If you’re going through the process of setting up a limited company for your freelance business, your accountant may well ask you to choose between the normal VAT scheme and the Flat Rate VAT scheme.
It should be pointed that they you will only have to register for VAT of you’re revenue will be above the threshold over which VAT registration is mandatory.
You might be unclear which of these two VAT systems work, so let’s look at how these two VAT rates work.
What is VAT?
Firstly you need to understand what VAT is.
VAT is a tax on consumption.You sell something for £x, and if you are VAT-registered, you are obligated to also charge VAT on top, at a rate determined by what the supply or goods are (essentially).
You then collect that tax for HMRC and declare it via a VAT return.
So, you sell services for £100. The VAT due on a standard rated supply of £100 is 20% of that which is £20, so you need to collect £120 from your client.
You declare your sales to HMRC, how much tax was due on it, and pay it over.
Separately, VAT registered traders can sometimes reclaim what is called “input tax”.
The point of VAT is a tax on consumption, not a tax on the intermediate steps.
So if you “input” something into your business, you shouldn’t be paying VAT on it.
But, for the purposes of enforcement, collection and statistics, every tax authority in the world that has a value-added / goods-services / consumption tax, uses what’s called the invoice method – except for one, Japan, which uses the subtraction method.
How is VAT calculated?
VAT is calculated per invoice and transaction, so you have to pay it when you buy anything.
But, you also then declare that tax paid (which is why you get VAT receipts) to HMRC as “input tax”, and that is subtracted from your “output tax” (the tax you charge) – so when you come to pay it, it “balances out”.
Ultimately from a tax authority’s point of view, only the end consumption has actually been taxed, as each payment of VAT in the chain has been cancelled out by a reclaim of input tax on any tax return.
Now – the flat rate. HMRC also think that for many small businesses, that’s a bit too much hassle, to go through everything and do it exactly.
Under the flat rate, you charge your normal rate – 20%, and without having to reclaim all the input tax exactly, they simply ask you to pay over a flat rate.
That changes between sectors.
So say your flat rate was 14%. You’d be charging, £20 of VAT on your £100 sale, but when it comes to pay HMRC, instead of claiming back all the input tax in the period alongside all your sales for the period, you’d only be paying back 14% of the £120 = £16.80
Normal VAT Rate
Normal VAT means that you charge the customer 20% on top of your invoice price ie You invoice them for 100£ + 20£ VAT (20£).
The total your customer pays you is 120£. And you pay 20£ of that to the Taxman.
However when the company buys anything that has VAT added (ie most stuff) you get to claim this back from the taxman.
So if your company makes a 120£ purchase you can claim 20£ back from the Taxman.
Flat Rate VAT
Flat rate is slightly different, you still add 20% to any invoice you write for a customer.
However you only have to pay your arranged Flat Rate to the Taxman and this flat rate depends on what service you provide. ie a computer repair shop will have one agreed flat rate and a hairdresser another.
The rates are listed here: https://www.gov.uk/vat-flat-rate-scheme/how-much-you-pay
But if the company buys anything with VAT added you cannot claim it back from the Taxman.
So you gain on the difference between the 20% you charge and the reduced flat rate you pay to the Taxman, but you lose on the VAT reclaim.
Which VAT rate is best for you?
If you don’t plan on buying anything much maybe the flat rate is better for you.
You will need to think carefully about your company costs before making a decision.