The Appeal and the Hidden Trap
The VAT Flat Rate Scheme was introduced to simplify VAT accounting for small businesses. Instead of calculating the difference between VAT charged on sales and VAT reclaimed on purchases, a business on the scheme applies a single flat percentage to its gross turnover and pays that amount to HMRC. For many service businesses with low input costs, this can result in a financial benefit compared with the standard method, as they pay less VAT than they collect.
The problem is that HMRC tightened the scheme significantly in April 2017 by introducing the limited cost trader category. Businesses that spend less than two percent of their gross turnover on goods, or less than 1,000 pounds per year on goods, are classified as limited cost traders and must use a flat rate of 16.5 percent regardless of their sector. For a business on the scheme that falls into this category, the financial benefit largely disappears.
How the Flat Rate Percentages Work
The flat rate percentage depends on the business sector. A management consultancy uses 14 percent, a computer repair business uses 10.5 percent, and a catering business uses 12.5 percent. The percentages are set by HMRC and applied to the gross, VAT-inclusive turnover figure. The difference between the VAT collected from customers at 20 percent and the amount paid to HMRC at the flat rate represents the amount the business retains. HMRC publishes the full list of flat rate percentages for each sector on the VAT Flat Rate Scheme guidance page.
Under this scheme a business does not reclaim VAT on purchases separately except in one specific circumstance: where a single capital item costing over 2,000 pounds including VAT is purchased, VAT can be reclaimed on that item outside the scheme. For most service businesses with minimal equipment costs, this exception rarely applies.
Determining Whether You Are a Limited Cost Trader
The limited cost trader test must be applied to each VAT period individually, not just once when joining the scheme. If your goods spending falls below the threshold in any quarter, you must use the 16.5 percent rate for that quarter even if you were above it in previous periods. The goods definition is specific: it excludes food and drink consumed by the business, vehicles and fuel unless the business is in transport, and capital expenditure items.
This means that a marketing consultant who buys stationery and printer paper but has no other goods costs will almost certainly be a limited cost trader in every period. The amount of VAT retained under the 16.5 percent rate is negligible compared with the standard scheme, making scheme membership pointless or even costly once the administrative overhead is considered.
When the Flat Rate Scheme Still Makes Sense
For businesses with genuine, regular goods purchases that keep them above the limited cost trader threshold, the scheme can still offer a useful financial benefit and significant administrative simplicity. A small retailer, a trade business buying materials, or a food business buying stock may find the scheme worthwhile. The key calculation is comparing the VAT retained under the flat rate against the VAT that would be reclaimed under the standard scheme, net of any additional accounting cost.
If you are unsure whether the scheme is working in your favour, the simplest approach is to run the numbers for the last four quarters under both methods. Our bookkeeping services include VAT analysis as part of the monthly work, so this comparison is available without additional effort.
Leaving the Flat Rate Scheme
A business can leave the scheme voluntarily at any time. If turnover exceeds 230,000 pounds including VAT, exit becomes compulsory. Leaving requires written notification to HMRC and takes effect from the start of the next VAT period after notification is received. Once outside the scheme, standard VAT accounting applies from that point forward.
Getting VAT accounting right from the moment you leave the scheme requires accurate purchase records that may not have been maintained in detail while on the flat rate. Our outsourced bookkeeping service ensures the transition is handled cleanly without gaps in your VAT records.
About the Author
Stuart Kerr is Managing Director of Bookkeeping Packages Ltd, an outsourced bookkeeping service supporting UK small businesses and accountancy practices. With over 20 years of bookkeeping experience, Stuart specialises in helping businesses maintain accurate records and management accounts. Stuart is a bookkeeper, not a regulated financial adviser. Nothing in this article constitutes tax or financial advice. Call 0161 531 0087 or visit bookkeepingpackages.co.uk.
The information in this article is provided for general guidance only. Stuart Kerr is a professional bookkeeper, not a regulated financial adviser. This content does not constitute tax or financial advice. For advice specific to your circumstances, please consult a qualified accountant or tax adviser.
By Stuart Kerr, Managing Director, Bookkeeping Packages Ltd