold. If you are still deciding whether to register, read our guide to when a UK business must register for VAT.
Check whether the 16.5% limited cost rate applies
A business with low spending on qualifying goods must use the 16.5% limited cost rate, rather than its normal business sector rate.
For a normal quarterly VAT period, spending on relevant goods must meet both tests:
- At least 2% of VAT-inclusive flat rate turnover.
- At least £250, which is the quarterly equivalent of £1,000 a year.
The spending figure includes VAT. Falling below either threshold means the limited cost rate applies.
Which purchases count as relevant goods?
Relevant goods must be used exclusively for the business. Examples include stationery, cleaning products and stock bought for resale as part of normal trading.
Many common expenses do not count. Accountancy fees, rent, advertising services and software subscriptions are services. Capital equipment, such as a computer bought for long-term use, is also excluded from this test.
A business can therefore have substantial expenses and still be classed as a limited cost business.
You must check the position for each VAT return period. A business that qualifies for its sector rate in one quarter could fall within the limited cost rules in another.
Why the percentage needs careful attention
Your customer will pay £120 for each £100 of standard rate sales. At 16.5%, the flat rate payment is:
£120 × 16.5% = £19.80
This leaves only 20p out of the total 20 pounds VAT that has been collected in the first place.
Flat rate VAT vs standard VAT in practice
Consider two VAT-registered IT consultancies. Both have quarterly sales of £25,000 before VAT, and all their sales are standard-rated.
The normal flat rate for computer and IT consultancy is 14.5%, provided the limited cost rate does not apply.
These examples assume neither business receives the first-year discount. There are no qualifying capital purchases or other special VAT transactions.
| Quarterly figures | Consultancy A | Consultancy B |
| Sales excluding VAT | £25,000 | £25,000 |
| VAT charged to customers | £5,000 | £5,000 |
| VAT-inclusive turnover | £30,000 | £30,000 |
| Relevant goods purchased, including VAT | £800 | £100 |
| Total recoverable purchase VAT under standard accounting | £400 | £800 |
| Applicable flat rate | 14.5% | 16.5% |
| Payment under standard accounting | £4,600 | £4,200 |
| Payment under the Flat Rate Scheme | £4,350 | £4,950 |
| Lower VAT payment | Flat rate by £250 | Standard by £750 |
Consultancy A spends more than £600 on relevant goods, which is 2% of its £30,000 turnover. It also exceeds the £250 quarterly minimum.
Consultancy B fails the goods test. Its expenses mainly relate to services, so it uses 16.5% despite having more purchase VAT.
The purchase VAT figures include any recoverable VAT within the goods purchases. These are illustrative VAT comparisons before income tax or corporation tax.
How the first-year discount works
The eligible new VAT registrations will receive a deduction by 1% from their flat rate.
For instance, 14.5% will be reduced to 13.5%, while 16.5% will be reduced to 15.5%.
This deduction will be in effect for the first year after registering for VAT.
If you join six months after registering for VAT, only the remaining part of that first year qualifies.
Compare the figures after the discount ends as well as during the first year.
Can you reclaim VAT on equipment under the Flat Rate Scheme?
There is an exemption for one purchase of qualifying capital equipment costing £2,000 or more, including VAT.
For instance, a qualifying machine that costs £2,400, including £400 VAT, can be used to claim back that £400. The usual VAT recovery conditions must still be met.
This exception applies to qualifying goods used in the business. This does not include services, stocks purchased for resale, or items that will be consumed within a year.
Just because separate purchases have a total cost of more than £2,000 does not mean that they qualify.
The purchase must be assessed separately from the limited cost business test.
When standard VAT deserves a closer look
Standard accounting should be compared and contrasted with care in situations where the company is paying considerable VAT recoverable on its inventory, machinery, and services.
What matters here is the VAT that you can reclaim, not the total amount spent. Some costs will have no VAT at all, while some will have VAT that is limited or non-recoverable.
Your sales mix also matters. In most cases, flat-rate turnover includes both zero-rated and exempt sales. This implies that the calculation may include sales where VAT was not charged.
For a business with these sales, comparing only standard-rated invoices would give an incomplete result.
Review the scheme as your business changes
The £150,000 joining limit is not an automatic exit threshold.
The business is required to leave the scheme when its VAT-inclusive sales are above £230,000 during the anniversary review of the scheme. Another rule of exit may be applied if the anticipated turnover in the next 30 days is more than £230,000.
You may also leave voluntarily if any other alternative proves more suitable for the business. Tell HMRC and obtain confirmation of the leaving date. You normally have to wait 12 months before rejoining.
Keep cash flow in mind too. Under ordinary invoice-based accounting, VAT can become payable before a customer pays. Eligible businesses can consider cash accounting, while the Flat Rate Scheme has its own cash-based turnover method.
Whichever method you use, VAT records still matter. Making Tax Digital requirements continue to apply unless the business is exempt.
Choosing a VAT scheme for your business
Start with a representative quarter of sales and purchases. Check your sector rate, apply the limited cost test and calculate the payment under both methods.
Then consider planned spending, the end of any first-year discount and expected growth. A scheme that suited your business at registration might produce a different result later.
RMA Accountants can examine these figures and assist you with determining the VAT accounting method that is best for you. Book a meeting to discuss which approach fits your business.
